Four Flashpoints of Volatility

1 – Trade Wars Flashpoints, From China to Canada and Mexico

Wall Street has knee-jerk reactions to any trade war related headlines.

There are legitimate reasons to be concerned about trade wars. The world is increasingly more connected than ever. Many major American companies that are household names such as Starbucks (SBUX), Boeing (BA) and Apple (AAPL) rely on their exports (and imports) from China for a sizable portion of their overall sales and profits.

If China continues to retaliate against trade war policies from the U.S. with harsh measures of their own, it could hurt revenues of those firms.

But, here’s the latest revelation:

China wants to keep more of what it makes — in China — across a variety of sectors. Trade wars elevate the Chinese government’s desire to do that. The country has just recently launched a new $1.6 billion initiative called “Made in China 2025.”

The strategy entails an increase in research and development spending. That would cause Chinese companies to rely less on international technology and equipment. The more China buys internally, the less it will buy American products or need to export to the U.S.

What all of that could mean is that similar products in the U.S will become more expensive for consumers. That would hit directly at stock of those companies, making them more volatile.

While headlines from the White House continue to target China, our regional trading partners are undoubtedly some of the most important, and currently some of the most fragile.

To the north, Canada is playing up its optimism over NAFTA talks. Rhetoric is one thing, reality is another. It’s important to look at what institutions are doing, not what they’re saying.

Canada is currently enhancing its participation in several other trade agreements, including an updated Trans-Pacific Partnership that does not include the U.S. In the wake of Brexit, Canada has also made important trade links to both Europe and the U.K.

That means it could shift its trade focus away from the U.S., while purchasing fewer American goods. All of that could hurt manufacturers in both countries and increase volatility into the share prices of companies involved.

Southward, Mexico is taking the risks of NAFTA talks going wrong seriously. The threat of failed NAFTA negotiations is considered the greatest threat to the Mexico Peso in 2018, according to a survey conducted by Bloomberg of 100 foreign exchange professionals gathered for a recent event in Mexico City.

If financial anxiety builds, a trade war could ignite a currency war. That would cause central banks to protect or position their currencies in order to fight a trade war, inflicting a pattern that elevates volatility on the markets.  Expect trade war headlines and related action to pump up and tear down the markets on any given day.

2 – Geopolitical Flashpoints

The U.S. could attack Syria any minute now in response to its alleged chemical attack against civilians last weekend. Russia has warned Washington that it would face “grave consequences” if Russian military personnel in Syria are harmed in any attack.

Needless to say, any armed conflict between two nuclear powers carries great potential risk. One single incident could trigger an escalating spiral. But it’s not just Syria.

Since President Trump took Washington by storm, the elephant in the room has been the nuclear threat on the Korean Peninsula. When North Korean leader Kim Jong-un took a heavily guarded train to Beijing for what Western media dubbed a “surprise visit,” the markets went into a rally, and then a correction.

The rally was based on the notion that the visit would forge a truce in favor of the U.S. and cause both parties to back down from aggressive saber-rattling.

The tailspin was based on the interpretation that it meant Kim Jong-Un was cozier with China than President Trump believed. Concerns built that this could cause more trade and other agreements between the two nations, excluding the U.S. even further.

Now that President Trump has John Bolton as his National Security Advisor, the geopolitical flashpoint has increased even further. On Feb. 28, Bolton published an op-ed in the Wall Street Journal supporting a pre-emptive nuclear strike against North Korea.

That gives us an insight into what policy recommendations President Trump might be provided with now.

Even the perceived threat of a diplomatic fallout and rumors of a military response can elevate volatility. War games between the U.S. and North Korea would be an expected recoil — and that would mean uncertainty over China’s response.

That would give greater rise to volatile conditions in trade, regional security and stability on the Peninsula. By isolating China — North Korea’s top economic partner and military alley — tensions would only escalate.

3 – Stock Buybacks Flashpoints 

In order to have volatility, you need positive moves to counteract negative ones. Stock buybacks are on the positive side. When companies buy their own stock in huge amounts, it serves to push up the share prices, which in turn lifts investors’ confidence to also buy their stocks. As a result, these measures push prices up even higher.

In the U.S., the Dow Jones finished 2017 up 28.11% adjusted for dividends (compared to 16.47% adjusted for dividends in 2016.). Despite President Trump taking credit for this rally (as President Obama did for rallies during his presidency), stock markets were actually bolstered by $21 trillion injected from global quantitative easing policies.

Access to that money fueled a record amount of stock buybacks for major companies and banks. They could borrow money cheaply, pile on more debt, and use that debt to buy their own stock. Share buybacks in 2018 have averaged $4.8 billion per day, double the pace from the same period last year.

This had the effect of artificially inflating stock prices. In February, my former employer, Goldman Sachs, indicated that S&P 500 firms would return $1.2 trillion to shareholders via buybacks and dividends in 2018. We see this pattern continuing and acting as a positive counter balance to any of our negative volatility flashpoints.

4 – Washington Political Risk Flashpoints 

Remember, it’s not volatility without both positive and negative factors. The most recent, CNN poll showed that 42% of those surveyed approved of Trump. That’s his highest approval level since his first 100-day mark.

Though, that remains comparatively below Trump’s modern-era predecessors, it’s still an indicator of added support for the president’s policies. The passage of the $1.3 trillion budget and tax cuts increases the deficit and U.S. debt burden while alleviating volatility, but the long-term repercussions could raise it further.

Why does that matter?

Because midterm elections are this November. The way in which the country views Trump can (and will) rise or fall by the time elections come. However, if Republicans were to lose both the House and Senate, the U.S would be caught up in more political instability and potentially, impeachment hearings.

That harms market stability. It would also mean even less would get accomplished in Washington.

I’m in D.C. often. Since President Trump took office, I have personally met with more Republicans than Democrats to discuss financial and economic policy — my expertise. One of my favorite Congressmen, from a Southern state, recently told me, “All this stuff — it just makes your head spin right off. Try getting anything done.”

That signals that markets are being left in the dark to guess what happens next. Uncertainty breeds contempt. That’s why volatility is here to stay, at least through the mid-term elections in November.

As any rollercoaster ride goes, fasten your seat belt and keep all arms and legs in the vehicle. With the first three months of 2018 behind us, it is clear that this year will be very different from the last.

Regards,

Nomi Prins
for The Daily Reckoning