There are four primary drivers behind Monday's market weakness. Some are directly linked to the clown show in Washington, D.C., while others have causes of their own.
Friday's congressional failure to pass U.S. President Donald Trump's health care reform bill is sociologically important on its own, but for investors the apparent political dysfunction – which raises fears that market-friendly corporate tax cuts and infrastructure spending will also fail to become reality – is the real threat to future returns. Bloomberg cites Citi research to underscore this point, "Although tax reform appears to have broader support and may be easier to pass, the AHCA [American Health Care Act] experience sends investors a cautionary message about opposing factions within the GOP caucus," Citigroup Inc. analysts wrote.
Bond markets have been consistently signalling skepticism about future U.S. economic growth in recent weeks. Economic optimism initially caused higher five- and 10-year Treasury bond yields to surge higher, and huge speculative short positions were amassed on these bonds in futures markets. At least in the past few trading sessions, investors are finding returns in bonds more attractive than equities.
Since March 13, however, bond markets have rallied. The 10-year yield has fallen from 2.62 per cent to 2.35 per cent and the five-year yield has fallen 24 basis points. Speculative investors are now scrambling to cover their shorts, driving bond prices higher and yields lower. In general, lower bond yields indicate slower growth expectations. But at least in the past few trading sessions, investors are finding returns in bonds more attractive than equities, and allocating their assets accordingly.
The U.S. dollar, measured by the trade-weighted dollar index, has dropped 5.1 per cent from the 2017 highs, and weakness in the Russell 2000 index of domestic-facing U.S. smaller companies, are two more signs that U.S. growth expectations are being adjusted lower, and the belief that the American economy can re-take global leadership is waning.
Weaker crude and copper prices have drivers of their own beyond Washington. In the first case, the oil price is heading lower as mistaken speculative optimism is reduced. Hedge funds had built record long positions in crude futures markets, only to be confronted by stubbornly high U.S. inventory levels (thanks to rising shale production) that caused the commodity price to stagnate. The removal of these bullish trades continues to weigh on the spot price.
Copper markets are affected by both economic growth expectations and market supply. The copper price appreciated 32 per cent between October, 2015, and February of this year as part of the reflation trade. The rally intensified because as labour action interrupted supply from Chile's Escondida mine, the world's largest, and also as a result of a dispute between the Indonesian government and Freeport McMoran Inc., which limited exports from the world's second-largest producer of copper concentrates.
These disputes have now ended at a time when inventory levels remain high, creating excess supply and lower commodity prices.
Political incompetence has combined with separate issues in commodity markets to create weaker asset markets. It is not, however, time to panic in my opinion. The Citi Economic Surprise Index, which measures developed and emerging market economic growth relative to consensus expectations, continues to soar higher. Morgan Stanley analysts note that the synchronized strength in emerging markets and first world economies has not occurred since 2010.
Market weakness is never fun for investors but it looks very much like we're looking at a re-calibration of expected growth, with the most bullish global investors having to pull in their horns, rather than the beginning of an extended equity bear market.
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