For those who subscribe to the "sell in May and go away" adage, now is your last chance. Monday was a bank holiday in the United States and the U.K. leaving trading volumes lite globally, however, this week will be heavy on predictors for the summer season. With an early election in the U.K. slated for next week and shifting alliances between global powers imminent, now appears a risky time to be invested in global markets. As U.S. markets have continued to rally despite domestic political uncertainty, Chinese markets have also remained relatively resilient in the face of their first ratings downgrade in 30 years.
In a campaign stop made in Munich on Sunday, German Chancellor Angela Merkel said, "The era in which we could fully rely on others is over to some extent. That's what I experienced over the past several days." Referring to meetings with President Trump last week, Merkel was dismissing the decades-old relationship that the United States, the United Kingdom, and Germany have had post-WWII. With the U.K. leaving the European Union and Trump making clear that Germany should be prepared for a balancing of the trade deficit between the two countries, Merkel had no choice but to hit back at both countries.
Trump's insulting Oval Office meeting with Merkel in March was only a preview of what the U.S. president had in store for Germany and the European leaders. Trump not only scolded NATO members at a meeting of alliance members, he also set the tone for trade with Germany in the coming years. With the ECB balance sheet already very bloated, a complete lack of inflation, and slow downward growth across the region, the euro's rally in the past month has been surprising. The common currency's rally appears to be exclusively the work of continued political uncertainty in the United States. As I explained in my column last week, while an impeachment of Trump would be devastating for the United States financial markets, it is very unlikely. So why the euro rally and will it last? Not likely.
China's Shanghai and Shenzhen composite indexes dismissed Moody's first downgrade of Chinese local long-term and foreign currency debt in 30 years last week. The downgrade from Aa3 to A1 means virtually nothing for the Chinese economy today as both ratings are investment grade and the Chinese economy is one of the only reliable growth engines globally. The real question is, is this downgrade a signal of things to come? Can the Chinese government continue to intervene in its real economy as much as it has in its financial markets without negative repercussions? As long as there is no collapse in global demand for Chinese goods and domestic demand continues to increase, the Chinese may be able to use debt to fuel their economy for the foreseeable future. The mini-devaluation that the yuan has experienced may have helped Chinese exports but further decrease in value of the yuan will lead to panic in China itself and make the quasi-peg that exists now difficult to hold, especially if the government will return to a more rigid peg.
On Monday, the Federal Reserve's San Francisco president, John Williams, signaled continuing tightening by allowing the debt on the Fed's balance sheet to mature at a conference in Singapore. Beginning this year, Williams outlined a five-year period in which the $4.5 trillion Fed balance sheet will be decreased saying the balance sheet will become "much much smaller." Should the Fed allow debt it currently holds to mature, this will be a de facto interest rate hike and will make borrowing costs higher. Such a move would mean the Fed believes both unemployment and inflation are in line with Fed targets. If the targets have been met, then this would signal further hikes in the Federal Funds Rate target. This should end the euro rally against the dollar as well as cause the U.S. dollar to rally against other foreign currencies. Is the U.S. economy prepared for a stronger dollar and higher interest rates? I think such moves would be premature.
On Monday, ECB President Mario Draghi also spoke and said that "some of the tail risks have receded measurably," and reiterated his view that downside risks are diminishing in the eurozone. The ECB also holds a $4 trillion balance sheet, yet has not signaled it would begin allowing its holdings to mature as the Fed has. Perhaps this is a signal of the weariness of the ECB versus the Fed and may signal dollar strength in the future.