Submitted by Eric Peters, CIO of One River Asset Management

Three Worlds

“America’s yield curve inversion can mean one of three things,” said the CIO. “We’re either living in a world of secular stagnation and investors worry that central banks no longer have sufficient policy tools to spur growth and inflation,” he continued. “Or the economy is simply sliding toward recession and the inversion will persist until the Fed panics and spurs a recovery,” he said. “Or we’re living in a world, where the market is moving in ways that defy historical norms because of global QE. And if that’s the case, the curve is sending a false signal.”

“If we’re sliding toward recession, then it seems odd that credit markets are holding up so well,” continued the same CIO. “So keep an eye on those,” he said. “And if the curve is sending a false signal due to German and Japanese government bonds yielding less than zero out to 10yrs, then the recent Fed pivot and these low bond rates in America may very well spur a blow-off rally in stocks like in 1999.” A dovish Fed in 1998 (post-LTCM) and 1999 (pre-Y2K) provided the liquidity without which that parabolic rally could have never happened.

“But if investors believe America is succumbing to the secular stagnation that has gripped Japan and Europe, and if they’re growing scared that global central banks are no longer capable of rescuing markets, then we have a real problem,” said the CIO. “Because a recession is bad for markets, but not catastrophic provided that central banks can step in to spur recovery. But with global rates already so low, if investors lose faith in the ability of central banks to do what they have always done, then we’re vulnerable to a stock market crash.”

Sovereignty:

Turkish overnight interest rates squeezed to 300% on Monday. Then 600% on Tuesday. By Wednesday, they hit 1,200%. Downward pressure on the Turkish lira, and the government’s efforts to punish speculators fueled the historic rise. Erdogan allegedly wants to limit lira loses ahead of today’s elections. The pressures that drove the currency lower were mainly of Turkish origin. Of course, the Turks have every right to their own economic policies, but they must bear the consequences. That’s what comes with being a sovereign state.

The Greeks and Turks are neighbors. The Turks began negotiations to join the EU in 2005, with plans to adopt the Euro after their acceptance. Those negotiations stalled in 2016. As they look across the border at their Greek neighbors now, and see their interest rates stuck at -0.40%, are they envious? Perhaps. But having witnessed the 2011 Greek humiliation, would the Turks be willing to forfeit sovereignty for the Euro’s stability and stagnation? And how do the Greeks (and Italians) feel about having forfeited their sovereignty?

Anecdote:

“Only optimists start companies,” I answered. The Australian superannuation CEO had asked if I’m an optimist or pessimist. “I see the potential for technological advances to produce abundance in ways difficult to fathom. But I also see the chance of something profoundly dark,” I continued. He observed that people seemed consumed by the latter but spend so little time on the former. “That’s good. Humans are wonderful at solving problems of our own creation. The more we worry, the less goes wrong,” I said. So he asked what worries me most?

“Not the displacement of human labor by machines, we can solve the resulting social challenges. I worry that the only thing Americans seem to agree on now is that China is our adversary.” And pressing, he asked me to list the things I admire about China. “Okay. I admire China’s work ethic, drive, ambition, economic accomplishments. They’ve overtaken us in many advanced scientific fields. I admire that very much.” He smiled and asked me to carry on. “I’m grateful for their competition. It makes us better. And I admire that they’ve evolved communism to make it work while all others failed. The world is better with diversity of thought, philosophy – diversity increases resiliency, robustness. And democratic free-market capitalism will grow stronger with a formidable competitor.” He smiled.

“But China’s system values the collective over the individual. We value the opposite. And I’m concerned the two systems cannot peacefully coexist now that we’re the world’s two largest economies. I don’t want to live under their system, I don’t want their vision of the future for my children. They probably feel the same way. Both views are valid but incompatible, and increasingly in conflict,” I explained. He nodded and said, “I don’t want that for our children either."