Trade war with China, rising tension with Iran – markets just don’t care

Donald Trump © Getty Images
Trump: first a trade war, now an actual war?

This article is taken from our FREE daily investment email Money Morning.

Every day, MoneyWeek's executive editor John Stepek and guest contributors explain how current economic and political developments are affecting the markets and your wealth, and give you pointers on how you can profit.

Sign up free here.

If markets really reflected geopolitics, then this week would have been a pretty brutal one for stocks.

On the one hand, the trade dispute between China and the US is only getting worse. On the other, there’s been a significant ratcheting up in tensions in the Middle East.

And yet, having had a bit of a wobble at the start of the week, stockmarkets look on course to end this week roughly where they were this time last week.

Get this – even Uber is getting close to rising back above its IPO price.

What on earth is going on?

It’s not been a good few weeks for global peace and love

A couple of weeks ago, everyone thought a trade deal between the US and China was simply a couple of signatures away. Today, it’s anyone’s guess and it only looks likely to deteriorate.

Then there’s the fact that – while I don’t want to speak too soon – it does look worryingly as if at least some members of the US government have entirely forgotten about the mess of Iraq and are now spoiling for a fight with Iran.

Maybe everyone is over-egging it, but put it this way – there’s a headline on the BBC website this morning: “Is the United States heading for war with Iran?” So that’s not reassuring.

Oh and almost an afterthought – Italy looks as though it’s kicking off with the EU again. That doesn’t feel like a big deal in the grand scheme of things, but in fact it is the one conflict most likely to lead to a break-up of the euro in the long run, so I suppose we should be paying attention to that too.

So, all in all, not a great week for global peace and harmony.

What’s the market’s reaction?

“Hey – you know how we sold off Uber early in the week? Maybe we were too hasty. Maybe they’ll set up a division delivering Beyond Meat burgers in self-driving Teslas to hungry vegans. Gah, buy before it’s too late!”

In other words, oblivious.

Relax – the Fed will sort it

What’s at the heart of the market’s relaxed state of mind?

I think it boils down to something I mentioned earlier in the week – we’re shifting towards a “bad news is good news” environment again.

On Wednesday, CNBC pointed out that GDP growth for the second quarter of the year in the US looks like it’ll be a lot weaker than in the first quarter. Retail sales for April were disappointing, while industrial production was also weaker than expected.

As a result, markets are now betting on the Federal Reserve  – America’s central bank – stepping in to cut interest rates by September this year. Futures markets – which reveal which way the market is betting on interest rates – were pointing to a 51% chance of a cut by September, and an 80% chance of one by January next year.

That’s quite the vote of no confidence.

Now, to be clear, the Fed has shown no sign as yet of planning to cut rates. I mean, remember that it’s only been a few short months since the Fed was insistently pushing rates higher.

But if markets are already convinced that Jerome Powell and chums will swing in to the rescue, then the worse the data gets, the closer the rate cuts will come. In turn, markets will anticipate the joys of more easy money, and act accordingly.

Markets are assuming far too much

This faith in central banks is impressively strong, but given the last ten years we’ve had, that’s no surprise. Every bump in the road over the last decade has been met with money printing, and so far it has worked (if your definition of “worked” is avoiding a 20% drop in the US stockmarket).

And this is the problem with markets. They grow too accustomed to things. We assume that tomorrow will be the same as today, because yesterday was the same as the day before that.

This confidence grows with every day that the market behaves as we expect. “Buy the dip” keeps on working, so we keep on doing it.

Meanwhile, the backdrop can be deteriorating steadily, even as the confidence in the market continues to build. There’s still an assumption that all of this will blow over. That we’re not seeing a significant change in the global economic and political backdrop. That things will be just fine.

Maybe they will be. And to be clear, markets have weathered far greater storms of change. We have a terrible tendency to assume that our present situation is a unique age of uncertainty, when in reality, human beings deal with uncertainty all the time – that’s our default setting.

The real problem as far as I can see is that the market is already overpricing an “all is well” outcome. When this over-optimism eventually collides with reality – in the form of a problem like inflation or restrictions on capital flows, that a central bank can’t just wash away in a flood of money – then it could get very messy.

Stay diversified.