Markets Are Unprepared For A Government Shutdown

Authored by James Rickards via The Daily Reckoning,

Will Republicans and Democrats agree on a budget, and avoid a government shutdown after midnight Friday?

I’d say the odds are 50/50. Actually, I put the odds of a shutdown at about 55%. There’s certainly enough substance here to be wary.

The government could shut down because of disagreements over defense spending, funding for Trump’s wall with Mexico, deportation of illegal immigrants brought to the U.S. as children (the “Dreamer Act” also referred to as “DACA”), funding for Planned Parenthood, funding for Obamacare (called “SCHIP”), disaster relief and more.

There’s not much middle ground between Democrats and Republicans on many of these hot button issues.

How would a shutdown affect the Fed’s plans to raise rates on the 13th?

If an agreement can’t be reached and the government does shut down, it’s very difficult to imagine that the Fed would go forward with its planned interest rate hike on Dec 13.

Meanwhile, markets are almost certain the Fed will raise rates. It’s already “baked into the cake.”

The euro, yen, gold and Treasury notes are all fully priced for rate hike. If it happens, those instruments won’t change much because the event is priced.

But we could see a violent market reaction if Janet Yellen stays put and doesn’t raise rates.

If the Fed doesn’t raise rates, gold could soar as the Fed passes on its best chance to raise rates and markets perceive that easy money is here to stay. Euros, yen and Treasury notes will also soar.

Of course, saying the government could shut down is different than saying the government will shut down. Again, I give it about a 55% chance at this point.

And there are lots of ways for things to go wrong.

Late last week the Commerce Department released the October PCE core inflation data. This is important because that’s the number the Fed watches. There are plenty of other inflation readings out there (CPI, PPI, core, non-core, trimmed mean, etc), but PCE Core year-over-year is the one the Fed uses to benchmark their performance in terms of their inflation goal.

The Fed’s target for PCE Core is 2%. The October reading was 1.4%. For weeks I’d been saying that a 1.3% reading would put the rate hike on hold, and a 1.6% reading would make the rate hike a done deal. So, the actual reading of 1.4% was in the mushy middle of that easy-to-forecast range.

What’s interesting is that the prior month was also 1.4%, so the new number is unchanged from September. That’s not what the Fed wants to see. They want to see progress toward their 2% goal.

On the other hand, the 1.4% from September was a revised number. It was earlier reported at 1.3% (the same number as August).

You can read this two ways. If you see the August 1.3% as a low, then you can say the 1.4% readings for September and October were progress toward the Fed’s 2% target. It’s a thin reed, but Yellen could use this to justify her view that the year-long weakness in PCE Core is “transitory.”

On the other hand, these 0.1% moves month-to-month are really statistical noise and may even be due to rounding. The bigger picture is that PCE Core is weak and nowhere near the Fed’s target. Another rate hike in December could be a huge blunder if it slows the economy further and leads to more weakness in PCE Core.

On balance, the PCE Core number is probably just enough (barely) to justify a rate hike. I’ve raised my probability of a December rate hike from 30% to just over 50% — 55%. That’s what analysts are supposed to do; they update forecasts continually based on new data. You can’t be stubborn about your analysis.

I’m not trying to be “in consensus” or “out-of-consensus.” I just want to get it right, and that means sometimes I’ll be in consensus. Other times, I won’t be.

But you should forget how the market is pricing the outcome. The Fed funds futures market has been off by orders of magnitude before. In mid-February 2017, the futures markets gave the odds of a rate hike in March at 30%.

I was giving 80% odds.

Within three trading days at the end of February, the market odds shifted from 30% to 80% before converging at 100% by the March meeting.

That does not mean I’ve got it right this time. But it does illustrate that the futures market does not always get this right — not even close.

And markets are being set up for a fall.

Bull markets in stocks seem unstoppable right up until the moment they stop. Then comes a rapid crash-and-burn phase.

Is there ever any warning that a collapse is about to happen?

Of course there is. Analysts warn about it all the time and provide mountains of data and historical evidence to back up their analysis. The problem is that everyone ignores them.

You can talk about the dangers represented by CAPE ratios, margin levels, computerized trading, persistent low volatility and complacency all you want, but nothing seems to slow down this bull market.

Yet there is one thing that can stop a bull market in its tracks, and that’s corporate earnings.

The simplest form of stock market valuation is to project earnings, apply a multiple and, voilà, you have a valuation. Multiples are already near record highs, so there’s not much room for expansion there.

The only variable left is projected earnings and that’s where Wall Street analysts are having a field day ramping up stock prices. Earnings did grow significantly in 2017 on a year-over-year basis, but that’s mainly because earnings were weak in 2016, so the year-over-year growth was relatively easy.

Now comes the hard part.

How do you expand earnings again in 2018 when 2017 was such a strong year? Wall Street just uses a simple extrapolation and says next year will be like this year, only better! But there is every reason to doubt that extrapolation.

Earnings are likely to fall short of expectations, which can lead to a correction. Once that happens, multiples can shrink as well. Soon you’re in a full-scale bear market with stock prices down 20% or more.

That’s without even considering a war with North Korea and all of the dangers others have already mentioned. This may be your last clear chance to lighten up on listed equity exposure before the bubble bursts.

Markets are creatures of manipulation by Fed policy changes, statements, forward guidance and the other prestidigitation of modern central banks. That’s what you get after 10 years of ZIRP, QE, tapering, QT, forward guidance, currency wars and musings about NIRP.

Shutdown or no shutdown, the Fed has painted itself into a corner and there’s no way to escape the room. That’s the larger story to keep in mind as Dec. 13 approaches.

Tune out the current sideshow and keep that in mind.

Comments

Pandelis Fritz Wed, 12/06/2017 - 10:41 Permalink

market are not prepared for the moon falling upon earth either.Get a grip man and call it a day, stop predicting pure bs.  This guy has been wrong for as long as I can remember.  I understand people want to make a living but get into something you can do ... well i guess a con is a job to some people. The only close second to this guy is Richard Armstrong with his Pi computer model that can predict everything from the crisis to ukraine, to earthquakes ... let alone small things like market crashes etc.

In reply to by Fritz

Escrava Isaura eclectic syncretist Wed, 12/06/2017 - 11:38 Permalink

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Markets are people’s creation. Of course they are not prepared for anything but forever growth or, it will die in 5 seconds. Of course this rule doesn’t apply to conservatives thinking, because they believe in myths.  

In reply to by eclectic syncretist

E.F. Mutton Wed, 12/06/2017 - 10:45 Permalink

Do we really have to do this fucking drama every few months?  They aren't shutting down jack shit"At the Eleventh hour....bipartisan agreement...blah blah blah"

LawsofPhysics Wed, 12/06/2017 - 10:35 Permalink

Bullshit.  The last government "shutdown" was in fact a two week paid vacation!!!!shutdown...  LOL, I don't think you know what the word really means."Full Faith and Credit" 

The First Rule Wed, 12/06/2017 - 10:36 Permalink

This is a Big Nothing Burger. 83% of the Govt stays open in the event of shutdown.Only 17% "Non-Essential Govt" gets shut down.Most of this 17%, we shouldn't be funding anyway.  After a few weeks, no one outside the Washington Beltway is going to care or notice that this Non-Essential Govt is shut down.    

bidaskspread Wed, 12/06/2017 - 10:40 Permalink

Shut it down. Make the citzens become so fustrated by it that they circumvent the obstacle and come to the realization they don't need it.... shut it down

Ban KKiller Wed, 12/06/2017 - 10:51 Permalink

Some of you know I chose 02/02/18 as the date. Why? No reason as good as a good reason in this rigged market. Guessing the FED won't allow any type of correction....EVER! Meanwhile China and Russia are STILL buying all the gold. Hmmmm....

Dg4884 Wed, 12/06/2017 - 11:09 Permalink

This is one of those articles that you skip and go straight to comments. .Gov is a cancer. It's tumors need to be permanently removed.

JBPeebles Wed, 12/06/2017 - 15:18 Permalink

Not so fast, Bucko. Earnings are earnings per share. These have gone up because they are expressed as a ratio where the denominator is the number of shares.As N shrinks due to stock buybacks, the earnings as expressed per share will grow even with flat to little revenue growth.Revenue is the amount of sales generated. For the "total market", it grew by 10.3% on a year over year basis according to CSI market. If tracked sequentially (as opposed to quarterly), it grew at an anuual rate of 1.52% in the third quarter 2017.OK, so revenue growth is slow. Well, aren't companies making more money? This, as described as Operating Income, is the difference between total revenue and cost of goods sold. Year over year, this grew at 5.82% annual rate in the third quarter 2017.CSI's total market is broader than the S&P 500, which is far broader than the Dow. Investors need to exercise extreme caution when evaluating projections of future stock market performance! The narrower the index, the easier it is an illusion of broader market growth to be coaxed out of E.P.S.-based data.Earnings as they are doctored give a false impression of improving margins and productivity. Where growth is slow in the overall economy, sales (B2B and B2C) can't go up. So the appeal of stock buybacks lies in how E.P.S.-based numbers mask the underperformance with a constantly shrinking number of shares. That in turn relies on the ability of the company to borrow.So you're taking considerable risk betting on continuation of a very low rate environment through which new borrowings can fund further stock buybacks. This is market- and interest rate-based risk that you probably didn't know you had.Of course with the corporate balance sheets bloated with vast sums of long-term debt, interest carry costs grow if the status quo requires a stream of new borrowing. The interest rate risk is that the company cannot issue debt to fund further buybacks due to higher costs of borrowing in the future. The market risk is that corporate debt will get less attractive as it's issued in the future as the presumptive method of E.P.S. enhancement (accounting trickanery that will get more expensive as share prices rise.)The weaker the government's fiscal position, the likelier it'll crowd out the finite pool of investment capital that would otherwise  go into corporate debt and the stock market, which are perceived as riskier. Market risk means a precipitating crisis that poses short-run liquidity risks in the event of a rapid sell off, a risk exposure above and beyond that individual equity valuations which are based on traditional analytical tools. Not sure if volatility covers the lack of earnings and revenue growth as a slow painful end to this rigged bull might be more likely in light of the broader economic malaise hidden by per share distortions.