Buckle Up, We May Already Be in a Recession

With every waking day, Trump decides to place tariffs on yet another country. Its latest target is Mexico and potentially Australia as they dared export more Aluminum into the U.S. market. Trump seems to be more like a UK high school principle than a politician, placing any country on the detention list and commanding obedience, or in this case submission. Other than try to comment on Trump's involuntary spasms with regards to his morning tweets, there is something bigger at play here.

Britain held the reserve currency status from 1815 through 1920, followed by the U.S. which has held this post since. Prior to Britain, countries such as France, Netherlands, Spain and Portugal all held that position for about 95-100 years. It has been 94 years since the U.S. dollar took command, but now what?

China has been taking steps over the past few years towards forming a currency alternative to the U.S. dollar. Oil now trades in Chinese yuan, the third largest trading volume in the world. With sanctions placed on Iran, Europe and China are finding ways around getting their barrels. Trade wars have just been a smoke screen overlaying a much bigger scheme behind the scenes.

If it was only about normalizing the trade deficit with China, Trump would have been happy with their concessions to buy more from the U.S. But for the U.S. to blacklist Chinese companies (Huawei), coercing them to change their domestic policy and dictating terms, not even a third world country dependent on IMF loans would acquiesce to such pressure, purely out of principal.

Trump's plan, other than to use the U.S. consumers as bait by placing higher taxes implicitly on them, is to rattle the financial system, which has been built like a Jenga tower. One piece removed incorrectly can cause the entire structure to collapse -- and Trump knows this, as he is weaponizing the U.S. dollar.

The Chinese system over the past decade has been fuelled by credit, debt and dubious banking loans. As the yuan falls and there is stress in the system, one by one things can come crumbling down. We already heard about Baoshang Bank's failure which had about 576 billion yuan in assets. Beijing injected about 250 billion yuan in liquidity into the system to protect rates from squeezing higher. We may have another victim, Bank of Jinzhou, with about $105 billion in assets, as their auditor resigned prior to the annual general meeting.

How this will play out is anyone's guess, as China is exceptionally good at printing money and masking any cracks. Needless to say, the longer the Trade War spat continues, the more the fragile system can crack.

The U.S. is not immune, but Trump is willing to wager the entire economy on his candidacy and has a long way to fall before things get scary. It seems Trump wants to get the Fed to act -- and quickly. Just when the Fed thought they were out of boiling water as the S&P 500 touched all-time highs in April, Trump threw a spanner in the works in May and blindsided the market. The macroeconomic data has become considerably worse since May, but we shall only see the real damage in June and July, when numbers are reported.

The Fed FOMC meeting June 18-19 is certainly going to be a blockbuster event. All focus is now on Fed Powell. The bond and rate markets are in turmoil with the U.S. 10-year trading below 2.10% and 10-year vs the 3-month curve staying in inversion, with the 3-month rates trading below Fed funds. The rates market is pricing in about one rate cut for 2019 and three for 2020.

Clearly, the Fed did not get the memo. Global bond markets are in a state of mess, trading at negative yields, with even the German 10-year yield trading at -0.16% recently. Bond markets have been flashing alarm bells for the past year, but of course equities are dictated by non-cerebral algorithm trading flows that follow Trump tweets, unable to decipher what is happening underneath the surface.

The S&P 500 is only down 7% from its highs, not even close to its December lows, when the economic outlook is getting progressively worse and a shift in the global supply chain is occurring. The market hopes the Fed will cut rates and save the day. It is important to remember that historically, when Fed cuts towards end of a cycle, it signals more weakness as it implies things are much worse than seen in the system.

Cyclicals have been trading lower vs. defensive industries, and emerging markets, including China, have been weak as the dollar rally continues, pressuring the servicing cost of U.S. debt in these countries. Copper and base metals have been weak for the past month. Oil surely followed suit, as OPEC holding back production will not stop global growth weakness eating into the demand side of the equation. Commodities suffer when growth slows, let alone when the economy enters into a recession. The million-dollar question is what and where is the floor. For oil, that could very well be around $45-50/bbl WTI, which is  where shale projects will become uneconomical. For Copper, around $5500/tonne could be where companies are not incentivized to produce anymore.

Value is meaningless if the economic growth faces in the wrong direction. Given China not backing down and Trump not able to u-turn from his decision, it seems growth will continue falling off a cliff, unless Fed Powell comes to the rescue. But can he really, when the actual numbers do not show room for concern, only the implied ones do?

Things will stay uncertain going into the G-20 meeting, when Trump and China meet again. Until then, equities will take the bond market's lead and reprice lower accordingly.