5 Questions to Separate Investment Signals from Noise

The dramatic headlines that capture attention may trigger a fight-or-flight response for many investors.

Google search results provide insight into the ubiquity of attention-grabbing headlines. For example, the keyword search term “trade wars” displays 300 million results, “Trump threatens” displays 192 million results, and “Trump impeachment” displays nearly 32 million results. “Emerging markets crisis” displays more than 63 million results, a number likely to increase in the coming weeks.

Distinguishing investment signals from noise is vitally important for investors trying to resist fight-or-flight impulses. Headlines about trade tensions and stresses in emerging markets create real but sometimes exaggerated concerns. Headlines about the three “I”s — Impeachment, (yield curve) Inversion, and “Italexit” from the eurozone — also create understandable concern.

[See: 10 Investing Tips for Busy People.]

Answers to five questions may help investors resist fight-or-flight responses:

What are the prospects for tensions to ease between the U.S. and China? The Chinese view is that the Trump administration is more motivated by containing China’s ascent as a world power than by improving the fairness of trade. Although compromises on certain issues will likely be negotiated in the coming months, friction between the U.S. and China is likely to be a long-term cause of investor uncertainty.

China is trying to respond to U.S. protectionist threats by deepening ties with other countries targeted by the Trump administration, including Japan, Russia and South Korea. China is also allowing its currency to weaken, which softens the blow from U.S. tariffs. Chinese growth is slowing, more from government “reforms” than from tariffs. Slowing property investment, measures to curb shadow banking and changes at state-owned enterprises are part of Xi Jinping’s plans to curb systemic imbalances in China’s economy.

The Chinese economy may get worse before it gets better, which creates potential ripple effects for the rest of the world. China and the rest of emerging Asia remains an attractive long-term destination for capital, but the near-term ride is likely to be turbulent.

Will emerging markets suffer from the contagion experienced in the late 1990s? Global trade tensions, the strong dollar and economic crises in Argentina and Turkey were catalysts for the recent sell-off in emerging markets. Argentina is paying the price for economic mismanagement during the Kirchner era, while Turkey’s debt boom and “magical thinking” about the causes of inflation led to a sell-off of the Turkish lira.

Argentina, Turkey, Indonesia and South Africa are among the countries viewed as most vulnerable by investors, while Brazil faces political uncertainty with populists leading the polls for October’s presidential election.

Although emerging markets GDP growth is slowing in the aggregate, growth is not collapsing in most countries. In contrast with the environment in the late 1990s, fewer emerging markets countries today face the toxic combination of high current account deficits and burdensome near-term external debt obligations. Although long-term prospects for emerging markets are solid, in the near-term, selectivity at the country and company level is crucial.

Would an impeachment of Trump crash the market? Despite the president’s assertions, it is unlikely that a Trump impeachment would crash the market. Granted, impeachment hearings are likely if mid-term elections return the House of Representatives to Democrat control. However, a two-thirds vote in the Senate would be required to convict President Donald Trump and remove him from office, which is unlikely absent a massive change in sentiment among Senate Republicans.

[See: 7 Ways the Midterms Could Affect Investors.]

Past impeachment hearings provide a limited sample size for analysis, with prior impeachments signaling that economics “trumped” politics. Although the stock market performed poorly during the Nixon impeachment hearings, the U.S. economy was in recession, suffering from high inflation caused by the spending binge associated with the Vietnam War, President Lyndon B. Johnson’s Great Society programs and the OPEC oil embargo.

In contrast, economic momentum was strong during the Clinton impeachment hearings — consequently the stock market barely missed a beat.

If Trump were removed from office, it isn’t a given that the stock market would fall. The stock market has already gotten what it wanted from a Trump presidency in the form of corporate tax cuts and a lighter regulatory touch. The aspects of the Trump agenda that the stock market doesn’t want — trade wars and battles with real and imagined foes — might be minimized if Vice President Mike Pence became president.

Is an inversion of the yield curve an imminent signal of recession? The yield curve, as measured by the spreads between 10-year and two-year Treasury yields, has been flattening since the early 2011 peak of nearly 2.9 percent. The spread remains slightly positive at approximately 25 basis points (0.25 percent). An inverted yield curve, which is when the two-year yield is higher than the 10-year yield, is considered one of the most reliable indicators of an upcoming recession. There is a significant difference between flat and inverted yield curves, and there can be a long lag between yield curve flattening and inversion.

Stock market returns are often strong when the yield curve is flat, and the yield curve often has stayed flat for more than a year before inverting. Expected rate hikes on the short end of the curve aren’t a guaranty of inversion. Flattening pressure from rising short-term rates could be offset by a re-anchoring of long-term inflation expectations that causes long-term rates to also move up. Consequently, investors should be monitoring for yield curve inversion, but not assume that inversion is imminent.

Will the eurozone break up because of an exit by Italy? Italy has serious long-term issues, but the near-term risk of “Italexit” is slim. Italy’s financial challenges are considerable. Stagnant incomes, high government debt, low worker productivity and high youth unemployment have created an environment in which populist solutions appeal to Italian voters.

Despite mutual frustration, Italian and eurozone leaders both face constraints that make worst-case outcomes less likely. Italian populists are constrained by a weak banking system and high retail ownership of bank debt. Legal barriers are also an issue for those who favor an “Italexit.” The Italian constitution prohibits a referendum on treaties, so a Brexit-like referendum isn’t in the cards.

Europe, particularly Germany, is constrained by the magnitude of Italian debt and liabilities held by foreign investors. Given these constraints, Italy’s problems are likely to be “kicked down the road” for an extended period of time.

Agile investors may be able to take advantage of the fight-or-flight reactions of investors who fail to look beyond headlines when making investment decisions. Investors who take the time to distinguish between signal and noise will be well-positioned to take advantage of short-term market dislocations that are likely to present themselves in the near future.

[See: Build Your Investment Strategy With These 9 Questions.]

Disclosures: Registration with the SEC should not be construed as an endorsement or an indicator of investment skill, acumen or experience. Investments in securities are not insured, protected or guaranteed and may result in loss of income and/or principal. Unless stated otherwise, any mention of specific securities or investments is for hypothetical and illustrative purposes only. Advisor’s clients may or may not hold the securities discussed in their portfolios. Advisor makes no representations that any of the securities discussed have been or will be profitable.

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