The macaw in the coal mine today was Brazil’s stock market, down 4% with large banks down 6%-7%. The start of negotiations over pension reform is the apparent culprit: The new president Jair Bolsonaro has dazzled investors, but he now has to solve a pension problem that appears politically intractable. Brazilians can retire at 55 with a pension equal to 70% of their pay, and this will cost Brazil 14% of GDP by 2021, and 26% of GDP by 2050.

But investors knew all that before they bid up Brazil’s ETF (EWZ) by 14% this year, the best performer in the emerging market universe. Today’s tumble in Brazil (and more measured pullback in all emerging markets) is a warning that the Federal Reserve-driven euphoria of the first five weeks of the year is exhausted.

US equity markets barely budged during the past three sessions, in contrast to the thousand-point swings in the Dow Jones Industrial Average on so many days in the last weeks of 2018. It’s possible that everyone has taken the week off for the Lunar New Year, but a simpler explanation is that the Federal Reserve and the European Central Bank have promised the markets that they will do nothing for the foreseeable future, and for that reason investors expect nothing to happen.

That by itself is a big statement: There is a word for a market environment in which investors either run for cover or dive headfirst into risk on a nod from the central bank, and that word is, “Bubble.” Many commentators have pointed to the relationship between the Federal Reserve’s purchases of securities and the performance of the S&P 500:

The reversal of quantitative easing in the US and Europe, and the prospect of higher US interest rates produced a panic in December. Fear of trade war with China already caused a sharp drop in capital investment as corporations waited to see where supply chains would end up. When the Federal Reserve (and shortly afterward the European Central Bank) promised not to do anything, markets recovered.

We can see how closely equity markets have followed the whims of central bankers by comparing the option-implied volatility of US Treasury futures and German government bond futures, respectively, with the main US and European equity indices. Fear of Federal Reserve (or ECB) action boosted the likelihood of a big move in government bond yields, and the stock market followed.

Now central banks have no place to go. Italy is in recession and Germany well may be entering one, but the European central bank can’t cut rates that already are negative. As I reported in January, the drop of German government bond yields during 2018 prompted Germans to save more and consume less, weakening the economy. Cutting rates might make things worse, so there is nothing for the European Central Bank to do.

The Fed meanwhile is stuck like a rabbit in the headlights. It won’t raise rates because it doesn’t want a repeat of last December’s panic, and it won’t cut rates until economic data show real weakness. That’s not likely, because the present wave of hiring is led by small businesses, and that has a momentum of its own. I expect US GDP growth of around 2% (rather than the 3% that the US Administration is predicting), which doesn’t motivate a rate cut.

All the great trades of the past few weeks are exhausted. Carry (high-yielding) ETFs have recovered and have no more upside.

China’s Lunar New Year holiday comes at a convenient time. It’s better to be on vacation. I still expect a provisional trade deal of some kind by March 31, which means that Chinese stocks should have some upside.

But problems will linger for some time. The prospect of trade war crushed capital investment around the world, because no-one knows where to locate supply chains. You can’t un-explode a bomb. Things don’t go back to normal so quickly. Chinese investors have modest returns to look forward to.

I continue to believe that this is a coupon-clipper’s market. 2019 may be the Year of the Pig, but that brings to mind an old Wall Street adage: Bulls and bears make money, but pigs get slaughtered. Stay cautious and stay liquid.


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