Unexpected forces are a warning for investors

When markets move in an unexpected way, it is always an alert for investors. And that is exactly what is happening in both the United States and China at present.

We are not seeing the same forces in Australia, but we will need to be on the alert. While they are connected by trade war fears, the China and US situations are very different. Let's start with the US.

The script the markets had prepared for the US was a simple and straightforward one. We had an American economy that was steaming ahead and, on top of that strength was a massive stimulation by President Trump in the form of tax cuts and greater spending.

Accordingly, that would drive the US economy faster and would cause interest rates to rise as a result. Those higher interest rates would boost the US dollar. There was a belief amongst some people that the limits on labour availability in the US would bring the boom to an early end, but a boom we would have.

Fast forward to the final weeks of June 2018 and money is pouring into American bonds, so instead of the bond yields rising they have been falling. American companies, according to the chief of the Federal Reserve, Jerome Powell, are deferring expenditure programs when they were expected to increase them.

The Fed, markets and China

There is suddenly a sense of fear amongst many investors, (although, of course, not all), who want the safety of bonds and cash rather than shares. The money flows involved in risk aversion contribute to the fall in the share market. Of course, these trends can quickly reverse but are very dangerous if prolonged. The Federal Reserve has said that it plans another two interest rate rises in 2018, but will now be thinking twice about such plans given the fall in bond prices, which signals a totally different environment.

The US dollar rises when in theory, given the lower bond rates, it should fall. What is happening is that the fear in the global market is driving money to the “safety” of the American dollar. It is also trashing emerging country currencies like India and, as I will discuss later, China.

The problem the American share market faces is that US shares have been priced on the basis of a boom taking place, which would see higher margins and much higher profits. If the sudden hesitancy that has been isolated by the Federal Reserve was to spread and gather momentum, then it is highly likely those future profit results will not match market expectations.

We have seen such phenomena previously, and it normally results in a sharp fall in the market. That's unless the analysts are confident enough that we are only looking at a one-year deferral and not a fundamental change.

The recent falls on Wall Street are, of course, triggered by the prospect of global trade wars, but particularly a war with China.

A large number of American companies are integrated into China, which provides their components and a large amount of their turnover and profits. Driving President Trump is his fear that the China 2025 program will see the middle kingdom overtake America in computer technology.

China is throwing a lot of research into bridging that gap with the US, but it is also undertaking below the line techniques including theft in the case of a US company called Micron. Trump can't stop China undertaking research, but he wants to protect existing US technology. China is very reluctant to grant him his wishes.

Meanwhile, China has its own problems. For decades it has been expanding on borrowed money, albeit domestic borrowings, but it substantially increased its debt during the years after the global financial crisis.

More particularly, it has developed an underbelly of financial institutions that have a great deal of dodgy loans. China is trying to sort the situation out, but it is clearly not at all easy and this plus the threat of a trade war with the US has sent the Shanghai Index down 20 per cent. It is one thing to have a 10 per cent correction, which is a fairly normal event in stock market patterns, but a 20 per cent fall normally indicates that the economy is going to slow much faster than previously expected.

Indeed, a 20 per cent-plus fall often fulfils its own prophecy because it spreads nervousness in the business community. China realises that its economy is slowing much faster than expected and has released a large amount of banking credit to stem the downturn – in other words, more borrowing.

In addition, we are watching a big fall in China's currency. Some believe China may be using the exchange rate as a trade war tool adding punch to retaliating with like-for-like tariffs – a weaker Chinese renminbi currency would help Chinese exports and hurt US imports

But Donald Trump is unlikely to take that lying down. He could easily raise import tariffs further to offset the effects of a weaker renminbi.

So, what we can see is that the trade war is changing patterns in China in the same way it is changing patterns in the US. This is a “Gunfight at the O.K. Corral”. No one can be sure how it will end.

High speed in the Highlands

On a brighter note, during our holidaying in Scotland, the Royal Scotland train on which we were travelling spent the evening at the Aviemore Station.

Most of you will never have heard of Aviemore, which is deep in the Scottish Highlands. Barbara and I were up early and went for a walk on the platform. We began talking to the one male passengers waiting for the 6.12 am train to Edinburgh. He is a medical data researcher who lives out at Aviemore and took advantage of the excellent internet communication that was available.

The 6.12am train to Edinburgh enabled him to catch the morning flight to Chicago, where he would actually attend breast cancer treatment trials. The Highlands of Scotland is promoting itself as a place to live remotely and work with full internet connection.

In other words, you can operate anywhere in the world including taking phone calls as if you lived in a major capital city. I think it is the way of the future, but remote communities must have the right internet communication.