The de-escalation of the potential conflict between Iran and the United States sent markets higher this week. It could have turned out much differently. The question is why did the situation  defused so rapidly, and who really is responsible for that outcome? I'm thinking it was China.

 

Taking out the number two guy in Iran, Maj. Gen. Qassem Soleimani, in a U.S. drone attack last week was a highly provocative move. The world expected push-back from Iran and feared a tit-for-tat escalation on both sides. That didn't happen. Sure, the Iranians did lob a dozen-plus missiles at two military bases across their border into Iraq, but relatively little damage resulted from that attack.

 

The following morning, the president seemed to offer an olive branch to the Iranians. It wasn't quite a kiss-and-make-up moment, given we slapped more economic sanctions on them, but it was dovish enough to calm the nerves of global investors.

 

Investors feared that, at the very least (after last year's Iranian drone attack on Saudi Arabian oil facilities), Iran would respond by either more of the same or attempting to shut down shipping through the Strait of Hormuz. For those readers who aren't familiar with that strategic piece of real estate, the Straits accounts for 35 percent of all seaborne oil traffic, or about 20 percent of oil traded worldwide.

 

Of all the major powers that could have been hurt by such an action, China stands out as the potential number one casualty in a war of escalation. China is the world's top importer of oil, buying 41 million tons, or more than 10 million barrels a day, with Middle Easten imports accounting for over 45 percent of that total.

 

China's imports of Saudi oil are at record levels (up 53 percent since 2018), thanks to the decline in Venezuela's output and the impact of America's sanctions against Iran. As of this year, Saudi Arabia replaced Russia as China's number one importer of energy. Iraq is also an important supplier and, although Iran‘s oil exports to China have declined by more than half, they are still substantial.

 

Given China's reliance on this energy pipeline, ensuring that the Straits of Hormuz remains open is as much in their strategic interest as it is in our own. And when China speaks, Iran listens. Readers may fail to realize how deep and long political and economic relations have existed between these two countries. The two nations, for example, were instrumental in the development of the ancient Silk Road of Marco Polo fame.

 

In the modern-day era, the break in diplomatic relations between Iran and the U.S. in 1980 only brought Beijing and Tehran that much closer. Trade blossomed in the decades since with petroleum products exchanged for imports of clothing, vehicles, electronics, chemicals, household appliances, telecommunications equipment and, from a strategic perspective, arms and influence.  Since 2010 (the sanction era), when the U.S. and the United Nations imposed all sorts of sanctions on Iran to deter the country from building nuclear weapons, Iran's dependence on China escalated.

 

Bridges, subways, ports, highways, schools, hospitals and so much more in infrastructure projects have been planned, engineered and built in Iran, thanks to China. As in other nation states throughout the world, China has used their expertise and funding in infrastructure projects to cement economic and political ties to countries like Iran.

 

On the diplomatic front, China, along with Russia, has been against sanctions and trade embargos levied on Iran that hurt their own economic interests. But, at the same time, they do not want to see an Iranian nuclearized threat in the Middle East either. 

 

As such, China has long been willing to be the negotiator behind the scenes, trying to forge peaceful solutions to the issues at hand. Just a week prior to the U.S. assassination of Soleimani, the Chinese, Iranian and Russian navies were conducting joint exercises. A week later, China's Foreign Minister, Wang Yi, was on the telephone with Iran, Russia and France while Yang Jiechi, the country's top diplomat was urging Secretary of State, Mike Pompeo, not to start a regional war in the Middle East.

 

I would expect that next week's signing of the Phase One China trade agreement here in the U.S. will be accompanied by further diplomacy by China in reducing tensions between the U.S. and Iran, so stay tuned.

 

Donald Trump's decision this week to kill Iran's second-most important figure, Gen. Qassem Soleimanai, this week placed a time-out on the stock market's bull run into the New Year. Do you run for the hills or do you buy the dip?

 

If I look back to other geopolitical events, my first reaction is to use any further declines as an opportunity to increase exposure to the stock markets. At the same time, I wouldn't chase those categories of assets that have vaulted higher in response to this event. Gold and oil both moved higher overnight, but those gains could be fleeting as investors begin to assess whether or not there will be any further downside.

 

That is not to say that dropping a bomb on the architect of many of America's greatest problems in the Middle East will go unanswered by the Iranian government. How and when the Iranians respond should keep all the markets on edge in the near future. And therein lies the problem.

 

In my opinion, the best of all possible outcomes is for the Iranians to respond quickly, maybe this weekend or next week. That would give our side the greatest chance of thwarting such a move because we would be on high alert. As time passes, however, human behavior is such that gradually we would begin to let down our guard.

 

In the same way, investors will be cautious at first, but as time goes by without a response, it will be back to business as usual. Until it isn't. And while geopolitical events are always a risk when investing, the high valuations that presently exist throughout the markets could set us up for s a significant fall. Of course, it depends on what and how successful the Iranian response is.

 

Clearly, from a number of indicators such as momentum, sentiment and in some cases, extreme valuations, stocks are due for a pullback. This week's US Advisor Sentiment report indicates extreme overbought conditions right now. The bull/bear spread expanded to 41.1 percent from 40.4 percent. In the past, differences above 30 percent signal concerns and those over 40 percent indicate investors should begin to take defensive action.

 

For many of us, the spectacular gains we have enjoyed in 2019 set us up for disappointment this year. Like everyone, I would love to see this bull market continue. I am as greedy as the next guy, but I have been in this game long enough to know that rarely happens. And while the majority of strategists and analysts are uber-bullish right now about the prospects for stocks this year, that could change at the first hint of adversity.

 

As such, don't get your hopes up too high right now. What you wish for the most (more upside), would simply set us up for a nasty decline when we least expect it. Prepare, instead, for some volatility. Expect stocks to decline, likely sooner than later, possibly even before this month is out. And if it were to occur, whether because of Iran, a snag in the Phase One trade deal, or something else, be glad, be happy, because it could set us up for further gains in the months ahead.

 

The inflation rate has not been a cause of concern in this country for well over a decade. On the contrary, economists have been worried that the opposite might occur, a bout of deflation.

 

Throughout the last decade, inflation has averaged no more than 1 1/2 percent, which is well below the Federal Reserve Bank's targeted inflation rate of 2 percent. Historically, that is highly unusual, given how economics are supposed to work. Central banks around the world (although they don't like to admit it), have no idea why the inflation rate is as low as it is.  Neither do global economists, or Wall Street strategists.

 

World economies continue to grow, and interest rates remain at historically low levels, the previous correlations between inflation and economic growth have somehow gone awry. It's as if the basic economic laws of supply and demand no longer apply.

 

Usually, when economic activity is rising, there is more demand for goods and services, which pushes up prices on almost everything. In order to produce more, there is also a greater demand for workers. But in a historically low unemployment rate environment like we have now, companies can't find skilled workers. As a result, wages should have risen dramatically to keep and/or attract workers.

 

Here in the U.S., wages are one of the key variables in determining the inflation rate. And yet, while wages have increased about 3.1 percent year-over-year, this has had little impact on the inflation rate. Those demand pressures in any other cycle would have had a much greater impact on the inflation rate, but not this time.

 

There are several theories going around to explain this phenomenon. As a result of a decadelong low rate of inflation, for example, people now expect inflation to remain low and stable. Therefore, there is no reason to buy that widget now because the price may actually go down (not up) in a few weeks or months.

 

Globalization may also be partially to blame. Greater trade in goods and services, and tighter connections between financial markets worldwide, may be influencing the U.S. inflation rate more than we know. If, for example, another region's economy is slowing, or simply not growing as fast as our own, there could be a dampening effect on prices and wages worldwide.

 

Continued breakthroughs in technology, as well as continued global competition in labor markets, could also be improving productivity, capping wage growth, and in the process, keeping inflation lower than in the past.

 

And let us not forget the source of all this data on inflation: the world's governments. Statistics are based on data and the means and methods of acquiring and compiling this information is constantly evolving. Who is to say that the government's numbers accurately reflect the real inflation rate?

 

Think of how the U.S. government's official Consumer Price Index (CPI) differs from the real world of prices that we face every day at the supermarket, or the hospital, or in tuition fees for our kids. In any case, there are few, if any, arguments that inflation is about to spike in the year ahead. 

 

 

It is that time of the year when fortune telling becomes a popular past time in the financial markets. Every Wall Street strategist releases their projections for the economy, the markets, and earnings for the New Year. What strikes me about 2020's crop of predictions is their similarity.

 

My own informal survey of analyst's forecasts seems to converge around a 1.8 percent-2.0 percent prediction for economic growth in the U.S. Earnings, for the most part, hover around the unchanged mark, or slightly better. These professional forecasters are looking for no more than average gains in the rate of return (ROR) for stocks based on the equity benchmark index, the S&P 500. What does that mean to me?

 

On average, over the past 150 years or so, the S&P 500 Index has returned roughly 4-5 percent. If you add in dividends, that ROR increases to 6-7 percent. You can read these consensus forecasts in one of two ways. They could mean that none of these people, who are paid to forecast, really know what the stock market is going to do next year, so they are hiding behind an average return. If they are wrong, they can always point to the fact that, from a historical perspective, the markets should have at least provided that much in gains.

 

The second possibility is that all of these high-paid Wall Street pundits actually believe their forecasts, in which case, as a contrarian, I worry that with everyone leaning to one side of the boat there is a chance that the markets will do something quite unexpected. If that is the case, you have to ask "Will stocks perform better, or worse, than the average?"

 

Ask yourself what could go right (or wrong) for the economy and therefore the markets in 2020. First of all, we are entering a new decade. The last one was wonderful for stocks. The chances of a repeat performance in the Twenty-Twenties could happen, but I doubt it. Physics would tell you what goes up, must come down, but who says it has to happen next year?

 

For me, the largest risk out there in 2020 is a spike in inflation. This year, wage growth finally exceeded the inflation rate. It took the entire decade to get there, plus trillions of dollars of global central bank monetary stimulus. That stimulus is still going on and, according to all these strategists, should continue into next year on a worldwide basis.

 

If I accept that the U.S. economy will continue to muddle through, and unemployment will continue to remain at record lows, one could expect wage growth to gain even greater momentum. And wage growth, my dear reader, is the main engine of inflation in this country.

 

In addition, we could actually see economic growth higher than what the economists are predicting, because it is an election year. No one can predict what politicians will do, or who will win an election this early in the political cycle. Yet, the market's performance will depend on not only who wins, but prior to that, who is perceived to be winning.

 

However, I can confidently predict that neither political party will be willing to reduce government spending in 2020.  In fact, the opposite almost always occurs during a presidential election year. We are already witnessing both parties "coming together" to pass a flurry of legislation (including a spending bill) at the end of this year. I expect to see more of that in 2020. More spending should equal more growth, more growth means higher wages, etc.

 

Then there is the Trump trade war. Everyone seems to be predicting more of the same: tariffs will remain, Trump will continue to use trade to get what he wants, and. as a result, business confidence and investment will remain subdued, thus the "muddle through" economic forecast. What might happen if the president switches tactics?

 

Donald Trump has two things going for him when it comes to voter sentiment. Even those who hate him believe he has done a good job on the economy and the stock market. The only thing that has held back even stronger growth, people believe, is his trade wars. If he were to change his tactics, shelve the trade war for nine months, and work to expand the economy through government spending, then what?

 

The economy may grow faster than expected. Global growth could get a boost. Emerging markets might benefit, as would other overseas markets. As a result, Trump would probably win in November, because no matter what Americans say, they tend to vote with their pocketbooks.

 

Stronger economic growth, both here and abroad, a historically low unemployment rate, and the inability (thanks to Trump's immigration policies) by companies to hire the skilled labor they need, would mean more wage hikes. That would translate into higher consumer spending, higher prices for goods and services, and maybe, just maybe, the inflation cycle begins.

 

In my next column I will pursue this line of thought and provide some other scenarios that could play out in the New Year. Until then, have a most wonderful New Year.

 

Abuse of power, obstruction of Congress; these are accusations that ordinarily evoke sharp emotions among Americans. Yet, the financial markets have barely blinked, if they have paid attention at all. Why?

 

The short answer is that investors have done the numbers and calculated that Donald Trump has less than a snowball's chance in hell of being impeached by the U.S. Senate. For those who don't follow the actual political process of impeachment, once the Congress voted to impeach the president, the next step is up to the Senate. They are required to hold a trial to decide whether to remove him from office. A two-thirds majority is required to convict and then remove the president from office.

 

Trump is only the third president (after Andrew Jackson and Bill Clinton) to be impeached by the House. However, Trump's predecessors were acquitted in the Senate. And therein lies the reason investors are ignoring the event. Republicans hold the majority of seats in the Senate (53 seats). In order to get a conviction, 20 Republicans would need to join the Democrats' entire minority of seats to pull off a palace coup. That's not likely to happen.

 

Now, while the country is roughly split down the middle by those who believe impeachment is the only solution to end the reign of America's Mad King, an equal number of Americans believe that President Trump is an innocent victim who is being nailed to the cross of political partisanship by the Democrats. None of that matters to the markets.

 

The only question financial markets care about is "can money be made from this event?" Given the answer is no, (not directly) global traders focus on things that can provide an immediate return. Next month it will be the chances of a Brexit, the signing of a Phase One China/U.S. trade deal and the prospects for earnings in the first quarter.

 

I understand that the market's disregard of social issues rubs many Americans the wrong way. To be sure, it bothers plenty of Wall Streeters as well, but righting wrongs is not the mission of financial markets. It never has been.

 

Plenty of people, including the president, in my opinion, get confused on this point. Every time the stock market hits a new high, a tweet from the White House follows shortly thereafter. It appears that the president attributes the market's gains to some policy or action he has taken or may take. His view is that the market is a better and more accurate indicator than voter polls. And he is correct, as long as the action or policy is something investors perceive will move the market.  Good or bad, traders will respond, otherwise it is ignored.

 

Markets don't care if immigration policy is changed, for example, unless it has an immediate impact on prices. Trump can fill containment camps to the brim. He can kill, maim, and starve whomever he wants, but markets won't care unless money can be made (or lost) over it. Markets do not approve or disapprove of the impeachment of President Trump. They just don't care.

 

That's why financial markets need to be regulated. If the most profitable business in the world is building and selling nuclear weapons to terrorists, the markets will do it, if they can get away with it. It is society's responsibility, through their governments to make sure that does not happen. Right now, few if any market participants are enamored with either Bernie Sanders or Elizbeth Warren.

 

Both candidates are proposing policies that Wall Street fears might curtail or change the game for everyone in the economic arena. People in the financial markets worry that they will make less money, or worse, actually lose money, if either are elected. As such, they will oppose everything those candidates do.

 

It is nothing personal. In fact, some trader or other might actually approve of their social platforms. And if suddenly one of them proposed something that could make investors lots of money, you would see Wall Street change their tune. It is the nature of the beast, so you might as well get used to it.