The Phase One trade deal with China was signed with a great deal of pomp and circumstance this week. While happy that trade tensions on both sides have been reduced, the vast majority of Wall Street players saw the deal as a win for China.

 

After almost three years of threats, bluster and on-again-off-again tariffs, we are right back where we were before Donald Trump was elected. Yes, China has agreed to purchase an additional $200 billion in U.S. goods over the next two years, but the trade deficit was always the wrong metric when comparing our overall trade with China.

 

Trade imbalances are caused by capital flows. Don't take my word for it, just ask any economist in the world. In addition, the U.S. dollar is the currency of choice around the world and our U.S. Treasury debt is also considered the safest in the world. Those two factors create an environment where foreign investors use dollars earned from exports to purchase U.S. assets and not U.S. goods.

 

The president's entire focus on trade imbalances has been bogus from the start. One can only assume that either he does not understand that key point, or that his political base can't grasp anything more than a simplified and erroneous concept of trade imbalance as the source of all our problems with China.

 

In theory, under this new deal, U.S. exports should increase to $263 billion this year and as much as $309 billion in 2021. That should provide the president with good optics on the campaign trail. The lion's share of the $200 billion in the deal would be in manufactured goods, followed by energy, services and agricultural goods. If the truth be told, much of what China needs from us is on this list. 

 

They want more oil and LNG from America to counterbalance their energy suppliers in the Middle East. U.S. financial services and insurance have long been on China's shopping list since these are areas they need in order to broaden and add competition to their own sectors. Telecom, cloud computing, and intellectual property are also on the list. As for food imports, all of the goods they have agreed to import are in short supply in their country.

 

Supposedly, some provisions on intellectual property enforcement and protections against forced technology transfers have been included in the Phase One deal. It remains to be seen whether or not these points have any teeth or are just "understandings" between the two countries.

 

As I have written before, the really tough issues have been rolled back and await a Phase Two agreement. The president has already warned that this will take time and probably won't happen before the November elections. Peter Navarro, an assistant to the president and one of the administration's most hawkish on China, wants China to stop subsidizing its state-owned enterprises. He also wants China to halt what he called "cyber intrusions" that hack into American businesses and steal our trade secrets. 

 

Clearly, intellectual property protections and technology transfers, along with state subsidies, are going to mean changing some of the fundamental tenants of the Chinese economic and political system. That could take years to achieve, even if the Chinese were willing to do so.

 

In the meantime, the threat of tariffs and more tariffs remains on both sides and will act as a barrier and a weight not only on both countries' economies, but also on the rest of the world. There is already concern that the president will now turn his sights on Europe and once again threaten tariffs on their imports as well.

 

Fortunately for us, throughout the last few years we have enjoyed moderate economic growth and robust employment. Those factors shielded most of our economy (but not the agricultural or manufacturing sectors) from the worst of Trump's trade tirades. What would happen if, over the next four years, conditions change and/or the economy fell into recession? Could the world and the U.S. economy survive four more years like the last three?

 

It was another up week for the stock market. As we hit record high after record high, investors want more and expect to get it. Forecasts are getting even rosier for this year and, if all goes well, we can expect the signing of the long-awaited Phase One China trade deal next week. What's not to like?

 

Geopolitics for one thing. As I wrote last week, investors should expect a response after the killing of Iran's No. 2 guy, Gen. Qasem Soleimani. I expressed hope that it would be sooner rather than later since the market hates the unknown. That turned out to be the case.

 

The Iranian response, however, was largely symbolic. Several rockets that did little damage and took no lives landed on two military bases in Iraq. Both sides then seemed to dial down the rhetoric and go back to their respective corners — until next time.

 

While the week saw some wild swings in the averages by Friday, it was on to the next thing. That turned out to be the non-farm payrolls report for December. Economists were expecting 160,000 job gains but received only 145,000 instead. Although that still keeps the unemployment rate at a 50-year low of 3.5 percent, wage growth also disappointed. Average hourly earnings grew by 2.9 percent. That is the first time since 2018 that wage gains were below 3 percent on a year-over-year basis.

 

But nothing negative seems to stick to this market. Rockets, impeachment, weak manufacturing data, even the weak job numbers have, at most, provided small dips in stocks at best.  As I mentioned last week, the investor sentiment numbers have been flashing red signals. More and more market strategists are warning of an "imminent" decline of 5-10 percent, but few care.

 

Don't think I am complaining. I enjoy a bull market as much as the next guy. However, the underlying reasons for this uninterrupted march to the clouds may be somewhat troubling to ignorant folk like me. I don't believe the tweets that take credit for all-time highs that are coming out of the White House. Nor would I believe that exercising military muscle against a tiny Middle Eastern country is all that bullish, except in the eyes of the "chosen few." It is still all about the Fed, in my opinion.

 

In several columns last year, I wrote about the sizable sums of money that are being injected into the nation's repo market by the U.S. central bank. It started last year and was supposed to be a temporary measure. The argument was that corporations were facing a cash crunch and needed extra funds to pay quarter-end tax bills. The quarter had come and gone and yet, by Christmas, the Fed had pumped almost $1 trillion into that market.

 

Dumping all this money into the market was like launching a stealth quantitative easing program (QE) that is almost as powerful as cutting interest rates one or two more times. I also predicted in December that the stock market would move higher as a result of an additional $255.95 billion that the Fed planned to dump into repos at year-end. However, that was supposed to be the end of this quiet QE exercise. 

 

Guess what? The Fed injected even more money ($258.9 billion) into repos last Friday. No one actually knows why or what is going on at this stage. All the excuses the central bank has used to explain the market's need for so much cash now sound shallow and certainly less than kosher.

 

I believe the end result has been that this money is being siphoned out of the repo market by enterprising financial institutions. It is then finding its way into the stock market where the arbitrage opportunities of borrowing at next to nothing and investing it in much higher rate of return stocks is going on at a furious rate.

 

The astute reader might ask, "what happens if and when the Fed stops injecting this money into the repo markets?"

 

Well, if I am right, we should get that 5-10 percent pullback everyone is expecting. The question is when does the Fed take away the punch ball?

 

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.