We all know the story of the boiling frog — you know, the one where you put a frog in a beaker of water, slowly turn up the heat, and watch as the poor thing doesn't notice the temperature is rising and eventually boils to death. It's a well-used and obvious metaphor for what geographer Jared Diamond, author of the rise-and-fall-of-civilizations classic Collapse, called “creeping normality.” In short, like the fabled amphibian, people can get used to almost anything. For a while, at least.
Investors included. And if you consider how markets have responded to geopolitical instability in the post-recession era, you could argue that they look remarkably resilient. Brexit and the prospect of the European Union's disintegration. The election of a protectionist (in rhetoric, at least) president of the United States. Continuing instability in the Middle East. Russia's bad behaviour on the global stage. Nuclear brinkmanship in the Korean Peninsula. None of those seem to have done any lasting damage to the near-decade-long bull market or dampened investors' enthusiasm to ride it.
But now — well, things like they have changed, don't they
Where once geopolitical events, or outright bad policy, didn't seem to have much effect on sentiment, they are starting to stick now. Last month it was the imposition of tariffs by the U.S. and China, threatening a global trade war. This week it's the potential for heightened U.S. intervention in Syria over Bashar al-Assad's use of chemical weapons. Markets have responded like the textbooks say they are supposed to, but largely didn't during the bull market's heyday: oil is soaring, stocks are wavering, bond yields are falling. And it no longer seems a sure thing that those trends won't continue.
It's accepted wisdom that investors should avoid headline-itis. Whatever the news of the day, the chances that it would derail the underlying fact of stronger global economic growth and corporate earnings have seemed low. But the odds now seem to be rising.
How come One factor has to be that interest rates have been rising and seem set to rise further. When policy rates are near zero, equity prices have a heck of a lot of cushion to absorb downside events. But times have changed. The minutes of the U.S. Federal Reserve's March meeting, published Wednesday, suggest that the central bank is, if anything, likely to go further and faster in hiking rates than previously assumed.
This isn't just a matter of stock valuations, either. In their attempts to get ahead of inflation, the risk is that central bankers get too far ahead and push the economy into recession. That seems to be less of a concern here in Canada, where Bank of Canada governor Stephen Poloz has been striking a cautious tone of late, but that won't really matter if the Fed fails to get its policy normalization just right, will it Already, the U.S. yield curve is flattening, and an inverted curve is a pretty good predictor of recessions. The spread between two- and 10-year Treasuries on Wednesday was the narrowest it's been since 2007. (No points for guessing what happened then.)
The second factor is policy uncertainty. Ever since the election of U.S. President Donald Trump, commentators have been wondering whether there is method to his madness, and the answer now is pretty clearly no. Trump seems to develop policy while typing on Twitter, and the revolving door at the White House has been swinging wildly. And now a test of U.S. resolve and capability has come at just the wrong time. Al-Assad's latest bad behaviour coincides with a major shuffle in Trump's national security staff, and the confusion shows. The U.S. response to the Syrian chemical attack appears to be slow and uncertain, and so far has been conducted largely by Twitter. Even if the response were swift and decisive, it might not do anything to deter the Syrian dictator or weaken Russia's support for him.
You can see where this goes: escalating tensions, proxy war and maybe outright conflict between the U.S. and Russia/Iran in Syria and likely elsewhere. Trump's upcoming rejection of the Iran nuclear deal, whereby the U.S. and its allies would lose a lever over Iran, is unlikely to do anything to deflate the latter's Mideast adventurism. The upshot: oil prices, which leapt on Trump's Twitter threat of a missile attack, could stay up there.
At least for a while. Who really knows how far the escalation of trade disputes will go If Trump's tariffs and the retaliatory ones it will provoke end up stalling global trade, it will impact demand for oil from transportation and manufacturing; a recession could do the same for consumer demand. Nothing is a sure thing.
Of course, none of this might come to pass. The U.S. and China might negotiate away their tariffs; the Syrian conflict might get resolved, or at least contained. But it's one thing to wish for those outcomes when there's a steady hand at the tiller. Those days, it seems, are over.
Which gets us back to the frog story: it's baloney. What really happens when you put a frog in a beaker of water and turn up the heat is … the frog gets out of the water.
Investors might want to keep that option in mind.