Dear Valued Clients and Friends,
Markets were greeted Monday morning with a 300-point drop at the open, which hours later had led to a nearly 1,000-point drop (before settling down ~750 points). Monday afternoon the Treasury Department decided to label China as a currency manipulator, something that carries significant systemic implications. The futures market then dropped another 500 points overnight, but by the market open on Tuesday China’s relaxation of currency maneuverings had stabilized markets. The market actually ended up 300 points Tuesday, but then opened 300 points down on Wednesday. It went down nearly 600 points Wednesday before coming all the way back. As of press time Thursday we are up 150 points on the Dow. So while the market is, at press time, only down 300 points on the week, there is bad massive volatility around that result, and there remains substantial uncertainty in the market. There is much to unpack here and I am going to try to cover each and every aspect in this week’s Dividend Cafe. This is one week you will want to read all the way through!
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When an easy trade war blows up in your face
The last peace treaty in this trade war was supposed to be simple enough: The Chinese agreed to buy more agriculture from the United States and the U.S. agreed to lay off Huawei. Not even that was able to last. The intense stock market volatility of the last week is not the most problematic aspect of the trade war from an economic standpoint. We will focus our analysis on:
(1) The macroeconomic impact on U.S. growth, and
(2) The currency implications for global markets
The outlook for U.S. economic growth is falling apart under the pressures of this trade war. Focusing on the far right of this chart, you see the Business Investment aspect of GDP growth (blue line) accelerating significantly after President Trump was elected, in line with the CEO survey on planned capital expenditures (red line). And then you see both collapsing together in response to trade tensions.
* Strategas Research, Policy Outlook, p. 7, July 30, 2019
GDP growth has slowed substantially, and again if you look at the far right of this chart below, you see a spike up in GDP growth (the blue line) in line with our services sector growing (the red line), and then a slowing of GDP growth as our services sector has suddenly begun slowing since the trade war’s acceleration. Note how similar the pattern of this chart is to the chart above!
And last but not least, Manufacturing new orders have turned down (blue line below) after a big move higher for the last two years, reinforcing what all of these data points reinforce – the U.S. business economy was strong, and in concert with the trade war, has weakened.
The projections for U.S. GDP growth in 2020 are now down to 1.8%, essentially the same level averaged in the Obama administration. This is what has been called “muddle-thru growth” for quite some time, and it simply is not robust enough historically to hold off a recession for very long past 2020 (if we make it that long).
It is very important to note – what I am specifically highlighting here is the lost octane we were enjoying in our business sector, the previously starved part of the U.S. economy. The very basic sequence we have been looking for is:
Business confidence > Business investment > Productivity > Economic gains (jobs, wages, consumer, profits, etc.)
There can be little doubt that the trade war has undermined that first domino in this process – business confidence – and from that chain of dominoes, it has at best muddied the waters for economic growth, and at worst accelerated the path to a recession.
It takes two to tango?
China did not take the President’s announcement lying down, but (a) Suspended imports of U.S. agricultural products, and (b) Allowed their Yuan currency to weaken. The Yuan has weakened about 12% since the trade war began eighteen months ago. There are plenty of other retaliatory tools in their toolbox, including raising the level of existing tariffs, banning the export of goods that are hard to replace (i.e. rare earth minerals), intensifying inspections and border delays on products the U.S. sells them, and more financial regulations. Again, just as is the case on actions we are taking against China, any of these actions do indeed hurt the person firing the gun as much as the person being shot, but an assessment of what China is likely to do and what they can do is important to our understanding here. We will focus primarily on the currency aspect below.
Under the hood of global trade
The U.S. imports more than $150 billion of electrical machinery a year from China, $117 billion of machinery, $35 billion of furniture and bedding, $27 billion of toys and sports equipment, and $19 billion of plastics. Our largest exports to them are airplanes and machinery and medical instruments. The rough numbers are that we import $540 billion of goods from them and we export $120 billion to them (hence the so-called “trade deficit” of $400-425 billion).
One war is not enough. Trade, meet Currency
It was always rather likely that if the trade war were extended long enough it would lead to a currency issue. That came more violently than many expected this week when first China “allowed” their currency to further weaken relative to the U.S. dollar, and then the U.S. labeled China a currency manipulator. This escalation has elevated concerns that the U.S. may actively intervene to weaken their own dollar, most notably by instructing Treasury to buy another country’s currency by the same amount other countries are purchasing the U.S. dollar so as to offset currency manipulations (or put differently, to manipulate so as to counter manipulation). There is a limit to how much the executive branch can do here (based on the size of the Exchange Stabilization Fund) without going to Congress (though, “national emergency” declarations have become palatable in this administration, and open up further doors of policy intervention).
I wrote more extensively on the currency wrinkle to this whole escapade at Market Epicurean this week.
But for those who want to avoid the deep dive and just understand why this matters better, a currency war (like a trade war):
(a) Has no winner
(b) Is destabilizing to global economic conditions
(c) Compresses risk asset valuations as demand for U.S. assets is globally weakened
Right now the declaration is mostly cosmetic, but if coupled with retaliatory actions opens up the door to greater market instability and uncertain outcomes.
Glass is half full?
If there is anything this week that suggests dogs and cats are not, in fact, falling from the skies, it is that credit spreads have barely moved this week at all. And I am not bringing this up as a sort of weak, anecdotal “well, this is a good data point” … This is really significant, and frankly, really surprising. High Yield bond spreads have widened 50 basis points (which is something, but not Q4 2018 something, where they widened 220 basis points!!!! And the BBB spreads (index of credits that are the lowest quality within the investment-grade space) have barely budged at all. This simply means that, so far, credit markets are not fearing Armageddon, at all!
Where are we going from here: Trade
I am extremely skeptical that we will see a resolution before the 2020 Presidential election. I think China has ample reason to believe they can wait this out over a year and see what happens after the election. And I think the President has decided (for right or for wrong, more on that in Politics & Money below) that sustaining this fight is better for him politically than ending it. Structural reforms seem entirely off the table. Perhaps some tariffs will get frozen or suspended or delayed, but the idea of a master agreement or repeal of incumbent tariffs is now highly unlikely.
The pain does get to some point for one or both sides where it is significant enough that appetites and positions change. I believe China has decided their pain threshold has at least 18 months left in it. It is hard to see how the President can now salvage this without a grand bargain deal, and it is hard to see how China comes back to the table before the election. I think the optimal case is that it just finds a place of equilibrium (no acceleration or deceleration) in the near future, but then sits there until the election. And that is optimal case …
Where are we going from here: Fed
The Fed is almost certain to cut rates again, with there being a 100% chance priced into the futures market right now for at least one cut at the September meeting, and an 80% chance that there is either another .25% coming (or another .5% coming) by December. In other words, we are 2-3 rate cuts more to come now, per the futures market.
With the collapse of interest rates, Treasuries become even less interesting to U.S. domestic holders, a group that has gone from 80% of the buying market to 40% in 30+ years. Foreign buyers are vulnerable if the currency war escalates, and they have gone from 10% to 45% of the market. Will the Fed have to pick up the slack? Monetization by another name?
Trade war redux
I thought this chart was a rather keen summary of what the cycle has been now (multiple times) over the last eighteen months.
*MarketSmith, Investor’s Business Daily, Aug.1, 2019
What is the optimal debt-to-GDP ratio?
It all depends on the rate of growth in the economy. 40-60% debt-to-GDP worked for many, many decades without suppressing growth. The problem is that a growing economy affords one a higher debt-to-GDP ratio, and a higher debt-to-GDP ratio undermines a growing economy. Ultimately, and this is the most important thing I can ever, ever say about the topic, it is NOT about the DEBT-to-GDP, but the size of government. I prefer a $500 billion deficit on $1.5 trillion of spending to $0 deficits and $4 trillion of spending, assuming the size of the economy were the same. The debt-to-GDP can be higher if, and this is the if that has failed for the last three Presidents, if the government spending as a % of GDP is held down. That is always and forever the operative variable.
Politics & Money: Beltway Bulls and Bears
- Can the President win re-election with the economy in trade war-induced turmoil? That is the ultimate political irony in all that is going on right now … Many believe that the U.S. has more leverage as the economic impact is worse for China in this trade war, and that China will get a worse deal after the election than before. And yet, if on an absolute basis the damage to the U.S. economy is severe enough over the next year (regardless of the relative differential in impact to China), the chances of President Trump being there in a second term go down significantly. I would argue that how the market does over the next year will tell you more than any poll or pundit will about President Trump’s re-election chances.
- By the way, I agree with those pundits who say, “but President Trump’s tough posture on China is very popular!” I am not saying that the very idea of him going after China this way is undermining political prospects – in fact, I suspect it net-net helps him. However, polls overwhelmingly show (or imply) that the support is correlated to the assumption that there will ultimately be a deal. And furthermore, support has been affirmed without the context of real economic pain; it is incomprehensible that the support would be maintained if the process led to a recession.
- Does President Trump’s 43% approval rating suggest he is in real trouble? Let me share two other approval ratings of other recent U.S. Presidents in their third year: President George H.W. Bush (Sr.) – 72% in year three (admittedly behind the successful Gulf War). He lost 18 months later to Bill Clinton. President Barack Obama – 43% in 2011. He beat Mitt Romney 18 months later.
Chart of the Week
So are we bringing the jobs back to the United States that previously went to China for low-cost manufacturing? Hardly. China’s very modest loss has been Vietnam’s gain, Taiwan’s gain, India’s gain, and Mexico’s gain. There is a total gross suppression of trade, and to the extent there has been any adjustment in supply chains and the source of goods traded, it has shifted to other countries on the global stage, not Pennsylvania or Ohio.
* Strategas Research, Policy Outlook, August 5, 2019, p. 4
Quote of the Week
“History never repeats itself. Man always does.”
* * *
I am sympathetic to those who dislike these bouts of market volatility. The cause of the volatility is uncertainty, and in this case, I do not see a clear end to the uncertainty anywhere in sight. This is not the same as a bearish forecast, though. Market prices fluctuating have no impact on investors unless they are selling assets, and we position our clients to not meet liquidity needs from the sale of risk assets. Rather, from new funds being deployed to the reinvestment of dividends paid, there is actually great long term opportunity out of market volatility (I will never tire of offering this mathematical reality, no matter how cliche it may seem). And furthermore, fixed income is working its role well as the defensive diversifier of choice (as interest rates have utterly collapsed). Alternatives are performing impressively, as we expect them to in periods like this. These positive realities are not mere spin – they are real and economic and empirical and fundamental.
And most importantly, they come from fundamental truths that are inherent to our entire portfolio construction process. Can I promise that all of this will be over in a week or so? No, I cannot. What I can promise is that these circumstances and the environment in which they are playing out do not disrupt the financial strategy of our clients. To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
The Bahnsen Group is a team of investment professionals registered with HighTower Securities, LLC, member FINRA, SIPC & HighTower Advisors, LLC a registered investment advisor with the SEC. All securities are offered through HighTower Securities, LLC and advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk and there is no guarantee that the investment process described herein will be profitable. Investors may lose all of their investments. Past performance is not indicative of current or future performance and is not a guarantee.
This document was created for informational purposes only; the opinions expressed are solely those of the author, and do not represent those of HighTower Advisors, LLC or any of its affiliates.
The Bahnsen Group is registered with HighTower Securities, LLC, member FINRA and SIPC, and with HighTower Advisors, LLC, a registered investment advisor with the SEC. Securities are offered through HighTower Securities, LLC; advisory services are offered through HighTower Advisors, LLC.
This is not an offer to buy or sell securities. No investment process is free of risk, and there is no guarantee that the investment process or the investment opportunities referenced herein will be profitable. Past performance is not indicative of current or future performance and is not a guarantee. The investment opportunities referenced herein may not be suitable for all investors.
All data and information reference herein are from sources believed to be reliable. Any opinions, news, research, analyses, prices, or other information contained in this research is provided as general market commentary, it does not constitute investment advice. The team and HighTower shall not in any way be liable for claims, and make no expressed or implied representations or warranties as to the accuracy or completeness of the data and other information, or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice.
This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.
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