Cracks Forming…

361 Capital Market Commentary | August 12th, 2019

The September 1st tariffs on the rest of China’s imports are looming large and causing the U.S. Economy to slow down further. The big move in the U.S. Treasury market is confirming this fact. If the tariffs are implemented, the ball will then fall into the Fed’s court to try save the U.S. from entering a recession. Keep in mind that a new recession, and its accompanying stock market decline will factor into who will likely reside in the White House in 2020. So, will Fed Chair Powell and his board cut rates by 25 basis points or 50 in September? Somewhat ironic as to who might have the upper hand in Washington D.C. now.

To complicate the Fed’s decision, some new cracks have formed on the other side of the equator. The global financial center known as Hong Kong has widened into a full crisis with all business and transportation now being affected as the locals fight for their independence. The financial world needs a stable Hong Kong. And in Latin America, the free markets golden president of Argentina has just suffered a political defeat back toward socialism causing their asset values to collapse overnight and ripple through the rest of the continent. In the northern half of the globe, South Korea and Japan have restricted trading with each other and North Korea continues to light up its missile-of-the-week.

For equity investors, the markets have become very defensive with Utilities, REITs, Insurance companies and Defense contractors leading the market. The Gold commodity and its Mining stocks have even joined the leaders which is very reflective of how cautious stock buyers have become. While the valuations of the average stock has moved lower, so has its earnings growth outlook. This is not a time to be a hero unless you have an actual working crystal ball. Meanwhile, it is becoming much easier for investors to create lists of companies that are going to have a difficult time making it through this next downturn. Just dig for those companies with negative operating leverage, too much debt and high valuations.

These China tariffs bite…


“Eighty percent of my time and nearly 100% of my energy goes to dealing with the tariffs”

When the Trump administration first imposed 10% tariffs on many Chinese goods about a year ago, suppliers, importers, distributors and retailers worked together to defray the cost and try to avoid passing it on to consumers for fear of losing sales. Mr. Stone and his Chinese partners initially ate most of the vinyl flooring tariff cost, passing just a tad on to retailers.Tariffs at the 25% level are quite another matter. They are upending cost projections and business models and straining relationships built up over decades. For operations such as Mr. Stone’s, the math is painful. He and others are trying to figure out how much of the new expense can be dispersed throughout the supply chain, how much should be passed to customers, at what potential cost in lost sales, and how much they must swallow.

These tit-for-tat tariffs, at their new higher levels, are forcing businesses into tortuous calculations and negotiations. How these ultimately turn out will have ramifications throughout the U.S. economy, determining how the higher costs get distributed and what effects they may have on sales, as the U.S. and China dig in for what is becoming a protracted trade battle.

“This is a chaos moment. If I pay the tariffs, I don’t have any money,” said Mr. Stone.


It sounds like an advisory committee of “one” has led us into this currency war…


Where this currency convulsion ends is anyone’s guess. One of Mr. Trump’s trade conceits is that he can manipulate markets at will by dialing tariffs up or down. But currency markets have a tendency to overshoot and create unexpected casualties. Markets don’t know how much financial strain a company in Shenzhen can bear before it defaults on its dollar bonds, and Mr. Trump doesn’t know either.

To Mr. Trump, all of this is part of his grand trade showdown with Chinese President Xi Jinping. He was furious last week when his negotiators returned from China without significant progress. So he slapped on new tariffs, which he thinks will impose more pain on China than on the U.S.

But if the President believes adviser Peter Navarro’s counsel that the U.S. is immune from all this, markets are saying the opposite. The Dow Jones Industrial Average is now lower than it was in January 2018 when he began his game of China chicken, despite two years of strong corporate earnings. The uncertainty from tariffs has chopped U.S. GDP growth to 2% from 3%. Business investment is falling and global manufacturing is nearly in recession.

Mr. Trump is punishing China all right. He’s also putting U.S. growth in jeopardy by unleashing trade and currency risks that undermine the benefits of his tax reform and deregulation. Sometimes trade wars end badly for everyone.


The Wall Street Journal Editorial Board has taken its gloves off with this White House…


The irony, and a dangerous one, is that Mr. Trump doesn’t seem to understand that his trade policy is contributing to exchange-rate instability and a rising dollar. When he slaps tariffs on China he reduces the demand for Chinese yuan. He also encourages capital flight to safe havens like the dollar, which encourages more capital into dollar instruments and the U.S. China isn’t manipulating its currency. It is setting a lower peg to reflect supply and demand and prevent greater capital flight out of China.

We aren’t predicting a recession, but then few thought we were in a recession in mid-2008 either. Economic downturns can sneak up on the smartest policy makers. Dan Clifton of Strategas Research Partners has begun noting that Mr. Trump is “‘trading away’ his re-election” as his trade policy erodes what was a strong economy. Mr. Clifton is a supply-sider who supports Mr. Trump’s tax and deregulatory agenda.

This is a warning the President should heed, and probably one Mr. Navarro won’t tell him. If Mr. Trump can’t strike a broader trade deal with China before the election, he should at least call a trade truce to reduce the damage. Economic expansions don’t end on their own. They almost always end due to policy mistakes. Mr. Trump’s willy-nilly trade offensive could be the mistake that turns a slowdown into the Navarro recession.


If the White House won’t listen to the Wall Street Journal, then maybe they will give an ear to the New York Times…


Tariffs are a tax ultimately paid by American businesses and consumers, and Mr. Trump’s existing tariffs on Chinese goods already have cost Americans more than $20 billion.

There is no sign the tariffs are shifting manufacturing from China to the United States. The latest data shows the manufacturing sector is expanding at the slowest pace since 2009. JSW Steel, which said last year that Mr. Trump’s tariffs on steel had made it possible to begin a $1 billion expansion in the United States, is now suing the Trump administration for imposing tariffs on the company’s imports of raw materials.

China’s retaliatory measures also are hitting the American economy, particularly the farm belt. Mr. Trump has substituted handouts for lost sales, and he promised Tuesday, “I’ll do it again next year if necessary!” But many farmers are unhappy about the standoff. They say they would rather sell soybeans than collect federal aid. The taxpayers funding the handouts have reason to grimace, too.

China has suffered a loss of sales in the American market, but the Chinese government has taken an increasingly hard line, and it is not obvious that ratcheting up the tariffs would produce better results. The Chinese already are establishing new patterns of trade — buying soybeans from Brazil, opening export factories in Southeast Asia, investing in European infrastructure.


Meanwhile, farmers are about ready to throw in the towel as Ag prices grind toward zero with their largest customer gone for good…


This ETF Holdings: Cows, Corn, Soybeans, Sugar, Cocoa, Wheat, Coffee, Hogs, Cotton.

Invesco DB Agriculture Fund

John Deere dealerships in the U.S. are also feeling the effects of the end of U.S. agricultural dominance…


Schmidt says sales at his dealership, in general, declined by as much as 15% in the first half of the year, led by a fall in the demand for large equipment. In a sign of things to come, early orders for planting equipment for next season’s soybean and corn crops are down up to 25%.

He is not alone. Half a dozen dealers of Deere’s agriculture equipment across the Midwest shared similar accounts in interviews with Reuters. One of those dealers, in Geneseo, Illinois, said sales at his dealership were down 50% so far this year from the same period last year.

This is a worrying sign for Deere, which gets nearly 60% of its sales from the United States and Canada.


Oregon’s Tim Duy thinks that Powell now needs to pull out the 50bp bazooka at September’s FOMC meeting…


I agree with the assessment that risks to the economy have grown in the past 6 months. Boiled down to the essentials, the economy is slowing to trend and the multiplying downside risks leave it vulnerable to slowing below trend. The yield curve is telling me that these shocks will not overwhelm the Fed. Powell & Co. can still sustain the expansion and are expected to do so. “Expected” is key of course; the slower the Fed moves, the more likely they are to miss the opportunity to avoid recession. A policy error is a very real potential outcome here. To enhance the odds of avoiding recession, I would advise the Fed to get a 50bp cut done at the next meeting. While I fully expect the Fed to ease at the September meeting, at the moment the Fed seems likely to stick with the less aggressive 25bp cut.


Noting the acceleration in the trade wars, Goldman is now suggesting that investors shift their portfolios away from manufacturing stocks and into services stocks…


The outlook for US-China trade has collapsed. The likelihood of a trade deal priced by the equity market now stands at 13%, down from nearly 80% in April. A major sticking point in trade negotiations involves Huawei, the China telecom conglomerate on the US “entity list.” The US government granted a 90-day exemption ending August 19th that allows domestic technology firms to send software updates to Huawei phones. Government announcements this week suggest further extension is unlikely. Retaliation by China is possible.

(Goldman Sachs)

It was a very defensive week for the markets…Bonds and Gold higher, Stocks lower.


Returns 8-12-19

And we are all still watching junk bonds closely…


iShares High Yield Corporate Bond ETF

Among sectors last week, the defensive REITs and Utilities led…


Energy and bank stocks were among the worst.

Sectors 8-12-19

Things in Argentina just went from bad to worse…


@Schuldensuehner: Ouch! #Argentina Peso in free fall after a populist opposition candidate routed President Mauricio Macri in a shock primary election result. Plunges to fresh life-time low 59 per Dollar.

One of the markets most trusted recession indicators is at pre crisis lows

But good news for yield-seeking investors…


@Schuldensuehner: Yield of 100y #Argentina Dollar Bond jumps to fresh record of 10.9% after shock vote.

Yield of 100y Argentina Dollar Bond

U.S. earnings estimate forecasts continue to fall for the next two quarters…


2019 SP 500 EPS Growth Estimates inched lower last week

Merrill Lynch’s monthly survey of Portfolio Managers shows that they increasingly like to run to U.S. Treasuries to hedge…


This is interesting given the duration risk of 10-year Treasuries. But clearly Portfolio Managers are no longer worried about inflation or a strengthening economy right now.

What do you consider the most effective risk-off hedge?

Speaking of the 10 year-Treasury yield, what an incredible six-month head fake…


10-Year Yield Testing Broken Post-2007 Down Trendline

But if you are looking for a mortgage, now may be your time…


I saw a 2.75% 7-year ARM last week, but I am holding out for negative mortgage rates. Time for my bank to pay me for owning a home!

30-Year Fixed Mortgage Rate

We are still not seeing where lower mortgage rates are helping housing sales…


Existing home sales are down about 4% so far this year, according to an analysis of National Association of Realtors data by Ted Jones, chief economist at Stewart Title Guaranty Co.

The national slowdown in the housing market has been driven by high-price markets, especially in the West Coast markets like the Bay Area, Los Angeles and Seattle. Economists and real-estate agents said some of the factors driving the recent decline in borrowing costs—a weakening global economy, an intensifying trade battle with China, and new fears about a U.S. recession—are likely to have a bigger impact on the market than lower rates.

“What’s screwing everything up is the trade talks. When people have a lot of money and things are uncertain, they just kind of wait,” said Jeff Barnett, a regional manager at Compass in the Bay Area.

Mr. Barnett said business in his office is down about 20% compared with a year earlier.


A permanently ‘below-the-fold’ POTUS would get the vote of my ‘nightly-always-tired’ eyeballs right now…


Michael Bennet Tweet

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