Seeing Through the Smoke of the Trade War

Seeing Through the Smoke of the Trade War

I’d like to open this week’s piece with a bit of Twitter wisdom – as much as an oxymoron as that sounds.

The impact of Federal Reserve Chairman Powell’s sweet whispers to the market that the 2018 rate hikes are on hold for 2019 is wearing off as politics and trade tensions dominate the markets. I’m going to go out on a limb here and suggest that prescriptions for Xanax and the like have been on the rise inside the beltway in recent weeks. Those headlines investors are trying to navigate around are dominated by talk of the trade war with China, which has evolved from last year’s Presidential tweet.

Fourteen months later, the May 23rd, 2019 comment from Ministry of Commerce spokesperson Gao Feng in Mandarin, (according to a CNBC translation) casts a different tone.

“If the U.S. would like to keep on negotiating it should, with sincerity, adjust its wrong actions. Only then can talks continue.”

So that’s going well. China appears to very much be digging in its heels and preparing for a prolonged battle. We are hearing talk of a ‘cold war’ on the tech sector and the New York Times wrote, “Mnuchin Presses Companies For Trade War Contingency Plans.”

With all that, it is no wonder that the CBOE S&P 500 Volatility Index (VIX) has moved above both its 50-day and 200-day moving average.

May has not been kind to the major US indices.

^SPX Chart

^SPX data by YCharts

Many market bellwethers that had previously been investor darlings are in or shortly will be in correction territory.

GOOGL Chart

GOOGL data by YCharts

But the US economy is strong right? As we’ve mentioned in prior pieces here and here, not so much. This week the Financial Times reported that non-performing loans at the 10 largest commercial US banks rose 20% in the first quarter. That was in a quarter in which GDP came in above 3% and above expectations. What happens in a weak quarter? Those banks aren’t being helped by falling interest rates either, which crush their margins. The yield on the 10-year Treasury note has fallen below the mid-point on the Fed’s target range for the overnight funds rate. A flat-to-inverted yield curve just screams economic party-on.

As we look at growth in the second quarter, remember that the first quarter build-up in inventories was a function of the trade war. Businesses were stocking up before tariffs and in response to all the uncertainty. This buildup was a pull forward in demand for stockpiling which serves as a headwind to growth in later quarters.

We are also seeing reports of trade war related supply chain disruptions, which means declining productivity. Remember that the growth of an economy is a function of the growth of the labor pool (all but tapped out) and growth in productivity. The Atlanta Fed’s GDPNow estimate reflects this with second quarter growth down to 1.3% from 1.6% on May 14th. Following the week’s slump in April core-capital goods orders the New York Fed’s Nowcast reading for the current quarter fell to 1.4% from 1.8% last week.

While the headlines are dominated by the trade wars or the latest drama in DC, what most aren’t watching is the most important factor in the global economy today – the rising dollar.

The US Dollar Index (ICE:DX) has been in a steady uptrend for over a year.

The broader Federal Reserve Trade Weighted US Dollar Index has broken above is December 2016 high and may be on its way to new all-time highs – if it breaks above 129.85, we are in unchartered territory.

Why does the dollar matter so much? About 80% of global trade relies on the US Dollar. Last year the Fed’s rate hikes drove up the price (AKA interest rate) of the dollar for other countries. As the US looks to reduce its trade deficit with many of its trading partners, that means less dollars available outside of the US. When the US imports, goods and services come into the country and dollars leave. A shrinking trade deficit creates a double whammy on the dollar of rising interest rate effects (higher price) and a reduction in supply.

The rising dollar obviously hurts the sales of US companies internationally, (think on this in light of that 20% rise in non-performing loans at US banks) but it is also major headwind to emerging markets, particularly given the massive amount of US dollar denominated debt in emerging economies. As quantitative easing pushed the dollar down, emerging economies gorged on US dollar denominated debt. That seemingly free lunch is now getting expensive, and if the dollar breaks into unchartered territory, that free lunch could turn into spewed chunks.

In addition to the problems with existing dollar denominated debt, the rising dollar increases the scarcity of capital in emerging markets. As the dollar increases relative to another nation’s currency, domestic asset values decline which means banks are less willing to lend. Investment declines and there goes the growth in emerging economies.

With respect to China and the dollar, as the US imposes tariffs on China, the roughly 8% decline in the renminbi versus the US Dollar has helped to offset the impact. This week the renmimbi dropped to nearly a six-month low, falling briefly below 7. To put that move in context, from the mid-1990s to July 2005, China had pegged its currency to 8.28 to the dollar. It only dropped below 7 in 2008 before the nation halted all movement as the financial crisis rolled across the globe. Trading resumed in 2010 officially within a managed band of a basket of currencies, but in practice primarily against the dollar. The big question now is will China let the renminbi stay below the 7 mark.

As global trade slows amidst trade wars, rising populism and dollar scarcity, exports in April in Asia showed the strain.

  • Indonesia -13.1%
  • Singapore NODX -10%
  • Taiwan -3.3%
  • China -2.7%
  • Thailand -2.6%
  • Japan -2.4%
  • South Korea -2%
  • Vietnam 7.5% (woot woot)

Looking at South Korea, semiconductors account for 1/5th of the nation’s exports and we’ve seen global semiconductor sales decline the fastest since 2009. With the ubiquitous nature of these chips, this says a lot above overall global growth. And that’s before the growing ban placed on China telecom company Huawei, which reportedly consumes $20 billion of semiconductors each year, is factored into the equation.

Worldwide Semiconductor Sales Chart

Worldwide Semiconductor Sales data by YCharts

It isn’t just the emerging economies that are struggling with a rising dollar. The Brexit embattled UK, (who just lost its current Prime Minister Theresa May) has seen its currency weaken significantly against the dollar, losing around 25% over the past 5 years – effectively a 25% tax on US imports from currency alone.

Pound Sterling to US Dollar Exchange Rate Chart

Pound Sterling to US Dollar Exchange Rate data by YCharts

The euro hasn’t fared well either. While above the 2017 lows, it has lost nearly 20% versus the dollar in the past 5 years – effectively a 20% tax on US imports from currency alone.

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

If all that isn’t enough to get your attention, then just wait until later this summer when we have another debt ceiling drama to which we can look forward. With how well the left and right are getting along these days on Capitol Hill, I’m sure this will be smooth sailing. With volatility still relatively low (but rising) perhaps putting on a little bit of protection on one’s portfolio would be in order?

And on that note, have a great holiday weekend!

Markets Reach New Highs, But Why?

Markets Reach New Highs, But Why?

At Tematica, we separate our politics from our analysis to be able to provide objective assessments, which means that we need to call out an error we see in the prevailing narrative. Thursday the Dow hit its 7th straight record close, despite the news that Special Counsel Mueller has impaneled a grand jury in the Russia election tampering probe. While many are attributing the market’s gains to president Trump’s administration, this divergence calls that into question. As does the reality that President Trump’s approval rating has hit new lows with disapproval ratings reaching new highs while the market has continued to rise.

Apple (AAPL) and Boeing (BA) collectively have been responsible for 70 percent of the Dow’s gains the past 6 weeks while the FAANG stocks – Facebook (FB), Amazon (AMZN), Apple (AAPL), Netflix (NFLX) and Alphabet (GOOGL) – which account for just 11 percent of the S&P 500 market capitalization have generated 26 percent of year-to-date return. Juicing up those returns has been leverage, with margin debt up 20 percent on a year-over-year basis in each of the past 5 months and is today over 60 percent HIGHER than at the 2007 peak.

The reality is that in the past 6 weeks, the median stock price and median sector price haven’t actually moved. What has happened has been a falling U.S. dollar, which is on track for the weakest annual performance in 14 years. That’s really something in light of the prevailing narrative that assures us the U.S. economy is going like gangbusters. Ignore that recent ISM report which saw Services experience the biggest drop since November 2008 – same goes for the Composite Index. Amazing to have a falling dollar and the U.S. Treasury 10-year yield right around where it was during the depth of the Great Recession while the Fed is tightening and yet we are to believe the economy is firing away, hmmm.

The top three stocks in the Dow for foreign revenue, Apple (APPL), Boeing (BA) and McDonalds (MCD) account for 50 percent of the Dow’s year-to-date gains, hmmmm.

So what’s going on here?

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

In euro terms, the S&P 500 is actually down 1.9 percent year-to-date. In Mexican peso terms it is down around 4 percent and even in the polish zloty it is down roughly 5 percent.

In fact, when President Trump was elected, the U.S. stock market capitalization represented 36 percent of total global market capitalization. That ratio rose to nearly 38.5 percent but has since fallen to 35 percent where it was all the way back in June 2015. On a relative basis, the U.S. stock market has significantly outperformed. What we are seeing here is more a function of a falling currency that a rising stock market reflecting a robust economy.

What could go wrong? The Intercontinental Exchange now has a net short position for the U.S. dollar for the first time since May 2014 and after that time the greenback gained 5 percent within 3 months. If the market has been rising on a falling dollar….

Then there is that debt ceiling debate that, when taking into account recent dynamics in D.C. between various members of Congress and the White House, could make Game of Thrones appear rather tame. This coming at a time when the tax reform debate is set to kick off. Oh and there are those November elections to really bring out the softer side of politics. With the Chargers no longer playing in San Diego this Fall, (What the hell?) I think I’ll have more than enough games to watch coming out of Washington.

Brexit from London

On June 25th, while in London, I had the pleasure of joining David Asman on Fox News to discuss the meaning of Thursday’s vote to leave the European Union. The view of Brexit from London has been stunning. All those who underestimated the British sense of self-confidence and desire for sovereignty or who were over-confident in the betting odds giving only a 25% change of leaving, are now paying dearly for that confidence. The shock amongst most in the financial sector in London is palatable, with the lights burning bright in most offices all weekend, as portfolio managers, investment bankers and traders work to get their arms around just what this means for them and their clients.

What this means for the US

Pundits in the US are trying to calm markets buy assuring them that this won’t over overly impactful for the US as the UK, the fifth largest economy in the world, only accounts for roughly 3.8% of world GDP, according to estimates for 2016 from the International Monetary Fund, versus the United States, which accounts for around 25.4%. But that misses that this is not just about the UK, but rather about the future viability and success of the European Union, whose GDP is nearly the same as the US. With the tumultuous and highly contentious presidential election cycle in the US,  about 50% of the world’s economy is now experiencing a high level of political uncertainty within the context of an already weak global economy. That is a strong headwind to growth for everyone.

The most immediate impact of Brexit for the US likely a continued increase in the strength of the dollar, which is great for American tourists abroad, but a challenge for American multinational firms that export their products and/or services. The strong dollar will also impact emerging markets that have a good deal of debt denominated in U.S. dollars, acting as a headwind to those economies as that debt becomes more expensive. The uncertainty of how this all will pan out means transactions and contracts between companies in the European Union and with companies outside of the union may be put on hold or cancelled entirely – more headwinds to growth.

Many today are harshly criticizing the Brexit leadership for not having a clear plan for what to do if their side actually won, but the reality is that kind of a plan was literally impossible. A plan would have required having some clarity on how agreements would be worked out with, primarily, other European nations. The leadership of the rest of the European Union had every reason to assure the UK that, “Fine, you want to leave us! Then we will refuse to play with you anymore!” as they desperately wanted the UK to stay. But now that the decision has been made, and after time soothes the many bruised egos a bit, real conversations can begin.

Impact on European Union

The bigger issue here is that the European Union has not delivered on its promises to all who joined. Many countries are suffering in ways that were not expected, with internal tensions rising with every passing year of weak economic growth, high unemployment (particular among the youth) and supercilious finger-wagging from the stronger nations at the weaker ones. As hope for a recovery fades, desperation is rising and the belief that those in Brussels are a cure is shifting to suspicion that they are instead the disease. One of the greatest lessons of political history from the dawn of nations is that the further the decision-makers sit from those affected by the decisions, the poorer the quality of the decision. History shows that the more people that are forced into one size-fits-all solutions, the poorer the end result, often times with dramatic actions to break those bonds.

Those countries in the European Union that have been struggling to reignite their economies post-financial crisis will be closely watching as the events unfold for the UK, placing a lot of pressure on everyone involved. European leaders find themselves in a catch 22. On the one hand, they will be better off having strong trade relationships with the UK, but on the other hand they don’t want other nations that may be contemplating their own exit to see the UK benefiting from this move. Expect more threats, grandstanding and predictions of doom and gloom before this breakup drops from the headlines around the world.

Brexit

Brexit

Brexit. It’s all the rage these days. The word is whispered over candlelight glasses of wine in dark corners at swanky post-market-closeBrexit, Symbol of the Referendum UK vs EU cocktail bars. It is spit out over conference room tables amongst such phrases as “contingency planning” and “hedging strategies.” It has everything a news agency drools over, drama with the dark horse effect as the yes vote gains unexpected traction on the very last loop around the track.  It provides angry rants that skirt around xenophobia or at least a level of indignant nationalism that can generate eye-catching headlines. It paints the image of a battle of wills between the confident and worldly intellectual, gazing with vague annoyance over wire-rimmed glasses at the rough and tumble, calloused working man who is damn tired of those immigrants stealing jobs. It is a story filled with fear, hope, anger, frustration, isolation and unity.  Whatever version of the story attracts you the most, as an investor a “yes” vote for the UK to leave the European Union has two major impacts, currency and uncertainty.

Currency Effect

The currency effect means a stronger US dollar relative to the Euro and Pound Sterling. This would make american exports more expensive and imports relatively less expensive. The United States is the second largest exporter in the world, so when our exports become more expensive, that’s harder on everyone buying our stuff so it becomes a headwind to growth. With imports relatively less expensive, Americans are more likely to purchase an imported product than they otherwise would have been, which can also hurt american producers.

The currency effect can also be a problem for emerging markets where companies have issued unprecedented levels of debt denominated in US dollars. As the US dollar rises in value, that debt become more and more expensive, resulting in everything from reduced investment in growth to defaults which are further headwinds to global growth.

The currency effect can also have a secondary impact in its correlation with oil. With oil denominated primarily in dollars in the global marketplace, strengthening dollar means weaker oil prices. This can then affect the sovereign wealth funds from those oil-dependent nations as they are pressured to sell assets in order to pour more back into their domestic economies. This is a headwind to global asset prices.

Overall the currency effect is essentially deflationary for the US, which makes it more difficult for the Federal Reserve to return us to a more normal rate environment, prolonging the negative side effects from low-to-zero interest rates.

Uncertainty Effect

The uncertainty effect is all about the impact on companies. Although the word sounds easy enough, Brexit, short, simple and comfortably straightforward, the reality is no one really knows just how this darn thing will pan out! If there is in fact a yes vote, unthinkable a few weeks ago but now looking increasingly like it just might happen, no one is clear as to just how it would be implemented. Then there is the reality that the vast majority of politicians in the U.K., regardless of party, are all against a Brexit, so these folks will find themselves having to enact legislation based on a vote by their constituency that goes against what they believe is best; rock meet hard place.

With the realities of the actual implementation unknown, companies will be much less likely to invest which means less spending/less growth. There will be less M&A activity and the potential momentum of this vote with respect to rising nationalism is a further headwind to already falling levels of global trade which means even slower growth across the globe.

Brexit, the end of french kisses along the Thames?