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Dusty recesses

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The Days Ahead: Fed minutes and lead up to Central Bankers’ Jackson Hole meeting

One-Minute Summary: Trade talks took a welcome break from the news last week as investors’ confidence in a settlement rose.

No, no, no. We'd like to write that one day and our guess is we probably will. But for now it's trade and economic policy on the fly. If there’s a grand strategic plan, please let us know.

Argentina kicked off the week with the crushing of the reformists and likely reelection of the disastrous Peronists. Emerging Markets bond funds were particularly hard hit.

We'd summarize the trade talks as the U.S. blinking. The good news is that the 25% tariff on the $300bn of consumer goods will take place in December, not September. Full list here. That was good news for the likes of Apple and chipmakers like Micron, Qualcomm and Roku and for the wider market. The tariffs are showing up in inflation. Prices for things like appliances, furniture, auto parts, flatware and lighting are up 4% more than the broader CPI. They're likely to continue to do so. Average tariffs with China have risen from 3% in 2017 to 21% by December 2019. It's going to show up in inflation, lower wages and  lower corporate margins.

There’s really no good news in the tariffs. Rolling them out slowly is better than all at once. But this issue will hang over markets for a while.

Market reaction was predictable. We had intraday swings of over 1% every day with a net loss of 0.9%. We're down 4% from the ding-dong highs in July but up 15% for the year. Bonds had another strong week with the 10-Year Treasury at 1.5% and the 30-Year Treasury below 2% for the first time since its launch in 1977. It’s been a good year for bond and particularly Treasury investors.

1. What's with the inverted yield curve?

We've talked a lot about the inverted yield curve over the last few months. A few years ago, curve inversion was the talk of the geeky corner of Fixed Income desks. Interesting in a technical way but not great predictors of wider events. Now it’s gone mainstream. In the last big yield curve inversion in 2006, when the inversion was nearly 100bps, the New York Times mentioned it a total of 20 times. Last week, the Treasury 2s/10s inverted briefly. It mentioned it 80 times.

The 2s/10s was almost the last one to invert. The more important 3m/10 year inverted back in March. So here’s an update of our thinking.

Do other countries have inverted yield curves?

Yes. Germany, Japan, France, U.K., Switzerland and Australia

Is the inverted curve a recession indicator for them? Are they in recession?

No and no.

Is the inverted curve a good recession indicator?

Erm…not really. The curve has inverted 7 out of the last 9 recessions. But its timing is lousy. It can be up to two years early, which is not helpful, and it gives false signals.

Does it cause recessions?

No. The fact that short-term rates are higher than long rates usually means the Fed is behind the market in rate expectations. Low confidence, inflation and, critically, unemployment cause recessions (that’s over simplifying, we know).

Could this time be different?

Yes. Rates were much higher in past cases. In the 1950s the 10-Year Treasury averaged 4.5%, in the 1970s 8% and 1980s 9%. Now Ten-Year rates are around 1.5%. The absolute level does matter. The Fed also all but ignored past inversions. They're paying attention to this one and likely to do something.

Are there better recession indicators?

Yes. Debt service, claims, employment, housing sales and starts, hours worked and consumer confidence.

Are they indicating a recession?

No

So what now?

We know the economy is slowing. Trade, manufacturing, housing, consumer confidence have all stopped rising but they're not falling much either. That doesn't mean “all clear” and data can deteriorate quickly. But we’re well positioned for the slowing growth.

2. “Is this the end of the bull market?”

Is what you would have heard tuning into, well anyone, last week. But wait, what bull market? Bull markets have exuberance, irrationality, quick wealth, swapping jobs to day trade. You know, moron stuff. But this bull market is a decidedly dull affair. Take a look at the following:  

That’s a nice chart, no? Up from 700 or so at the 2009 bottom and now 2850, or +256% growth. But a few points:

  • The market fell from 1600 in 2007, so the return from then is +41%

  • The snap back from the bottom to mid-2015 was +105%

  • Then the market went sideways for a year and rose +36% from mid-2016 to January 2018.

  • Since January 2018, the market has done precisely nothing (excluding around 4% in dividends)

And finally, the rolling 5-year return is a healthy 10% but the rolling 20-year return is 6% (see below)…respectable but not a bull market.

What we've really seen in stock since late 2016, is a one-off adjustment for lower tax rates. All things being equal, the S&P 500 corporate tax rate dropped from an effective 28% to 18%. Corporate taxes now bring in around $800bn compared to $1,600bn in 2016. Put the stock market multiple of 17x against that, net out dividends, and you're at around the increase in total stock market capitalization since then. So, it's a straight transfer of tax revenues to shareholders.

This is all to show that we’re not in a bull market and haven't been for nearly 20 years. What we've been in is an extended sideways market with some upward trends. Beating inflation, beating bonds, beating international. But also settling into flat trends for long periods. We're in one now.

We expect it to break upwards and there will be short-term corrections. But it’s not a bull market.

3. Is a rising stock market good for everyone?

No. The general opinion is that a strong stock market is one of those rising tides, all boats things. Everyone benefits. It all rests on the wealth effect theory. People feel wealthier because of strong house or stock prices. They feel more confident. They buy more stuff. The trouble is that the top 1% of earners own 38% of the stock market. And 50% of all families own less than $54,000 in stocks. That upper group, the 1%, have a “low propensity to spend”, which is another way of saying, they look at the stock market and say “meh…what’s for dinner?” They don't adjust their spending one iota.

Anyway, courtesy of an old friend of the firm, David Ader, here's an update on the number of hours the average guy needs to work to buy the S&P 500.

It’s bounced around for the last two years but remains high by past measures. So what? It simply says the average worker has to work a lot to keep up with stocks. And the wealth effect is irrelevant for most people.

Bottom Line: Stop-start and bluffs on trade. We used to think Presidents’ had little effect on markets…more just stay and keep out of the way. This is, well, different. Companies seem to be keeping a cool head but we’d stay defensive.

Please check out our 119 Years of the Dow chart  

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Other:

T.E. Lawrence 131 years old today

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Artist: Euphemia Charlton 1885-1969

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Ten Years After

Market Corrections – here we go again

Market Corrections – here we go again

We're not minimizing the concerns around market corrections. We've seen the market drop by around 6% in recent days although we’ve had a bounce and they’re now down 3.3% from record highs at the end of July.

We think this is all down to the trade, slowing economy and not-so-great news coming from overseas. One thing we do know is that small corrections are frequent and part of the pattern of stock market investing. We've also seen this before.

Take a quick look at the table below. In all the corrections going back to 1970, most market dips have seen quick recoveries.

So the message is, whatever today’s cause for stock market weakness, dips happen and happen often. You just don't need to react to them all.

  --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Once a jolly swagman

The Days Ahead: NFIB will tell us how small businesses are doing

One-Minute Summary Political interference in the markets reached a new high last week. We go into further detail on the Monday sell-off below. By Friday, the latest twist was that the Administration said Huawei, the Chinese 5G company considered a security risk, was still not approved…but could be if there is a trade deal. So the normal off/on again. For the week, the market was down 2.5% but at one point was down 6%. 

We’re not concerned about stocks. Most of the moves are in normal ranges. There was a spike in volatility as measured by VIX but we’re skeptical of its reliability as a risk measure and don't feel it warrants much attention until it gets into the high 20s and stays there.

Bonds had a remarkable week with the 10-Year Treasury trading as low as 1.64% and the 30-Year Treasury below the Fed Funds rate. It’s only done that four times in 40 years and a rate cut normally follows. That alone puts a September rate cut back on the table. And keeps us invested in Treasuries.

Other central banks also cut. India, New Zealand and Thailand. The U.S. remains the high interest economy (all relative!), which is why we don't see much relief on the dollar or big downside on bonds.

1.     Trade wars easy to win? If you target a single number and outcome, and in the U.S. case it’s China’s exports, you have to be prepared for retaliation and consequences. It came on Monday when this happened:

There’s a long history of the Renminbi and the U.S. dollar. Some 20 years ago it was at 8.0. Then, with years of growth, exports and surpluses, it appreciated to 6.0 (it goes backward in the FX world). At that point, China began to accumulate U.S. Treasuries, with meant selling Renminbi, and it depreciated to 6.9, which is where it's been for most of the last three years. During most of that time, the Bank of China (PBOC) regularly intervened to stop the Renminbi weakening.

Why would it weaken? Because of capital flight and the necessary buying of U.S. Treasuries from trade surpluses. China is still the world’s largest holder of Treasuries at around $1.2 trillion.

On Monday, it drifted past 7.0 for a depreciation of about 3%. You don't really get a 3% currency move in a liquid market unless someone wants that to happen. So, yes the Chinese stepped aside and let the currency find a proper clearing level. And yes, it was a move directly tied to the tariff threat. As was the Chinese government’s decision to stop buying any U.S. agricultural products.

We'd say the currency move is not that important by itself but tells us:

  1.  China is willing and able to retaliate

  2. China can shift some of the tariff damage around to other countries

  3. We may see more capital flight from China to the dollar

  4. It will accelerate the trend of a lower China-U.S. trade imbalance, down $18bn from a year ago, to a higher “All-Other-Countries’” – U.S. trade imbalance. Deficits with Europe, Mexico, Japan and others are up $55bn from a year ago. 

Later on Monday, the U.S. Treasury declared China an official currency manipulator. This is a completely meaningless gesture as all it does is push the issue over to the IMF. Who won't and can't do anything. In effect, the U.S. Treasury is saying “Hey, China, you kept the currency from depreciating all this time. You stopped. Can you please restart?” Yes, bonkers, I know.

By Friday, things had settled down a bit. We think China will keep the rate around 7.05 and we won't see any major disruptions. But it shows that there are many rounds left until the trade war is “won.”

2.     That bond rally…can't last can it? Oh yes. We like long term charts around here. It often helps to take a headline “this has never happened before” and tell us, that, well, yes it has and it's not that surprising. Let's look at the 10-Year Treasury since the beginning of the end of the great inflation era.

For 35 years, we've seen a bond bull market. Indeed if you’d bought a 30-Year Treasury in 1982, held it until maturity, you would have probably beaten every other asset class. There’s an obvious trend here. Yields have fallen and since 2009 have bounced between 3.5% and 1.5%. If they cross a moving average (here at 100 months and 200 days) they tend to keep going for a while.

So what would make it change? Well, for higher rates, say 4% on the 10-Year, we'd have to see:

  • Higher inflation, well over 2.5%

  • Higher growth, over 3% consistently

  • Other Central Banks increasing rates

  • Global growth

  • More fiscal response from surplus countries (looking at you Germany)

  • Strong growth in U.S. housing, spending and borrowing

  • Higher oil prices

But we don't see any of those. And we’re late cycle. So, we'd prepare for another long period of trading in the same range. And at the bottom of that range for the next few months.

3.     Are defensive stocks the answer? If you can find them. When markets crack, there’s usually a move into the fear or safety trades. The classic examples are Treasuries, gold, the Yen and the Swiss Franc. They all were up last week but nothing like what they did in 2008. So, the fear level seems contained.

In the U.S., the defensive stocks are usually real estate, utilities and consumer staples. The first two are bond proxies. Staples are just what you have to buy regardless of economic conditions. So far so straightforward but the problem is that there are fewer defensive stocks around:

Thirty years ago, defensive stocks were 25% of the stock market. Five out of the top 10 companies were defensive stock. At the height of the dot-com, they were less than 10% and there were no defensive stocks in the top 10. Today it’s 12% and, again, none in the top 10.

We wrote about this a year ago and it meant that, in our view, the market was more vulnerable to a correction. We're in some defensive sectors, such as Aristocrats and Berkshire (it has $122bn or 25% of its market value in cash).  We'll keep it that way for now. But remain wary of overpaying for defensives.

Bottom Line: We started to lighten up on international. The dive to lower rates won't help economies until the trade issues look clearer. It's a real-time experiment in game theory without the rationality. So caution remains.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

FedEx and Amazon part company.

Artist: Eileen Agar 1899-1991

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

Market Outlook: 2019. Video version

Click here for our take on markets and economy for rest of 2019

(You may need to register for the website to view the video)

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Need to jump ahead?

5.50 Fixed Income

7.13 Stocks

11.14 Federal Reserve

20.20 Fed in 2020

20.30 Europe

28.00 Volatility

31.00 Brexit

50.00 Yield curve inversion

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Tariffs spoil the party

The Days Ahead: Light economic calendar. Focus on Germany and Japan.  

One-Minute Summary Things were going so well. Until Thursday when a tweet appeared saying that the China tariffs were back on for September. Guess when the tweet went out?

Now, there’s a story going round that goes like this:

  1. The Fed cut but, in the Administration’s view, not enough

  2. The Fed uses employment and inflation to set rates except…

  3. On Wednesday, the Fed said they cut because of the “implications for global development”

  4. The Administration controls trade tariffs and “global development”

  5. Higher trade tariffs cause more concern and a slowdown

  6. The Fed cuts more

  7. Administration gets its way

Who knows? But it worked. The 10-Year Treasury rallied on Thursday and stayed at around 1.86% on Friday.

We still think a China trade deal will happen but perhaps the tactics are to delay. Or provoke more? Markets were a little complacent in the last few months. After all, trade is slowing, and leading indicators like airfreight, rail movements and shipping containers have all trended down. Trading in August always over reacts so all this may calm down.

We'll continue our defensive strategy. We're likely to trim anything to do with Asia Pacific and return assets to the U.S.

1.     Did the Fed surprise anyone? No. On Wednesday, the Fed announced a 25bp lowering of the Fed Funds rate. That was as expected a few weeks ago but, as always, the market overreached itself and wanted more. This was the first cut in the cycle since September 2007. That’s nearly 12 years. Remember the average Wall Street trader has been in the business for 8 years and the average portfolio manager in place for 10 years. This is the first cut many have seen.

As we've discussed, the economy has slowed but not stopped. Employment is fine. Most consumer activity is fine. So why the cut? It’s all about worries that trade is holding corporate confidence back. And about the lack of inflation.

Here’s what the move looks like (Federal Funds rate in yellow):

The only times that remotely look like 2019 were the mid-cycle cuts in 1995 and 1998. The 1995 cut was from a much higher level, when Federal Funds had doubled in 15 months and with two quarters of weak growth. The 1998 cut was all about the fallout from a hedge fund called LTMC (here’s the full horror story). So both were insurance cuts as in “things aren't too bad, but they look like they could be, so here you go.”

So all pretty much expected. The key parts of the announcement were:

  1. Two governors dissented. That’s more than usual and in the collegial Fed, it’s a problem

  2. Chair Powell talked about a mid-cycle “adjustment” not a “lengthy cutting cycle.” This means he’d like to be done.

  3. The run off in the Fed’s balance sheet will stop. Since late 2018, it’s declined at an annual rate of 12%. That means more Treasury buying as bonds mature.

Initial market reaction was a yawn for the long end, so 10-Year Treasuries barely moved, but a spike in the 2-Year Treasury from 1.80% to 1.96% (that’s a big move in the Treasury world). And that meant, of course, a flatter yield curve. Stocks sold off. They wanted more.

On Thursday, however, the 10-Year moved down to 1.89%, equivalent to a 1% price change. That was down to a tweet announcing an initial 10% tariff on the $300bn of trade not yet subject to tariffs. The price action was probably overdone but it confirms our confidence in Treasuries.

But putting this all together, we’re probably done on the rate side for a while. Unless the growth really deteriorates between now and late fall, or inflation drops, we think rates will stay where they are for the September meeting.

2.     Aww, come on. This is something you don't see often.

That yellow line is the yield curve of the German Government Bond market (Bunds). It’s not also inverted (that's old news) but it’s entirely below zero. So if you buy a 6-month bill, you will receive €996 in time for the Holidays. If you buy €1,000 of a 10-Year Bund at par, you will receive €950 in 2029. And if you go all in and buy a 30-Year bond, you will receive no coupon and your €1,000 back in 2049. With a big thank you from the German government (h/t FT Alphaville).

There seems no end to the era of negative and zero rates. For us, this points to very mediocre growth in the world’s fourth largest economy.

3.     Update to our South Korea story.  Japan took South Korea off the “white list” of preferred export markets. This means the vital raw materials for chip production won't find their way to South Korea easily. The Korean stock market was an ocean of red on Friday.

4.     How about the employment report?  Normally a headline grabber, but this month’s employment report was overshadowed by trade tweets. The headline number was in line. This is how it looks:

  1. But all was not good. Here's a quick take:

  2. Downward revisions of 41,000 for the prior two months.

  3. The three-month total is down to 421,000 from 521,000 earlier this year.

  4. No dent on the underemployment number or…

  5. Average hourly earnings

The market had other things on its mind. But this shows slowing but not stopped job creations.

Bottom Line: Some caution is needed. Bonds have rallied fast and far. The economy is not going to respond to lower rates. International has had a good run this year and it's perhaps time to take some money off the table.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Uber layoffs

We’ll start attributing the art in the blogs. This week:

Art: Elaine de Kooning (1918-1989)

--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Chumbawamba - Tubthumping

The U.S. earnings machine.

The Days Ahead: Earnings with Apple on Tuesday close. Fed meeting.

One-Minute Summary Good earnings week. The ECB committed to lower rates. They’re worried about the lack of inflation and slower growth. They should be. Government bond yields of six major economies in Europe are negative. There isn't a single country in Europe that pays more than a U.S. Treasury. That includes Greece, Italy, Spain and Ireland, all given an undeserved acronym a few years ago. European markets were up around 1.3% with Germany leading the way.

The U.K. got its third Prime Minister in three years. Boris Johnson was elected by the party, not the country with a mandate to exit the EU by October 31st. Despite his bluster, we'd put the odds as follows:

60% - Prolong the negotiations

10% - Hold another referendum

10% - Hold an election

20% - No deal exit

We've been out of the U.K. since 2016 and see no upside in equities or sterling.

The S&P 500 hit another record high. It's now up 21% for the year but, lest we forget 2018, up 6.5% over 12 months and only up 10% since January 2018. As we've noted, the market is not expensive and lower rates help valuations.

The dollar continues to strengthen. That’s bad for Emerging Markets and good for inflation. The Administration came out on Friday to say they would not try to intervene in the FX markets to drive the dollar lower. We'd stress that the Fed has no mandate or public view on the dollar. That’s the Treasury’s job. If they want to weaken the dollar through intervention, it would take massive cooperation with other central banks to make that happen. It won't. 

1.     How’s the trade war going? No not that one. That one is all about “talks are going ahead, not going ahead” and which bureaucrats are in Beijing this week. No, there’s another trade dispute between South Korea and Japan. And it’s getting quite serious what with one country evoking “national security” issues to stop trade. It’s what the Administration said about steel tariffs last year and is a time-honored way to dodge Article XXI of the GATT.

So, what’s it all about?

 It goes likes this:

  • In 1965, South Korea and Japan signed the Treaty of Basic Relations and agreed on war reparations. All claims were“settled completely and finally”. However, South Korean courts ruled it applied only to governments, not to individuals. So victims of forced labor could still apply for compensation.

  •  Japan disagreed and asked for arbitration. South Korea refused. In late 2018 the Korean Supreme Court said it was ok to confiscate Korean assets of Japanese companies to repay victims. So the stage was set. Meanwhile…

  • South Korea is the world’s third largest supplier of memory chips. Two Korean companies, Samsung and SK Hynix, make 70% of the DRAMs used for temporary storage of data so your smart phone, PC and servers work. South Korea also makes 50% of NAND chips, used for storing photos and videos. Unlike DRAMs they don't need power to retain data. In memory chips South Korea has 60% of global revenue.

  • To make memory chips, you need specialty chemicals (fluorinated polyamide, photoresists and etching gas, since you ask). Japan is the leading producer of all three.

  • Japan exports stuff to South Korea on a “white list” basis, which means Japanese companies don't need an export license. Japan has said it intends to remove South Korea from that list. That would require a lengthy bureaucratic process for companies to sell to South Korea. The reason they gave was that some of the chips made their way to North Korea. But no one’s really buying that…it's  a good old fashioned tit-for-tat.

  • In the world of highly complicated supply chains, we now have the prospect of South Korea unable to produce semi-conductors. And to add more knock-on effects, 25% of South Korea exports go to China. They fell 24% last month. Prices for semi-conductors also rose 12% in the last few weeks as smartphone, PC and computer companies scramble to keep their supply coming. If this isn't settled expect price increases.

So all a bit of a mess. Right now, both countries are at the WTO in Geneva trying to sort it all out.

We've gone into some detail here because we think this highlights two things. One, that a small change in supply chain logistics can have far-reaching consequences. Two, that South Korea is a highly important conduit to world and Emerging Markets trade. If it’s not doing well, chances are that most of Asia isn't either.

Recent trade between the two countries is down 12%, which is rare outside a recession. Last week, the Bank of Korea cut rates for the first time in three years. We think South Korea is a very good bellwether for Emerging Markets. This recent news isn't helping.

2.     How’s U.S. GDP? Slowing but not bad. Second quarter GDP rose by 2.1%. The first quarter was 3.1%. Most people were expecting more but there were some outliers. Nondefense government spending rose 16% and consumer expenditures were up 4.3%. It’s the last one that's important because the U.S. consumer accounts for 69% of GDP. So nice beat and here it is:

So why is the Fed easing?  Because the corporate sector is hurting. Inventory wind down detracted 0.86% to the 2.1% growth and net exports another 0.63%. Without those, GDP would have risen 3.6%. Investment in non-residential structures (so, retail, offices, plants etc) decreased at a 10% rate.

And that's the basic story. Personal side and government ok…anything to do with business, manufacturing, capex, not ok. The Fed is trying to help the latter to keep the whole thing going.

Meanwhile, the Fed’s chosen measure of inflation came in lower than expected at 1.8% and Q1 was revised down to 1.1%. That also gives the Fed the reason it needs to cut next week.

3.     How are earnings going? Well. Earnings are lower than last year but we've had some monster beats by some very large companies. Of the top 10 companies, seven have handily beaten estimates. And not through EPS manipulation. Amazon, Microsoft and Google showed between 12% and 19% revenue growth… remarkable for three out of four of the world’s largest companies. Nearly half of the S&P 500 companies have reported, showing average growth of -2.6%. Three quarters have “beaten” estimates.

As expected, those companies with overseas sales have underperformed those with a U.S. base. Mostly in the tech, materials and energy sectors. But investors expected that so we’re not seeing big revisions down. 

Bottom Line: The Fed will lower rates. We'll watch for any language that may hint they’d go more than 25bp this year.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Why your TV looks worse than the demo models in shops

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Lowdown

A slip of the Fed

The Days Ahead: ECB meeting…will probably announce a cut

One-Minute Summary Stocks were off less than 0.6% over the week. They were down 1.5% mid-week but good results from index heavyweights like Microsoft, JP Morgan and Phillip Morris all reported good numbers.

The economic data was mostly in line with expectations. Retail sales ahead, consumer confidence fine, housing starts and industrial production slightly below. No great dramas. But the Fed governors kept up the dovish talk with three leading voters implying rates could go lower than the 25bp cut already baked into prices. There was an unusual gaff from Governor Williams who said:

“If inflation gets stuck too low — below the 2% goal — people may start to expect it to stay that way, creating a feedback loop, pushing inflation further down over the longer term and it pays to act quickly to lower rates at the first sign of economic distress.”

Ok clear enough. Jump on rate cuts if inflation is running low. The 10-Year Treasuries dropped 4bps and the expectations for a 50bp cut went from 39% to 51% immediately. But then the New York Fed said, er, no, he didn't mean that.

“This was an academic speech on 20 years of research. It was not about potential policy actions at the upcoming FOMC meeting."

And bonds gave up their gain and the probability promptly fell to 20%.

Now we know the problems of reigning in the opinions of 17 regional governors and board members. But can we please get this straight? The market is reacting to every comment as if it was guidance and they are not all on the same page. Thankfully, there’s a blackout period next week pending the July 30th meeting.

All that Williams stuff meant gold had a run of 3.5%…it tends to do well if rates go to zero for the simple fact that a zero yielding asset looks better. But it didn't last.

1.     How’s small cap doing?  Could be better. We like to use the S&P 600 as our small cap benchmark, not the Russell 2000. It’s less well known but has a quality bias, which we like. The main differences are that the S&P 600 i) is slower to include IPOs ii) company must have four quarters of net income (so no tech companies selling $1 bills for 80 cents) and iii) no multiple share classes (so no companies where founders retain control with minority positions). The S&P 600 has comfortably outperformed the Russell 2000 over long terms but the Russell is easier to trade and gets most of the headlines.

Which brings us to this.

Small caps have underperformed since mid 2018

This shows the Russell 2000 compared to the S&P 500 over the last five years. An up line means small cap has done better. A down line means large cap has done better. Even if you’re not into charts (h/t Cameron Crise) you’d notice small caps have had a rough time recently, trading at the bottom of their 5-year range. They're still up around 15% this year but not as much as the S&P 500 at 19%.

Why?

  1. Small companies aren't cheap. The S&P 500 trades at around 17 times earnings. Small companies at 48 times.

  2. They've been harder hit with tariffs. Though they only have around 16% of sales overseas compared to the S&P 500 at 40%, they have less room to work around or avoid tariffs.

  3. They also don't make as much money. In the list we scrubbed, 614 out of 1861, or 32%, were loss making, compared to 5% for the S&P 500.

  4. The tax cuts were kind to small companies last year but that effect has worn off

We'd say that the small company sell off is overdone. These are fiendishly difficult timing calls but we’d look for some relative outperformance if the macro data improves.

2.     How’s business dealing with the trade issues?  Not well. We came across this report from the U.S.-China Economic and Security Review Commission about how some companies are trying to work around tariffs. Basically, it's hard to do without very deep pockets. Currently, more than 90% of Apple’s products are produced in China. It probably has the most entrenched supply chain in China of any manufacturing company, and it's going to take them 18 months to move 20% of production to India and China.

So, if it’s hard for Apple, it was no real surprise that in the latest Beige Book, a survey of companies in each of the 12 Fed districts, that uncertainty, tariffs and trade were cited 37 times. We'll admit this is not the most scientific method to measure concern but this compared to 31 times a year ago. So companies have had this looming over their heads for quite some time.

The overall message is “modest” growth and widespread concerns. Which is the same story coming out of the earnings reports.

3.     How’s the recession watch? Close but not there. We've talked about the Dow Transportation index as an indicator of goods moving around the country. One of the measures is “inter-modal” traffic, which simply means a container moving from ship, to rail to truck without any handling of the freight inside.

So, anything going on?

Freight volumes falling

This shows the one-year change in freight ton-miles (the weight of a good multiplied by how many miles it’s moved) and a broad freight index. Both are down, by 14% and 0.2%. That's more than normal for a pre-recession period.

Last week CSX, one of the four pure-play railroads in the S&P 500, reported. It runs freight rail up and down the East Coast and over to the Mid-West. Their CEO had some interesting points on the earnings call and this caught our eye:

 “The present economic backdrop is one of the most puzzling I have experienced in my career…many of our industrial customers’ volumes continuing to show weakness with no concrete signs of these trends changing…[and we] are seeing a range of conflicting data points and economic indicators…”

We looked at FedEx a few weeks ago and that’s shown weakness in volumes and revenues. We also looked at the Los Angeles port traffic where the basic story is that volumes have fallen steadily since last October.

None of this is a surprise. It’s linked to uncertainty, manufacturing and trade. The concern is that the slowdown might spread. But meanwhile, jobless claims are around the 200,000 to 220,000 range, down from recent highs in the January government shutdowns. So nothing to see or worry about.

Maybe the Fed is on to something with this “insurance” cut?

Bottom Line: Full blown earnings reports coming up. ECB meeting will probably confirm the easy stance. The U.K. will get a new Prime Minister and more Brexit purgatory. Oil may come under renewed pressure but it will be short lived. Stay invested. We're quite defensive already so no major changes to portfolios.

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“In all honesty, profitability is not one of our metrics”

 --Christian Thwaites, Brouwer & Janachowski, LLC

Art work is Burghers of Amsterdam Avenue 1963, by Elaine de Kooning

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Maconi Union - Weightless 

Powell delivers

The Days Ahead: Retail sales and manufacturing numbers

One-Minute Summary Market at record highs. It’s all down to that curious mix of a slowing (not recessionary) economy and lower rates, both here and in the major economies in Europe. Recent numbers on CPI and employment, the two biggest market moving data points, have come in above estimates. The yield curve steepened especially in the 5s/10s, so that takes some heat off recession fears.

Nothing remarkable in the details. Energy did well but that reflects a bounce in the oil price not some big global-growth-demand story. Stocks that did well were health care related and all to do with the ups and downs of the Medicare for All story.

1.     What will the Fed do?  Cut but not by much. We're writing this just as Chair Powell is wrapping up two days of Congressional testimony and the latest Fed minutes from June are out. We'd summarize the Fed’s position as i) the economy is fine ii) but we can't see inflation anywhere iii) we hear about some bad stuff especially trade iv) an “insurance” cut seems like a good idea and v) that will get the President off our backs. Ok, we made that last one up. But the direction is for easier money.

One interesting note was that Powell’s written piece (here), felt the need to stress the Fed’s independence. Then there was this:  

“I urge Chairman Powell and other Federal Reserve Board governors not to submit to the high pressure tactics of this President who continues to push reckless and harmful economic and social policies,” House Financial Services Committee Chair Maxine Waters, a Democrat, told Powell.

She asked Powell what he would do if Trump asked him to resign.

“Of course I would not do that,” Powell said, and repeated that he fully intends to serve his four-year term.

We cannot recall anytime where the Fed has had to state its own independence. I mean it’s one of those things, right? Most economies run independent central banks, no?

We felt it was Chair Powell laying down a marker. Not daring Trump to fire him. He seems too sensible for that. But calmly stating he’s holding his own and not intimidated. Of course, Trump could force the Fed’s hand by going all out on tariffs, inducing a slow-down and recession. The Fed would then cut rates, restoring the economy to health around, oh, say mid-2020. But he wouldn't do that.

We don't feel the Fed will cave nor do we think Trump will force a resignation. We don't think the rate cut is necessary. Employment is fine, inflation low but not heading into dangerous or negative territory. When we look for trouble, we look for depth, duration and dispersion. We see no material, widespread slowdown in any major leading indicator.

The Fed did not surprise the market, so full marks for communicating well. Here’s the 10-Year Treasury:

Yields rose which means the market expected a little more from the Fed and gave up some recent gains. But here’s the 2-Year Treasury:

Yes, it moved in the opposite direction. What’s happening is that i) the long end of the curve was overbought and ii) the front end could move down on the confirmation that a rate cut is coming.

Here’s how the yield curve moved with the blue line as of writing on Friday, compared to a week ago (yellow) and for grins, 18 months ago (black):

What does it all mean? Rates dropping. Long end looking cooked. The 30-Year Treasury popped up. It’s very inflation sensitive. Keep the floaters because we’re getting more coupon than the Ten-Year and stay in the middle of the curve.

2.     Top of the market. Should I buy? Yes. One of our favorite analysts, John Kemp, over at Reuters, had some interesting stats as we sail/crawl by the 3,000 mark on the S&P 500.

Here we go, with the S&P 500 going all the way back to 1929.

There’s an upward bias to the stock market. It reflects nominal GDP, inflation and productivity. Even if U.S. industry stopped making any productivity growth, the market would probably rise by 2% just to track inflation. Add in another 2% for dividends and 2% for share buybacks and you're in the 5% range without too much effort.

So, the long-term trend is up and the short-term trend is about the cycle, greed, fear and the thousand natural shocks we’re all heir to.

The S&P 500 has traded at record highs eight times in 2019. In 2018 it was 19 times, 2017 62 times and 2016 18 times. On average, the S&P 500 trades at a record level 13 times a year.

The current trend is not concerning. It’s come on a little fast in 2019, but it was oversold in late 2018. The average return for the last 5 years is 8%, which is slightly more than we use in our plans and projections.

So, yes, you can buy at these levels.

 3.     How’s the budget deficit going?  Ha, not well. The deficit is up 23% from last year and at this rate will hit $1tr, around 5% of GDP by year-end. Receipts are up 2.6% and spending up 6.6%. Interest payments on debt are up 16%... although some of that is due to the Fed running down its QE balance sheet.

The bond market seems not to mind but then the volume of new Treasury securities don’t drive rates much. Inflation and growth do.

We bring this point up because the debt runaway seems not to bother many people in Washington. In the week that Ross Perot died, we recall his charts and warnings when we ran deficits of around $300bn. Now it’s three times that and you don't hear about it. Or as Mr. Perot said:

“The debt is like a crazy aunt we keep down in the basement. All the neighbors know she’s there, but nobody wants to talk about her.”

We also bring it up because the debt ceiling runs out in September and, guess what, there is no agreement on raising it. So, we’ll put a pin in that.

Bottom Line: Earnings season starts in earnest with the big banks all reporting next week. Equities have come a long way. We'd like to see some consolidation.

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Last of the beetles

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Discovering India

18 Lessons from 40 years of investing

When markets correct, it’s worth revisiting why we like stocks.

When you buy an equity, whether a single stock or basket of index stocks, you become an owner in the company. As a shareholder, you receive what’s left after the company pays its employees, suppliers, overhead, debts and loans. These costs tend to stay fixed. Revenues, however, fluctuate.

If revenues go down, because of a recession, competition or less demand, the amount left for shareholders will fall.

If revenues increase, because of higher prices, new products or general growth, the amount left for shareholders will rise.

It’s what makes equities potentially rewarding but frustrating in the short term. Stocks try to anticipate the changes to revenue and earnings. Because these are difficult to forecast, equities tend to overshoot in both directions. Sometimes they rise too fast too quickly. Sometimes the gloom is overdone.

Here’s a long view of the annual returns of the S&P 500 since 1929. These numbers do not include dividends which add somewhere between 1.5% to 2.5% a year.

The average return is 7.1% a year. The average up year is 17.6% and the average down year -14.4%.

Note that real rates of interest don’t seem to correlate well with stocks. Sometimes stocks do well in low real rates (early 1950s) and in high real rates (1980s). And sometimes the other way around as in 1945 and early 1930. It’s the rate of change that probably matters more.

Here are some of our lessons from decades of investing. We don't claim them as all original. Better and smarter men and women have come before us and will follow us. Nor is this list complete but generally we think about these things when markets start to move.

  1. Markets tend to return to the mean over time.

  2. Markets go up by the stairs and come down in the elevators.

  3. Markets do not correct by going sideways.

  4. Every market has excesses.

  5. There are no new eras, so excesses are never permanent.

  6. Everyone buys the most at the top and the least at the bottom.

  7. Fear is stronger than long-term resolve.

  8. Markets are dangerous when they trade on a handful of can't lose names.

  9. Bear markets have three stages: sharp down, a rebound and a drawn-out downtrend.

  10. When all the experts and forecasts agree, something else will happen.

  11. Bull markets are more fun than bear markets.

  12. Never trade on headlines.

  13. Being early and right is the same as being wrong.

  14. Prices change more often than the facts. Don’t confuse the two. (h/t David Ader).

  15. You are either an owner (equity) or a lender (a bond).

  16. There’s no such thing as an alternative investment. Just variations of #15.

  17. It is very rare that drastic market events require immediate action (See#12).

  18. Intelligent people do stupid things, especially if it’s easy to do those things.

Please check out our 119 Years of the Dow chart  

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 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

Another day, another record

The Days Ahead: Payrolls and CPI

One-Minute Summary Market volume was down. It was a short week and we’re writing this on Wednesday. We have the jobs numbers on Friday but we expect a return to the 150,000 level from May’s 75,000. Not enough to tip the Fed’s hand into a July cut.

It was a case of another day, another record. The S&P 500 has now returned 19% this year. So did the Dow. We won't repeat our “don’t follow the Dow” lesson but it’s also up 14% this year. Since January 2018, however, it’s flat, which just goes to show much disruption the market has had to deal with in the last 18 months. The 10-Year Treasury continues to drop. It’s now at 1.95%, which is the lowest it’s been since November 2016.

We see no conflict between a strong bond and equity market. There are plenty of comments around that a low Treasury yield means a rate cut, which means a slowdown, which can't be good for equities. But that is to misread the equity market. Yes, growth is slowing and the Fed may well cut this year but stocks adjusted for slower growth a year ago. Stocks are at record highs but not record valuations. And in the last 18 months have only risen 8%. Small caps and international are still way off their record highs.

That’s hardly the stuff of exuberance.

1.     Has this been the longest expansion? Like ever?  Yes, but. But it’s also been the lowest rate of growth of any expansion in the last 70 years. Here’s the quick graph:

Since the 2009 crisis, we've seen average growth of 2.3%. In prior years it was much higher, even after the 2001 tech bubble. And we've had three negative, although not consecutive, quarters of growth. As we've said for a while: very bad recession and not-so-great recovery. This is how this recovery compares according to the NBER’s data going back to 1858.

So there, it is. It’s one month older than the prior record. But there are a few things to note:

  1.  This expansion has been slow from the start. Even today, anything to do with housing has yet to recover pre-recession peaks. Housing starts are at around 45% below the crisis. It’s the same with commercial construction, mortgage applications, refinances, existing home sales and new home sales.

  2. Unemployment used to take around 36 months to reach back to pre-recession lows. This time it took 10 years. For the underemployed it took 12 years.

  3. Household net worth never declined in prior recessions. This time it took five years to recover.

  4. Personal income never fell in absolute terms…growth would slow, sure, but it would not decline. This time it fell more than 5%.

  5. The first reaction to the recession back in 2009 was austerity. It seems a long time ago but it took nearly 11 months for QE to start.

You get the picture. A very scared and scarred consumer and a slow return to confidence.

Can it continue? Sure. There is no evidence that the “probability of recession increases with the length of the recovery.” There are no signs that we see right now. We look at housing, claims and unemployment and they're all stable. We think it would take some outside event (yeah, I know that could be anything any day) or an asset price inflation to really bring on a recession.

But outside of that, keep calm and carry on.

2.     Another round of tariffs. We saw some respite at last week’s G-20 meeting where both sides (China and America) agreed to keep talking. That was enough to send stocks moving up on Monday and at least postpones the worst. It may even lead to a break through. Meanwhile:

  • The Commerce Department slapped 450% tariffs on steel coming from Vietnam. The U.S. imports about $30bn of steel and Vietnam’s total exports to the U.S. are about $48bn or about 20% of their economy. So this will hurt Vietnam.

  • The U.S. Trade Representative added another $4bn of EU goods for additional taxes as a response to European aircraft subsidies (it's the decades old Airbus thing). The total up for tariffs is now $21bn. 

This could go on indefinitely, of course. For what it’s worth, we think the U.S. tactics used on China, Japan, Mexico and Canada will fall flat when dealing with the EU. It's not a bi-lateral discussion. It’s one vs. 27. The EU will close ranks very quickly if the U.S. pushes too hard.

Meanwhile, the “uncertainties” the Fed referred to are still front and center.

Bottom Line: Interest-sensitive stocks have done much of the running recently. That’s probably temporary. We'd look for strength in international.

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Bottle cap challenge

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Over to you G-20

The Days Ahead: G-20 meeting.

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One-Minute Summary. Markets had two things on their mind. One, the G-20 meeting and, two, quarter end rebalancing. What? Yes, rebalancing is a big deal given how many funds (think of all those target dates funds, pension accounts, risk-parity funds) have to maintain their Equity/Fixed Income allocations. After a barn-storming start to the year, with Treasuries up 7%, equities up 14% and similar recoveries in international and emerging markets, many portfolios will have rebalanced in the last week or so.

Outside the technical side, markets are running on low rates, the expectation of lower rates and the hope of a trade deal. Fair enough, but those have been the headlines for months now. We need a new narrative to keep things moving. While 2019 has been good (see below for our mid-year scorecard), we've only advanced some 4% since January 2018 with two corrections of 10% and one of 20%.

Now sit back and enjoy the G-20 meeting.

1.     How are Emerging Markets doing?  Better than 2018 (down 16%), which was worse than 2017 (up 37%) and much better than 2016 (up 11%). So far this year, we’re up 9%. The reasons why Emerging Markets took a hit in 2018 are pretty straightforward: trade tariffs, a strong dollar and interest rates.

What about all that growth, the richer middle class, the emergence of the, well, emerging markets? Well, all that's true but, one, these are countries that rely on exports for growth. For China and India, it’s 20% of GDP. For other SE Asian countries it ranges from 40% (Korea) to over 100% (Vietnam and Hong Kong). Compare that to the U.S. at 12% and you can see why the headline “trade wars hurts them more than us” holds true. And it's a general principle in capital markets that it’s not the level of change that matters as much as the rapidity of change. So a quick 10% fall in exports to some emerging markets is very dangerous indeed.

And, two, many Emerging Markets countries carry dollar denominated debt. China and India are at 14% and 20%. Some are more than double that, such as Turkey, Mexico and Indonesia. So when the dollar strengthens, debt-servicing costs rise.

Last year the Fed raised rates four times and the dollar strengthened by 8%. That was the average. Against the Renminbi, it strengthened 9.7% from 2017 lows. Against the Korean Won, it was 10% and against Turkey and Argentina (both in the news for economic crisis) it was 25% and 55%. That all meant higher debt service costs. And a lot of that debt is private so it hits companies and households.

Now, with U.S. rates on hold, a slower U.S. economy and lower short-term rates, we've seen some dollar weakness and that is good news for Emerging Markets.

We've shown the dollar (in blue) against the Emerging Markets index. The shaded areas show that when there's dollar weakness (blue line up), Emerging Markets do very well. And vice versa. While the dollar has not weakened materially this year, we think it’s likely to. The rationale is simple enough starting with the President calling for it, lower interest rates, the possibility of some, any, trade deal, the U.S.’ twin deficits, the rise of gold and the attraction of the Euro.

The last few weeks have seen a weaker dollar and, if this persists, it will undoubtedly be a very good signal for Emerging Markets equities.

2.     We said some things would happen in 2019, how did we do? Fair enough. The year’s not over but this is an appropriate time to pull out the scorecard. This is what we said:

1. Will the U.S. economy roll into recession? No. What we’re seeing is a slow down from peak performance.

Score: We'll stay with that. We’ve seen some slowdown. Every week comes with a slowing indicator. Last week it was consumer confidence but we think that was tied to the Mexico tariffs-that-never-were. Not enough to see a recession coming.

2. Will the Fed raise rates? Not in the first quarter and probably not in the first half of the year.

Score: Not only was there no rate rise but the whole talk shifted to cuts. We still think they’ll hold for a while. A July rate cut looks too soon.

3. Will there be a trade deal? Probably. We know that both sides have an incentive to close a deal.

Score: Not yet but we've had postponements of the extra tariffs with China. We still think something will break to the upside.

4. Will U.S. Equities start to recover? Yes, but it may be a rocky road. In 2018, U.S. stocks had their first down year since 2008.

Score: Wow, yes but we didn't expect the takeoff we saw since January. We’ve had a pause since May and we’re only recovered from September levels. We're cautious given the run up.

5. And how about international and Emerging Markets? Nearly 100% of global markets were either in correction (down 10%) or bear (down 20%) markets in 2018. But the markets are selling at a substantial discount to the U.S. and that looks like an opportunity.

Score: Right but for the wrong reasons. International stocks still look cheap but the trade and general slowdown has meant they've underperformed…but by a lot less than 2018.

6. Where will the U.S. 10-Year Treasury end?  About where it is now. We think U.S. treasuries will be a valuable “risk off” asset class especially as corporate credit spreads look vulnerable.

Score: Another one where we got the direction right but magnitude wrong. Treasuries at the end of 2018 were 2.7% and had rallied from 3.2% . Today we’re knocking on the door of a 10-Year Treasury with a “one handle” at 2.0%. They’re expensive but good insurance.

The year’s not over, we know, but so far we’d characterize 2019 as a lot of fire and brimstone but solid returns. And it will probably stay that way.

3.     Inflation, not a problem is it? No, it isn't but the Fed acts as if it’s non-existent. There has been plenty of talk over the last week that the Fed needs to get inflation moving. Here’s Neel Kashkari of the Minneapolis Fed arguing that inflation needs to grow and a 50bp cut in the Fed Funds rate will do the trick. The President should love this guy. And here's Jay Powell saying inflation is stuck at less than 2%.

But inflation is not absent, as we’ve described with the whole hedonic thing and here’s the latest Dallas Fed trimmed PCE.

The “trimmed” part is to adjust for outliers that tend to have a) small weightings and b) short term volatility. So out go eggs (0.09% of the index and down 23% in the last month) and car rentals (0.1% and up 26%). You're left with about 50% of the index and some big items, like home rents and meals. And that, as seen from the above, is sailing along at a pretty consistent 2% for the last year.

So what? Well, there may be reasons to cut (trade worries, a lower dollar) but collapsing inflation ain’t one (h/t Pantheon Economics).

Bottom Line: It still looks like defensive stocks are the way to go. We'd notice that dividend-paying stocks are having a day in the sun. Hold the Treasuries.

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How many squirrels live in Central Park?

--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Peter Green - Live

4th Time Around

The Days Ahead: Fed meeting.

One-Minute Summary Markets seem quite unperturbed these days. U.K. leadership battles, no trade news, except the Mexico “soya beans for immigration” deal, tech in the sights of regulators, oil tankers shot at, Hong Kong riots. But equities have their eye on a rate cut and ended up 0.5% after a four week losing streak. Still some 2.5% behind the all-time high but retracing much of the May correction.

Hardly a day goes by when the 10-Year Treasury doesn't seem to rally. We're at 2.09% on Friday. They rallied when the not-so-great NFIB and low CPI numbers came out mid-week, gave some back with the OK retail sales on Friday…only to rally again going into the weekend. No one wants to be short Treasuries over a weekend in these markets.

We still have differing messages from equities and bonds. Bonds are saying slower economy, rate cuts, low inflation. Stocks are saying earnings are cheaper to buy and a slowdown will be temporary. They can both be right and so far this year, investors have been rewarded with a 15% gain in equities and 11% gain in long Treasuries.

We're comfortable with both markets right now. Some caution in order on the equity side but not enough to sell.

 1.     Are we about to hit a recession?  No. Oh, come on, you know where we are with this. There are many recession indicators. Some so early as to be unhelpful (yield curve inversion). Others too late to do anything (credit spreads) and plenty in the middle (consumer confidence).

The common definition of recession is two consecutive quarters of declining real GDP. Fair enough. That’s enough to worry about. But it tells you little about depth or duration. The 1990 recession, for example, lasted 8 months peak to trough and unemployment went from 5.1% to 7.0%. The 2008 recession lasted 18 months and unemployment shot from 4.5% to over 10%.

The folk who determine if we’re in a recession are at the National Bureau of Economic Research and their definition of recession is quite long and complicated (see here). And it turns out, the two quarters of GDP measure is woefully inaccurate. The 2001 recession never had two quarters of declining GDP but many of the other measures (sales, employment, real income etc.) were turning south quickly. The 2008 recession was halfway done when it first showed two quarters of declining GDP.

And the NBER doesn't try to predict. Far from it. They announced the 1980 recession one month before it ended. And the 2008 recession 11 months after it started.

So we’re always looking for a good recession indicator. And we found one courtesy of Brookings, which says if the 3-month moving average unemployment rate is 0.5% above its recent 12-month low, then you're in a recession. That makes sense. It doesn't really matter if unemployment is 3% or 5%. If it starts to move quickly upwards, the chances are employers are getting nervous and laying people off. We've headed into recessions with 6% unemployment and we’ve had recoveries with 9% unemployment. It’s the rate of change that matters. The moving average just removes one-offs like, oh I dunno, government shutdowns, tariffs.

There’s a whole book on it and we’re probably doing a disservice in our summary but the 0.5% rule has a very high success rate. And it makes intuitive sense as well.

So where are we now?

The recent 12-month low in unemployment is 3.6% and the recent 3-month moving average is 3.67%. Add 0.5% to the low and we get 4.1%, the black dotted line. So if we see unemployment increase closer 4.1% in the next few months, we’re in trouble.

But not yet.

2.     Any sign of inflation? No. In fact it’s heading down. The latest CPI showed broad inflation falling to 1.8% from 2.0%. Core inflation was at 2.0% but has been running at an annualized rate of 1.2% since February. The PCE inflation, the one the Fed follows, is below even those at 1.57% and has also been trending down for the last 3 months.

Now you would be quite forgiven if you said to yourself that the official CPI doesn’t resemble anything like what you pay. And that’s down to some adjustments that the BLS makes when calculating inflation. Here's a graph of TV prices over the last 20 years.

They've fallen 97% in the last 20 years. And it’s true that it's never been cheaper to buy a good 40” high end TV loaded for $229.. Back in the mid-1990s a top of the line 32” TV would have cost around $1,000. But according to that graph it would have been around $7,700. That’s where the folk from the BLS say,

 “Yes, we know it’s not a 97% price decline but today’s TV has better sound, a 4K display, is internet ready, built-in Wi-Fi, HDMI ports, is lighter, flatter, bigger and just overall awesome, so we’re going to make a price adjustment for that”.

And that’s fine. It’s called hedonic adjustment and no one thinks it’s a government plot to suppress inflation (well some do but they’re fringe). But it's one reason why there is a downward bias to inflation reporting. Think of all the things that are cheaper or the same price than a few years ago but of much higher quality. Autos, phones, houses….all big-ticket items.

It’s one of the reasons that we’re looking at lower inflation for a while and although the Fed claimed back in April that

 “At least part of the recent softness in inflation could be attributed to idiosyncratic factors that seemed likely to have only transitory effects on inflation…”

 …it’s very possible they're not transitory at all. We'll know more with the Fed meeting next week where they might signal a rate cut for the July meeting (h/t Tim Duy).

Either way, things are slowing down and the Fed will probably act in the face of weak inflation.

3.     How’s the budget deficit going? Oh, you know….bad. Depending on your point of view tax cuts i) pay for themselves ii) increase capex and iii) employment and wages or iv) are a decidedly dodgy way to play with the country’s finances.

Anyway, the latest Treasury Statement shows that a year ago, the deficit was at $532bn for eight months of the fiscal year (government years run from October) and is now $738bn…or, wait for it, the same as the total for fiscal 2018.

Tax receipts are flat while expenditures are up 9%. Corporate taxes are way down, which was the plan, but interestingly custom duties, which are around 1% of tax revenue, are up…a lot.

That's a 66% increase and the government is pulling in around $100bn (annualized) from custom duties…which we all know as tariffs. It’s not enough to choke off consumer confidence yet but it cancels out the personal tax cuts. So, well done everybody.

Bottom Line: Plenty of concerns in the market right now but prospect of a Fed cut is front and center. Oil is not moving because of high inventories and low demand.  

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I met the Prince of Whales

 --Christian Thwaites, Brouwer & Janachowski, LLC 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 4th Time Around 

Equity Bounce Back

The Days Ahead: Fed black out. G7 Central Bankers meet.

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One-Minute Summary: Sometimes you wait for some, any news to come around. Sometimes, it comes fast and understandable. Sometimes it comes so fast, you just have to wait to see how the air clears.

So last week, we had i) weaker manufacturing numbers but ii) okay services numbers iii) weak employment but iv) okay vehicle sales. Tech companies are under regulatory review. The Mexico tariffs took their toll. But by Friday, there was talk that there was a deal going through if Mexico agreed to buy more agricultural products (I know, I thought it was about immigration too).

Bonds rallied again, equities came back 4.5% and we’re now back to where we were in the beginning of May. Fed speak was mostly dovish ahead of the blackout period for the FOMC meeting on June 18.

The Fed has a tough task. They have to weigh up:

Signals that Fed should cut: trade, stock weakness, manufacturing, slower Q2 growth and low inflation

Against

Signals to stay put: employment, claims, service industries, consumer and housing.

If there is a cut (we’d give it a more than 50% chance in the next three months) then we’ll see asset classes perform in this order of best to worse:

  1. Treasuries

  2. U.S. Equities

  3. Emerging Markets

  4. Credit

  5. Mortgages

  6. U.S. Dollar

Good news! A sign that the Trade Wars may be behind us arrived in a new ETF called “The Innovation α® Trade War ETF”. It buys companies that are insulated from trade wars. Companies like GE, MasterCard, IBM and Xerox, most of which sell a ton overseas and have been bad investments because, well, they’re not great businesses. Of course, it’s back tested and looks terrific. So, whew.

But when these types of ETFs hit the market, they’re a decent contrarian indicator

1.     Demographics as destiny. The fun part about demographics is that you can predict changes years ahead with some accuracy. After all, if you're alive today, you’ll probably be alive tomorrow and a year from now. So a birth cohort moves through the years pretty much unchanged.

Unless… unless, immigration increases, fecundity takes off or people start dying later than planned. In the U.S., immigration has slowed, birth rates are lower and later and life expectancy has dropped.

Put all these numbers together and U.S. population growth is around 0.6% a year, compared to 1.3% two decades ago. So instead of the population growing 3.3m a year it’s down to 1.9m a year.  Labor force growth is around 0.9% compared to 1.8%. So that’s down from 2.3m to 1.4m.

So what? Why should we care? Well we should care very much because while the U.S. has an impressive GDP record, it has a decidedly less impressive GDP per capita growth record. Here it is for the last 30 years.  

The GDP number (blue column) is always above the GDP per capita number (line), which means we’re getting about 30% of our growth through population increases. Or to put it crudely, we get growth through more people on the job rather than better productivity. It’s the reverse in Japan:

There, GDP per capita has tended to exceed GDP growth. It’s mostly down to labor productivity and increased labor force participation, especially for women which is 57% in the U.S. and 70% in Japan (using slightly different methodology).

So, ok, what next? U.S. growth is very population dependent. Slow that growth and GDP will slow. And that is precisely what has happened in recent years.

 2.     Great job numbers? Er, not this time. Before we dive in, following on from the last topic, the U.S. has to grow employment by about 187,000 per month to keep up with civilian Noninstitutional Population growth…yeah that’s a weird title but it's  basically the U.S. population over 16 and not in the military, prison or nursing homes.

So any time you see a new jobs numbers below 187,000, then you can roughly say that it’s not keeping up with population growth and the difference will show up as “not in the labor force” or “unemployed”.

 So this month it was 75,000 with no change in the already low unemployment rate.  

It was also flattered by 1,000 Census workers. We bring this up because over the next year, the Census Bureau will hire and fire over half a million people for the 2020 census. Last time that happened in 2009 and 2010, a certain administration got a little carried away about job growth on their watch…and it’s possible, just possible that it might happen again.

The biggest hit came in the private sector where there was a decline of about 90,000 over the prior two months. State and local government jobs also were down. Hourly wage growth slowed.

It’s difficult to pinpoint “why?” But the China tariffs (the Mexico one wasn't known on the survey date) and general uncertainty must have played their part.

So, job growth has slowed and it gives the Fed a reason to cut rates. The bond market seems already there and the 10-Year Treasury dropped 3bps on the news.

3.     What’s up with the yield curve? There’s more talk about the yield curve especially now the Fed Funds at 2.5% is above almost every Treasury bond out there until you get to around 25 years. One of the most cited spreads is the 10-Year and 2-Year Treasury, which are now separated by 24bps, up from 15bps two months ago.

As we've said before, yes, the inverted curve is a decent forward indicator of a recession but its timing is unreliable. In some years, it inverted and there was no recession, in some the recession came two years later and for some it came six months later.

And as we also like to say, being early and right is the same as being wrong.

We do know with some certainty that the Fed stops raising rates when the curve inverts. Sometimes they go on to cut but, again, with some delay. So, right now we'd say (and it's not a great insight but, hey, we’ll take certainty when we can get it) the Fed will not raise rates this year.

Bottom Line: Full pricing in Treasuries but still the best place to be in a risk-off market. Perhaps some tariff rate relief with Mexico but who wants to make an outsize bet on a tweet.

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Facebook shareholders don't count

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 June Bustin’ Out…

A strange game…the only winning move is not to play

The Days Ahead: Jobs next Friday. G7 Central Bankers meet.

So, it was a normal week up until Thursday. Weaker economic numbers, Fed on hold, yield curve inverting, more on China and Huawei. The revised GDP numbers and new low of PCE inflation all seemed important.

Then bam, Tweet time. This was the 5%, climbing to 25%, tariffs on Mexico. For the record, Mexico displaced China as the U.S.’  largest trading partner last month. Total goods trade between the two was $149bn in Q1 2019. China was $137bn.

U.S. companies may silently cheer from the sidelines on the Get Tough with China talks. But it is a very different story with Mexico. People make avocado jokes but Mexico trade is heavily into car parts, vehicles, medical instruments and computers. There is also the added problem that a finished good may pass back and forth over the border before completion (certainly not the case with China). So, does that mean a 5% hit every trip? Companies with big Mexico dependence took a hit on Friday. Constellation Brands (Corona beer among others) was down 15%. Levi down 9%. GM down 11%. And so on.

And that 5% tariff. The Mexican Peso dropped 4% on Friday. So that price increase is down to 1%. Funny how markets react. Perhaps the trade guys should follow this advice:

On that yield curve. We were bulls on Treasuries at the end of 2018. With a slowing economy and the Fed seemingly done with rate increases, the 3.2% on the 10-Year Treasury looked enticing. Now it’s 2.16% so that’s a 10% return if you bought something like ITE (a Treasury ETF) or the then new issue Treasury 2.87% of 2028. The curve is now inverted all the way to 20 years and every bond out to 30 years is below the Fed Funds rate. Even the 2-Year note is at 1.97% down from 2.6% in January.

At this point, Treasuries look rich. Corporate bond too. Equities aren't so cheap that they’re an obvious buy. Emerging Markets look more vulnerable by the day. What could reverse it all? A trade settlement of course. But for now, protection, safety assets and sidelining are our best strategies.   

1. Gettin’ Defensive.

In times of economic or market uncertainty there are a few pretty reliable defensive trades.  

  1. Full on fear: head for Treasuries (now 2.16%)

  2. Hedge your fear: Yen (+3% MTD) or Swiss Franc (+2%), although the Swiss Central Bank gets a bit twitchy if their currency rises too much. They clocked FX traders back in 2015 with a 30% rise in the Euro/Franc rates.

  3. Fearful but greedy: Gold (+3% but if you feel a need to buy gold, don’t)

  4. Fear of missing out: Defensive sectors of the stock market

It’s the last one that gets interesting. Over the last year, there’s been plenty to fret about. Heck a Tweet can move the market and we’ve had wars, embargoes, trade and politics to think about. So where’s a good place to hang out until things feel better?

Defensive sectors have done well

Treasuries have done fine but squint at the above and you can see Real Estate, Utilities and Consumer Staples have done very well against the S&P 500 in the last year (h/t Mike Mackenzie). The first two are interest-rate plays. Real Estate especially is very highly leveraged. Staples usually fail to excite investors much. The largest stocks are Coca Cola, Wal-Mart, P&G, Pepsi and they've been on a tear. They’re seen as safe (people gotta buy toothpaste, right?) and even with low single digit growth, that’s better than negative sales.

But we’d also put the run-up in defensive stocks in the context of a major sector change. Here’s another chart:

Not many defensive stocks left

The top line is the value or market cap of the S&P 500. We use this because share buy-backs mess up the numbers. The lines below show the proportion of the market considered defensive before and after last year’s changes, when Telecoms was merged into a new sector.

Apart from a brief period in the early March 2000, the defensive sectors have never been a lower proportion of the S&P 500, even after their recent run-up.

What does this tell us? There are fewer safe places in the S&P 500 and those trades can get pretty crowded pretty quickly.  

2. The changing U.S. economy.

Forget about tech for a while. We get that. But one of the most successful stories in recent years is U.S. production of oil. In 2011, 60% of the trade deficit was due to oil and oil products (diesel and petrol). But in the last two years, U.S. oil production jumped 31% (blue line), while oil imports fell 25% since 2010. The oil deficit is now very close to surplus.

US oil production is now world’s third largest

What does this mean? 1) The U.S. is rapidly becoming self sufficient in oil 2) higher oil prices used to put a dent in the economy but now higher output and prices will show in up in oil producing companies and 3) even with sanctions on Iran, oil prices are likely to remain low and remain a tailwind for the economy.

3. How much has the trade war cost?

Hard to say. At one level, just take the $500bn and throw 25% at it and call it a day. That’s $120bn or 0.5% of GDP. But the hidden costs are higher. Here’s an article about Huewei planning in case their executives end up in U.S. jails. That must put a stress on your executive decisions if you’re worried about your staff being arrested. Or you may be thinking of moving your plants to Mexico. But that takes time and then this comes out Thursday:

Or you run a company in China and want to move to Vietnam or Cambodia. But takes time to figure out regulations, labor and environmental laws. Or you stockpile as much as you can.

It’s a truism that businesses hate uncertainty (mind you, unless you’re a bookie, most of us do). And if the rules aren't clear, then it makes sense to just wait it out.

The indirect costs are high but difficult to calculate. Stocks can help. Since the beginning of 2018, when the trade wars kicked into high gear, the MSCI World Stock Market Capitalization has lost $7.7 trillion. U.S. stocks have been in a sideways pattern since then but managed to lose $723bn in value.

So there you have it. Bookkeeping costs low. Intangible cost high.

Bottom Line; More on the trade front. There aren't enough obvious bargains out there and Fixed Income markets look like the i) deflation ii) Fed won’t hike iii) low growth and iv) fear are fully priced. We may trim Pacific related stocks on a bounce.

Other
Wealthfront’s risk parity fund is a dud

--Christian Thwaites, Brouwer & Janachowski, LLC

Please check out our 119 Years of the Dow chart  

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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Cate Brothers - Union Man 

"Thank you driver for getting me here" *

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Short week. Second estimate at Q1 GDP.

Stocks opened lower seven out of the last 10 trading days. That means stocks sold off overnight in Asia and Europe but then picked up in the U.S. trading day. That shows high-risk avoidance. No one wants to be long overnight and find there’s no volume. Who can blame them? Stocks were down for the week amid trade tensions, weak manufacturing orders and lower oil prices (down 13% this year).

The deflation forces are showing up in a strong dollar and another rally in 10-Year Treasuries. The yield hit an inter-day low of 2.39%  (it was as high as 3.2% in October). A 10-Year note trading at $96 back then is now at $104 and that excludes coupon payments. If the slow down continues, trade talks deteriorate and inflation keeps slipping, we would not be surprised to see the 10-Year trade with a 1 handle.

1. Trade talks improving?

Ha, no. The Administration placed severe restrictions on Huawei, which is China’s trophy tech company with a huge lead in 5G technologies. They make Android phones, among other things, and so won't be able to use Google’s software. The restrictions essentially reduce a Huawei phone to the status of a brick. It’s not a public company but some of its suppliers are and they're down 15% to 50% this year.

The Chinese authorities did not take kindly to this, of course, and promised to play the long game which could mean anything from tit-for-tat tariffs, to selling down Treasuries, to withholding exports of rare earth minerals, which are vital to electric vehicle components, guidance systems etc. China accounts for seven out of every 10 tonnes of rare earth elements.

What is one to do while this all goes on? The obvious would be to stay away from U.S. stocks with China exposure. So that’s Hollywood, Apple, Starbucks, Qualcomm, Boeing, Wal-Mart and Intel. But that doesn't capture companies who depend on Chinese suppliers, like Nike, 3M and many others. Then you would stay away from European car and luxury goods on the basis that Chinese consumers will have less spending money. We’ve done most of that already. Next we’d look at Emerging Markets which are obvious casualties in the U.S. /China wars. But they've sold off already and don't yet look like bargains. So we wait. And keep the Treasuries as insurance.

Meanwhile, the latest Durable Goods orders were disappointing. If one of the claimed benefits of the tax changes was that capex would soar, then there are some disappointed supply siders around.

Here are the latest durable goods orders with the black line showing orders excluding defense. They're down 11% since last year.

Nondefense capital goods orders down

2. Does the Transportation index tell us anything?

Yes. Not many people use this index any more. Heck, there’s not even an ETF for it and there are some dopey ETFs around as we’ve discussed before. It’s made up of distinctly unglamorous businesses. Kirby (barges), JD Hunt (trucks), Expeditors International (ships), CSX (rail). All companies that move either people or stuff around. They're cyclical because costs are fixed and volumes and prices fluctuate so profits are volatile.

Expeditors is a good example. It’s up 38% in the last two years but has had many corrections of 15% or more. And that's in a good economy. In recession time, it gets ugly. The stock has massively underperformed the S&P 500 in the last 12 years.

So, if there is a slowdown in the economy it’s going to show up in transportation stocks' earnings.

What’s happening with Transportation? It’s underperformed the S&P 500 by 10%. We recently looked at tonnage coming in and out of the Los Angeles ports. Outbound containers are down every month this year. Airfreight through Memphis (through which all the iPhones are shipped) is also down. Memphis is the base for FedEx. It’s share price has fallen 40% since January 2018 and by 36% in the last year. Here’s the running annual stock price change since it went public in 1980 (h/t John Kemp).

One of the worst declines in FedEx share price

What does all this mean? Well, early signs of a slow down are everywhere. Freight, activity, volumes are all weaker. These are not recession triggers yet. But more evidence that the U.S. economy is slowing.

3. How’s Brexit going?

You had to ask? Terrible. Look, there are so many permutations here that we’re not going to say we have much insight other than the U.K. seems to:

  1. believe going it alone is better than cooperation

  2. dreams back to a glorious imperial past and

  3. think trade will work better using tools ditched 30 years ago.

If that sounds familiar to another great country, then that's on you.

Brexit has now claimed its second Prime Minister and the next one appears to be Boris Johnson. Although if we had a vote it would be for Rory Stewart but that’s a long shot. Johnson is a shameless self-promoter, with changing positions and values and opportunistic to the core. He should do well on the world stage. Yes, this guy.

Britain’s future Prime Minister?

So, these are the Brexit choices

  1. Leave with no deal

  2. Leave with negotiated deal

  3. Don't leave

  4. Have another referendum.

We only care about the markets at this stage. Stocks are down 11% since last October but for U.S. investors, they’re down 17%. We’ve been out of the U.K. for two years now and can't see any reason to change our minds.

Bottom Line: The Fed is probably the most predictable player in the markets right now. The minutes were all about “patience” and they're not going to make any big changes to the SOMA balances (i.e. the QE assets). Meanwhile, expect political headlines to rule the day.

Other

* Because it all seems Magic Bussy now.

All the Game of Thrones memes so we don't have to talk about it anymore

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 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Link Wray - Fire & Brimstone

There may be a winner in the trade talks

The Days Ahead: Geopolitics a wild card. Europe elections

One-Minute Summary Stocks marginally down and Treasuries up for the week. You’d think with that, the Fed must have cut rates or something. But no it’s another week of trade, slower economic numbers and the expectations of lower rates for a while. Every economic number that comes in low…and there were plenty this week with industrial production, capacity, retail sales, import prices…reinforces the lower rates for longer story. Confidence remains fragile. We see companies holding off on big decisions and playing it safe. It's not enough for a recession but definitely slower.

Markets are just taking this all on board. We track four “fear” trades: gold, yen, 10-Year Treasuries and the VIX. All trades which turn sharply up when things are bad. The only one with a sustained rally is the 10-Year Treasury, now at 2.4%. The other three have all calmed down.

1.     Trade talks, war, progress, and retaliation.  Yes, something for everyone. China responded with tariffs on $60bn of goods from June 1st and the U.S. went ahead with 25% tariffs on $200bn of imports (bad). Goods which are on board ships now (it’s a 4 week journey from China) aren't affected but they will be from then on (good). The U.S. agreed to remove steel tariffs on Canada and Mexico (good). The U.S. claimed military superiority depends on the automobile industry so is looking at imposing tariffs on auto imports from Japan and Europe (bad).

Auto tariffs are complicated. The U.S. imposes a 25% import tariffs on trucks. Trucks include SUVs….even small ones like RAVs and CRVs. So they're made in the U.S. They also outsell cars 2.5:1.

Here’s a rough guess on how much other countries charge.

So that’s as high as 60% if you want an American car in India and 25% in China. Even places like Australia at 0% , can have luxury car taxes, which hit U.S. manufacturers. The Administration’s goal, we think, is to have that entire map the same color as Canada.

With all that going on, why are stocks so calm? Well part of the reason is that the tariffs a) hurt the Chinese economy a lot more than the U.S. and b) tariffs are not necessarily paid for by U.S. consumers. There’s much debate on this ranging from “it's a straight up consumer tax” to “it won't cost them anything”.

Recent import prices were down year on year for the fifth straight month and we think consumers will barely notice the tariffs. We realize this is not the mainstream opinion. But we’re interested in stocks, investing and the economy not polemics. And so far, we’re okay with the U.S. outlook.

We discussed last week how tariffs may not hit consumers but skipped over the foreign exchange point. The Renminbi has weakened by about 3.5% in the last week and by 10% over the last year.

Weakening Yuan

That's not enough to cancel out the tariffs entirely but shows major risk aversion by currency and Emerging Markets traders.

What's next? Sit this out. We already reduced Emerging Market exposure and we could do that again if the tariffs stick or there’s a bad deal.

2.     Recession Watch Housing is a leading indicator of recession. One only has to think back to the carnage in 2008 to remind ourselves how overstretched borrowers, bad lending and a housing oversupply can crash the economy very quickly. There are numerous housing indicators: new sales completed sales, pending sales, mortgage applications, starts, permits etc. Existing home sales are important for homeowners. We all feel good when the house down the road goes for 20% more than we paid for ours. But existing home sales don't generate much economic activity other than some commissions and the occasional kitchen rebuild. New home sales are more important to the economy because they require some entrepreneurial activity, building materials and labor.

So new housing starts is the one to look at and it’s good news. Interest rates and consumer confidence drive starts. Last year, as rates increased, starts fell by 7%. This year, as rates eased back after the Fed’s “patient” stance, they've come back, especially with multi-family units, which are up 13% from 2018 lows.

This is quite a turn from last year when we (and others) called the top of the housing market.  So all better on the housing front? Yes from an immediate recession concern. Nothing to see.

But on the broader side, there are some important changes to the housing market. We've discussed many times the increase in student debt, local housing markets that have squeezed out borrowers and the delay in household formation.

This has meant mortgage levels have flattened and mortgage debt as a percent of GDP has fallen... a lot. Foreclosures (the lower line) are at 25-year lows. But as the New York Fed points out, people using a mortgage have fallen steadily and now (h/t BMO):

“At the end of 2018, about 26 percent of Americans between 20 and 69 had a mortgage, the lowest point reached in the twenty years of available data.”

Mortgage participation is way down

So, it seems more and more people are opting out of parts of the economy that made baby boomers so wealthy.

Bottom Line: Emerging Markets are our chief concern. They're going to be hurt most with trade problems. 

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Alice Rivlin died

Marin County has the wrong jobs

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Peter Green - Fool no more

The Tweet heard round the world

The Days Ahead: Brace for another week of trade stuff.  

One-Minute Summary Trade and new IPOs. That was pretty much all we needed to know about the week. We discuss both below but would just point out that stocks were up 17% year-to-date a week ago and they're now up 15%. We'd had a straight four months of gains. When you get your expected return for the year in one third of the time, some people are going to take profits.  

One of the things we’re reminded of, is that getting tough on China is a bi-partisan deal. Even corporate America is quietly cheering this on. We think one of three things can happen:  

  1. It all gets worse and confidence evaporates

  2. There is a deal and tariffs are reset

  3. There are more negotiations and something gets done

 We think #3 is the most likely but it will be a heck of a bumpy road.

Meanwhile Treasuries continue to rally. The soft CPI numbers on Friday capped a week of so-so economic reports. The whole yield curve out to 11 years is now below the Fed Funds rate, which suggests the Fed will stay put.

1.     Trade Tariff Tweets: was pretty much all you need to know about markets early last week. We saw some, frankly irresponsible, headlines from people like Bloomberg, who should know better. “Swoon…precipice…soaring volatility”. Gimme a break. The market was down 2% from Friday’s close to its low point on Tuesday. The worst performing stocks (those down 7% or more) had nothing to do with trade but were companies with their own set of problems. Mylan, a generic pharma company, for example, was down 22% but that was due to a big revenue miss. Companies with big China exposure (e.g. Apple, Yum) were down no more than average.

The tweets were quite straightforward.

Donald_J__Trump___realDonaldTrump____Twitter.jpg

We might also add that the tweets were two of 71 tweets sent out in 48 hours. That’s three per waking hour. So it’s unlikely they're the product of thoughtful deliberation.  And we certainly have no insight into the strategy.

But it's worth breaking down.

The tweet says simply that there will be 25% tariffs on $575bn worth of imports. The current tariff schedules would raise around $32bn. The new tweeted schedule would raise $143bn. That’s around 0.6% of GDP and a little less than the amount the U.S. economy grew in Q1 (see Table 3).

The U.S. imported around $539bn (not $575bn) worth of goods from China last year and ran a total trade and services deficit of $378bn. That’s made up of a services surplus of $40bn and a goods deficit of $419bn.

The actual imports of goods from China is around 15% lower this year (yes, tariffs tend to do that) so the more likely number for China imports in 2019 is probably $490bn, again, not $575bn. Plug 25% into that and we’re looking at $120bn. Still a big number but the same as about 6 weeks of U.S. GDP growth.

Now, there are a number of ways to pay that $120bn (ignoring FX changes):

  1. Chinese companies can lower their prices

  2. U.S. importers can face a margin squeeze

  3. U.S. consumers end up with higher prices

Of course, it’ll probably be all three. Governments may also make it easier on all three parties. Both China and the U.S. have provided aid to the most affected parties, as when U.S. farmers received $12bn in compensation for the collapse in soybean exports.

So far, import tariffs have not hit the consumer much. Some 35% of U.S. imports from China are cell phones, computers, telecom and computer accessories. Just looking at my desk, the phone, screens, laptop, desktop, keyboard, router and something else with many wires….all made in China. It's possible that they will all be 25% more expensive a year from now. But very unlikely. 

The bottom line is that the tariffs are really no big deal for the U.S. The worst case we can come up with is a 0.6% reduction in GDP. If the threat to growth was real, we would have seen the Australian Dollar weaken (a reasonable proxy for the Chinese Renminbi) or Mexican stocks rally. Mexico is a net beneficiary of U.S.-China trade tensions. But no. Neither moved.

China stocks were down a lot more than the U.S., some 6%. But that makes sense. Chinese export to the U.S. account for 3.5% of GDP. For the U.S., it's 0.6%. So there’s some truth that all this hurts China more than the U.S.

The biggest effect of the trade wars is on confidence and financial markets. Markets were due for a sell-off and some overdue profit taking. We think the overall effect is fleeting. 

2.     Recession Watch: Consumer Debt One interesting feature of the post-crash landscape is that households have become reluctant borrowers. Here's the growth of personal income and revolving (i.e. credit card) debt and fixed debt (i.e. vehicles).

Prior to 2009, consumers borrowed freely. Since then, income (top line) has grown 45% but both types of debt have grown 30%. Yes, there’s a lot more student debt around but that kind of debt is deflationary…it holds back household formation. The above tells us that there’s very little inflationary pressure coming from consumers and so any recession is likely to be mild.

Last week, new numbers came out on credit showing total outstanding credit rose only $10bn. For most of 2018, it was growing at $20bn a month. Consumers just don't seem ready to increase debt.

3.     When risk goes up…Treasuries do well. That's not always so but it has certainly been the case this time round. There are other risk-off trades such as gold, the Swiss Franc, Yen and German Bunds but U.S. Treasuries have the liquidity and depth those lack. Last week, there was plenty to worry the market and there was even a hint that Chinese buyers stayed away from Treasury auctions in retaliation for the trade threats.

The 30-Year Treasury is now around the same level as it was in January 2018 and the 10-Year Treasury is at 2.46%. Three-month bills, from which FRN price, are at 2.44%. We think the Treasury market strength signals an easy Fed, slowing growth, a trade stand off and a place to hedge against rising volatility, as measured by the VIX index. With that, we’re happy to keep our position.

4.     Top of the market? No. We've learned that if you play that game, it ends up badly. But here are a few indicators that make us go…really?

 Lyft reported its first quarterly earnings and lost $1.1bn on revenues of $776m and gave out $859m in stock-based compensation.

 Uber…enough has been said but companies selling a dollar for 95cents tend not to do well.

 Softbank, a Japanese investment trust that owns a bunch of tech stocks, including Uber and Sprint, tried to convince investors that it should not trade at a 50% discount to NAV and ended up with this slide.

So that's rainbow unicorns flying into AI traffic with the share price tagging along. We think. (h/t FT Alphaville).

Bottom Line: Earnings season winds down. Probably some short-term upticks as trade news comes and goes. As one of our long term lessons goes, “Never trade on headlines.” We feel we've set portfolios up to withstand the next few months of headlines.

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People who swear are honest.

 --Christian Thwaites, Brouwer & Janachowski, LLC 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

 

Keep growing and carry on

The Days Ahead: Light economic calendar so focus on earnings

One-Minute Summary We had a ton of economic data with a Fed meeting right in the middle of the week. The economic data was generally good.

Positive

Productivity numbers

Employment costs

Employment

 Not so good

Personal consumption

ISM manufacturing

ISM Services

Trade

Stocks finished April with a fourth consecutive month of growth. That doesn’t happen often. The S&P 500 and the S&P 600 (small cap) are both up 17% this year. Tech has led again, up 27%. Last week, Apple beat and Google missed. But Apple, Facebook, Microsoft, Amazon and Google, are up between 15% and 50%. They're the five largest companies in the world and around 13% of the index. That’s a heck of a good run.

1.     What did the Fed say? That they’re going to stay patient, that inflation was too low but that most of it was transitory (see below). The market expected most of what was said so there were no big market moves.

The Fed finds itself in an interesting position. Employment is going gangbusters, Q1 growth was fine but inflation remains well below target. For now, the inflation number rules and they’re going to keep watching and doing nothing.

Richard Clarida, a very fine Governor, made a speech on Friday, which emphasized the market and pragmatic approach to inflation, rather than a model based approach, and concluded “the federal funds rate is now in the range of estimates of its longer-run neutral level.” Which seems right. So don't expect a cut this year unless something very bad happens.

And this is good. Steve Moore: “My biggest ally is the president. He’s full speed ahead.” Ninety minutes later, he withdrew the nomination.  

2.     Why is inflation so low? Is a question the Fed keeps asking and comes up with “it’s transitory”. But is it? Despite many years of warnings that inflation was just around the corner (the Fed’s QE bought out a lot of the crazies on this)…well, it’s not.

It’s probably the most important question for markets right now. If inflation rises, bond yields will rise to compensate investors for a lower real rate of return. Same for stocks. Equities are a great inflation hedge because, in theory, they can raise prices. But their costs rise as well and investors need higher returns to compensate for the loss of purchasing power. Inflation was the bane of the 1970s. Eventually, we saw Treasury yields at 16% and stocks trading at 8x earnings and yields of 8%.

Since then, however, inflation has steadily declined. Here’s the headline CPI and the Fed’s preferred PCE inflation, showing the broad number and the “core” numbers, which exclude food and energy.

Inflation had barely broken 2% for decades

The latest numbers show 1.5% for the PCE and 2% for the CPI, with the former well below the Fed’s 2% target.

The two measures of inflation differ quite a bit. Here’s a full explanation but basically the CPI measures out-of-pocket expenses and the PCE measures those and other expenses which people pay for indirectly, like medical insurance. Housing is very big in the CPI at 42% but only 23% in the PCE. Medical costs are only 8% in the CPI but 22% in the PCE.  

Anyway, here are some of the reasons why inflation is so low:

  1. Strong dollar: decreases import costs

  2. Lower medical inflation: yes surprisingly but you won't know it because deductibles are through the roof

  3. Services: transportation (all those subsidized Uber rides), professional and personal services are all lower mainly because unit labor costs are down

  4. Substitution: it’s a lot easier to substitute products these days, so if TV prices are down 20%, people may just buy a tablet and hook it up to a screen. The same goes for foods. Lettuce fans (prices up 18%) can switch to lentils (down 5%). No comments, please, on our food choices.

  5. Productivity: showed a recent climb, which allows companies to reduce price without a margin hit

  6. Underreporting: there’s probably a downward bias in inflation reporting because of things like hedonic adjustments. This tries to adjust for things that cost more but are a heck of a lot better than a few years ago. Compare your car or computer now to a decade ago and chances are they’re about the same price but do a lot more.

    These adjustments are fiendishly difficult and I don't envy the pros at BLS but the sum effect, we think, is to understate costs.

 Will it continue? Yes probably. If the above chart is anything to go by, apart from momentary blips, inflation has anchored at 2% for the best part of three decades.

3.     Jobs numbers blow out. Well not quite but very good. You’ll have read about the best numbers since 1969 etc. and we’re not about to take the shine off the numbers.

What, wait, of course we are! First, we’ll not restate points about lower labor force participation, which fell again, or the low increase in Average Hourly Earnings, or the still high underemployment rate. No, not going to.

 Instead, we’ll point to lower average hours worked and a fourth straight month decline in the labor force. This time it fell 500,000. This doesn't take away from the fact that the numbers were strong but we’re not sure it means things like wage pressure or that these sorts of gains can continue.

Here’s the chart:

Nice recovery in new jobs

Treasuries rallied on the news. Normally (what’s that these days, I know) a report like this would mean a Fed ≠hike, inflation corner and blooming consumer confidence. But the Fed has said it’s on pause so it means that the curve steepened a bit (i.e. good for short Treasuries like FRNs).

Bottom Line: Earnings season continues. We've seen mostly positive comments from companies about the U.S. and with continuing caution on trade/China/Brexit/Europe. We expect that to continue.

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Other:

Whale is a Russian spy

 --Christian Thwaites, Brouwer & Janachowski, LLC 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 Just the smile