The Days Ahead: Earnings season kicks off.
One-Minute Summary We were out of town most of the week and holed up at home while the power was out. But, boy, a lot of headlines. First, the trade war escalated, then had a breakthrough. Second, the Brexit proposal that agreed Northern Ireland remains part of the EU and there’s a border somewhere in the Irish Sea. So goods would enter Northern Ireland under the EU no-tariff rules but if sent on to the U.K. would be subject to tariffs. It’s the same idea that the last Prime Minister proposed and lost her job for her troubles. Third, economic numbers continue to point to a slowdown but nothing that overly worried stocks or bonds.
Short-term rates fell causing the yield curve to not invert. That’s all to do with the Fed announcing more purchase of short-term paper…no, not QE4 but just more liquidity and reserve management. Still, all the talk about yield curves inverting, run-for-the-hills nonsense has taken a back seat. Quite right too.
Stocks snapped back on Friday to end the week up 0.6% but, as we've noted, the S&P 500 is bouncing between 2700 and 3000 without a break out. Earnings will soon take over as the main market driver. We're not expecting anything startling. The consensus is for a 3% decline. European stocks had a strong week. The big ones, like Germany, France and Switzerland are up 18% this year, about the same as the U.S.
The on/off trade talks had a breakthrough on Friday. The White House playbook has been to say how well trade talks are going late on a Friday after a bad week of politics. Normally, it’s the “China will buy more soybeans and we’re winning” rap. It’s effective. Nice headline. No details. What we got was “a substantial Phase One deal”. No idea either. But it’s likely the White House will postpone the $250bn of tariffs schedules for October 15th. So that's a good thing.
The soybean thing is kind of important. Two years ago, after the soybean fall harvest, the U.S. was selling $2.5bn a month to China. That went to $0 last year. So it’s likely this truce will hold up at least until December. China has been hurting, with weak imports, and wanted a deal as much as the U.S. It’s likely all the Intellectual Property (IP) and industrial subsidies, which have so irked the U.S., will be kicked down the road. And Treasury Secretary Mnuchin has already hinted that the currency manipulation charge will be dropped. Good thing too as China did not remotely meet the criteria stipulated under the Trade and Competitiveness Act of 1988 (h/t Brad Sester)
1. How’s inflation doing? Well on the core measure, not very well. That is if you're the Fed. We're at low and falling rates, wages are decent, full near employment and consumer expectations are strong (sort of). So if you're reared in the Econ 101 classes of, say, 1965 to, well, now, you’d expect inflation. That’s what the Phillips curve said and it makes sense. More workers, more money, more demand, prices rise.
But that relationship probably died years ago and there are powerful forces keeping inflation low. First is demographics. Older people spend less. Second is import competition. There’s a reason manufacturers outsourced to cheaper places. Then there’s our old friend hedonic adjustments. And, more controversially, income equality. If you're in the 0.1%, you're less affected by gas prices and more by Gulfstream 650s.
All this has kept inflation low and it “disappointed” last week, coming in below expectations. Here’s the chart:
Headline inflation was 1.7% driven in part by lower gas prices, down 8% on the year. Core inflation less food and energy was 2.4%.
Housing still runs higher. That’s the black line. It’s not been below the rate of core inflation for years and it's 25% of the index. Also this was a bit of a shock:
The black line is the cost of insurance to companies. They’re up about 5.5% and declining. The green line is consumer insurance premiums, up 18%. They were running at 0% for a few years but shot up in 2019. Why? That’s the ACA, which penalized taxpayers for not having health insurance. It started as a penalty of $285 in 2014 and was $975 in 2018. It's now $0. So, of course, the young and healthy left the risk pool and premiums shot up.
We'd expect this to hit consumers more than the 1.2% weighting of health insurance in the CPI. Our guess is that medical premiums will cost employers more. And where insurance costs go, medical and hospital costs tend to follow.
Bottom line: inflation is not an issue for bonds and capital market. But it is for financial planning.
2. How’s Small Business doing? Not as well as a few months ago but still reasonably well. It’s an index, which is driven by the stock market and how they feel about the four big things that worry them: big business, regulation, insurance and inflation. The outlook for labor is slowing: 22% of companies said it was a good time to expand. But it was 34% a year ago and 30% in the spring.
It all seems to be tied to the on/off trade talks. Tariffs certainly hurt small businesses. Not because they export but because they use raw materials sourced from overseas. Remember the original list of U.S. tariffs from China? It was 200 pages long. It’s difficult to think of any company not affected.
It may get a bounce from trade resolutions. But for now, rather like manufacturing, this is late cycle stuff with companies wary of what’s coming.
3. Anything in the Fed minutes? Not really. We know the risks in the economy by now. Although Chair Powell was too polite to mention it in his mid-week speech. There are three camps in the Fed:
Doves: Low inflation and a commitment to kick it up to 2%
Hawks: All the current uncertainties won't derail the economy
Super Doves: There’s a risk of low rates, low growth and low inflation. Do something now.
So there’s the i) leave it at one cut ii) do another and iii) do another big one. We'd say it’s likely to be “do another” but they are going to have to remain very flexible given the exogenous risks.
Bonds didn't do too much which suggest this was all priced in.
Bottom Line: Earnings season kicks in. The consensus is for a 3% decline led by big energy earners and tech, particularly the notoriously volatile semi-conductors. We'll be on the lookout for margin pressures and outlooks. Bonds could drop a small amount if the trade/Brexit deal sticks.
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