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.
Full on fear: head for Treasuries (now 2.16%)
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.
Fearful but greedy: Gold (+3% but if you feel a need to buy gold, don’t)
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?
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:
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.
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.
Wealthfront’s risk parity fund is a dud
--Christian Thwaites, Brouwer & Janachowski, LLC
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