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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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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.

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