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Hog Wash

The Days Ahead: Employment report and probably some trade talk. Shorter week.

One-Minute Summary: Markets lost their patience with the trade issues. Ye gods, on Friday the rumor was that the U.S. will withdraw from the WTO. That actually require an act of Congress so no immediate threat. The market recovered from its lows but there was a general risk-off theme.

The 30-Year Treasury had a good week, with yields falling from 3.08% to 2.96%. Why? Well, we’re in the middle of a great quarter for growth. We know this because 1) first quarter GDP was revised down to 2% 2) since the crisis, there are some very weird seasonals not captured in Q1 that flow through to Q2 and 3) with things like a lower trade deficit, the GDP now model is flashing around 4% growth.  There have been some quarters of 4% growth since 2009 but they have very quickly rolled over to the lower average growth of 2.0% to 2.5%. We think that’s going to happen again. The decline in the 30-Year Treasury yield tells us the market is not convinced growth will last.

A rough week for Emerging Markets, which are dominated by the dollar, interest rate and trade issues. We're watching to see how China reacts. They may impose more tariffs. But they could just 1) weaken the Renminbi 2) sell U.S. Treasuries or 3) go after U.S. companies doing business in China from China. Apple has 18% of its sale in China and another 18% in Asia Pacific. Any iPhones sold there are made there. If China was to start making life difficult for firms selling in China, then goodbye Queensberry and hello cage fighting.   

1.     Markets are jumpy – maybe because there are fewer defensive stocks around. Stocks feel like they're volatile but the standard deviation and VIX numbers are pretty much in line with levels from two years ago. It’s only against the unusually low 2017 levels that it feels more risky.

 But in some ways the market as a whole is a more risky animal than in past years.

 We looked at the classic defensive sectors of the S&P 500. So, that’s utilities (e.g. DUK, SO) telecommunications (T, VZ) and consumer staples (PG, WMT, KO, MO). We took their combined market capitalization as a percent of the S&P 500 market capitalization. Here it is:

Defensive stocks have indeed fallen to a near all-time low of 12% of the market from 21% in the pre-crisis era. Some of that is because these companies face more competition and they’re just not great businesses. But some is because big companies keep getting bigger because, well, they are good businesses and there has been little to no anti-trust enforcement.

So, Amazon is 25% of the Consumer Discretionary sector and accounts for 35% of the gain in the S&P 500 this year. The top 10 growth companies account for 100% of the gain. And the top four tech companies (AAPL, GOOG, FB, MSFT) are 42% of the tech sector.

It’s going to get worse too. In the fall, S&P will create a new sector called “Communication Services” by taking some stocks away from tech and consumer sectors. When that's done, the top five stocks of each of those three sectors will account for 50% to 70% of those sectors.

So, yes, the market has become less defensive which means the market is more vulnerable to any correction in non-dividend paying, momentum stocks (h/t David Ader).

2.     Bought a washing machine lately?  So how much will the tariffs cost us in the end? We're more concerned about the on/off mixed messages of the tariffs. If we take a more or less worst case scenario and all imports from China are taxed at 25%, we would see a about a $125bn cost to the U.S. economy. Sometime in the second quarter of this year, the U.S. economy passed $20 trillion. So that’s a 0.6% hit to GDP. The economy will grow around 3% this year. A drop from 3% to 2.4% does not remotely qualify as a recession. Of course, we can play with even bigger numbers. How about 25% on all auto imports? That’s 0.2% of GDP. Or the EU throws a 20% tariff on all U.S. exports? That’s 0.3%.

But of course, it’s much more than keeping score on who can raise the most or who blinks. The real problem is in the complex global supply chains of modern companies and flow of intellectual property. So, if Harley Davidson, which was in Twitter’s sights last week, faces a 20% increase in its prices in the EU and higher steel prices in the U.S., it must divert production to its existing overseas plants. To do otherwise would surely be a breach of its responsibilities. The stock (HOG) is down 25%.

We don't really know yet what the impact of the trade disputes will be. We do know that tariffs are a tax. Someone has to pay the tax. If companies pay the tax, margins are squeezed. If consumers pay the tax, prices go up. Back in January, the administration imposed a 50% tariff on washing machines and 25% on solar panels. Consumers ended up paying for this one. This is how washing machine prices have changed:

That top green line shows prices accelerating by 83% in the last few months. That's after many years of price declines. This tariff was targeted at LG Electronics and Samsung. Both companies’ share prices fell 13% to 25% this year and showed up in South Korea’s exports to the U.S. (in the blue bars).  

So, all together, tariffs hurt consumers. The question now is how will consumers, businesses and politicians respond to the trade talks? If there’s enough of a blow-back, we might get less bluster and more thought. But it will take at least six months to show up in the data. (h/t Ian Shepherdson at Pantheon Economics)

Bottom Line: Large cap will probably remain in a trading range. The S&P 500 should remain above its 2700 support level but expect some rapid moves.  Emerging Markets remain the weak point.

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