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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:
China is willing and able to retaliate
China can shift some of the tariff damage around to other countries
We may see more capital flight from China to the dollar
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
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.
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