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Summer trading starts in fits

The Days Ahead: Some durable goods orders. But trade will dominate as a problem.

One-Minute Summary.  We were unchanged on the week but had some odd days when the market fell at the open but closed higher. That seems to be a lot of quants at work (h/t Cameron Crise), which is leading to higher volatility.

Markets are trying to make sense of the increased taxes coming their way. They're in the guise of tariffs, of course, but they have exactly the same effect as a tax. Take steel. It’s up 53% from a year ago and 25% since March (the date the first tariffs came out). Someone has to pay the tariff. It will either come in higher prices to importers, which are then passed on, or in margin compression. Or both. The market doesn't know how all this will work out yet but last week’s Philadelphia Fed survey suggests there are price pressures around the corner. 

Meanwhile the U.S. will have another strong quarter ending in a week’s time. Most earnings estimates are for a near 20% annual gain. At least half of that is down to the lower corporation tax but a 3.5% GDP rate is certainly helping. Small caps and the NASDAQ index (confusingly it’s not the NASDAQ exchange but a warehouse for tech stocks) reached record highs. Europe is struggling with politics in Germany and, of course, trade concerns. The 10-Year Treasury marked time at the 2.85% to 2.95% range. Every time it tries to break through 3%, it rallies.

1.     Markets are jumpy – Emerging Markets edition: Not a great week for Emerging Markets. It’s nearly all tied to trade and the escalating tariffs. First, it was the U.S. imposing 25% tariffs on $50bn of Chinese imports (here’s the full list). Second, China came back with an unspecified tariff on $50bn of U.S. imports. They’ll probably target agriculture and autos. Third, the U.S. thought carefully and said they would charge a 10% tariff on another $200bn of goods. Fourth, the U.S. (well the White House) said, fine, we’ll charge the EU 20% on tariffs on all cars coming into the U.S. It’s true the U.S. can hurt China more than the other way round, for now, simply because imports from China are four times greater than exports to China.

Chinese large cap stocks fell around 11% (in thin markets, there was a national holiday). But Chinese small cap stocks “only” fell 7%. It’s the same story in much of the developed and emerging markets: small cap, domestically focused and non-financial companies have done much better than the large export, headline companies. This makes sense. They're more insulated from the trade problems and benefitting from domestic growth.

A good example of the complexity of the situation is Daimler Benz, Germany’s fifth largest company. It gave a profit warning not because of the U.S. threat of tariffs on cars from Europe, but China’s tariffs on imported cars from the U.S. because…Daimler makes a lot of cars and trucks in the U.S. for the Chinese market. So, it’s a roundabout Emerging Market story. And it's a good example of trying to target one trade sector and not knowing the complex global supply chain of a major U.S. employer.

There’s some short-term uncertainty in Emerging Markets right now. Not just trade. There’s an election in Mexico that will bring in a reformist administration that may not be good for business. The U.S. dollar is still strong and oil still high. Both will hold Emerging Markets back. Again, small caps are doing well, which is why we like the exposure. But we’re investing in protection for our large cap exposure.

2.     Why is everyone talking about the yield curve?  When you buy a bond, you're a lender. You want your money back. Lending overnight should be cheap and safe. Lending for 30 years should be more expensive and riskier. There’s a lot of discussion about what this “term premium” should be. For a five year bond, should it be an extrapolation of the 2-Year note? Or with some adjustment for inflation? Or other macro risk? If so, how much? The number has declined in recent years. We think it’s because investors don't require a lot of premium to lend long because they feel rates will ultimately settle at lower levels. And that the economy won't grow at the rate it used to. Think of it as a sentiment indicator.

A hard indicator, however, is the yield spread between two bond maturities. The most commonly used is the 2-Year Treasury and 10-Year Treasury. Here it is:

That spread is down to 36bps from 130bps at the beginning of 2017 and 71bps in early 2018. That means an investor only paid an additional 0.3% for lending money for five times as long. Why? Well, here’s a quick summary:

  1. The Fed is raising rates at the front end. It’s the only rate they control. The market sets all others.
  2. The market thinks that short-term rates will go up but either that or other things (think trade) will slow the economy, so…
  3. The Fed will start lowering rates long before that 10-Year Treasury matures, so…
  4. The spread or premium will be back to where it should be because short-term rates will fall, while the 10-Year Treasury will not change.
  5. In 2018, we think it means i) yes, the economy is growing gangbusters now, but ii) the Fed is worried about tight labor market so iii) will continue to hike but iv) trade/budget deficits/length of cycle/debt will slow the economy and v) we’ll be back to a Fed cut cycle.

In the past, when short-term rates rise above long-term rates, a recession is just around the corner (the shaded parts in graph). But here’s the thing: you can have a low or inverted curve for a couple of years before the recession hits. It’s all up to the Fed. If they wait too long to cut when the spread inverts, the worse the recession.

We think the rate hike cycle may stop in 2019 and it’s one reason why we’re cutting exposure to corporate credit, and using a short bar bell strategy of 2- Year and 10-Year Treasuries. Or simply, we're unconvinced this late cycle boomlet is going to run for long.

So, here’s a reminder:

h/t Macro Market

Bottom Line: U.S. large cap stocks will struggle to break out of a trading range. European stocks should recover from some of the trade shocks this week.

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