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Trade

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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 --Christian Thwaites, Brouwer & Janachowski, LLC

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.
All charts from Factset unless otherwise noted.
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Steel your face

The Days Ahead: Italy heads to the polls. Non-farm payroll numbers. More fall-out from trade.

Jerome Powell did rather well in the semi-annual report to the House and Senate. His comments were slightly hawkish. Two points stood out.

One, he said that the Fed will “continue to strike a balance between avoiding an overheated economy and bringing PCE price inflation to 2%.” No argument on the second but the Fed’s mandate is employment and inflation not avoiding growth. So, yeah, that was odd. Two, he said he finds "rule prescriptions helpful”, which is something the Fed has not pursued (thankfully) for the last few years. Otherwise Taylor rules and Philips curves would have led to much tighter policy.

On balance, I think this means he’s seen the new fiscal policy coming at a near fully employed economy and that it might tip the balance towards more cuts this year. We expect three cuts, which would take the Fed Funds Rate to nearer 2% by year-end.

But we like the bond market and especially Treasuries. Why? Well, first, much of the recent economic data has not been that strong. Yes, bad weather, New Year interruptions and so on. But more disappointment than elation. Second, they're going to be first in line to buy in time of anxiety. And what have we had this last week? A lot of anxiety and increased volatility. Meanwhile:

1.     Steel your face: Steel tariffs were announced on Thursday. Stocks took a dive. The tariffs amount to 25% on steel and 10% on aluminum. How big is the industry? Well, in the graph, the top line is monthly imports of steel, at about $3bn a month, and the bottom line is steel exports, at around $1.1bn a month.

So, a quick calculation would suggest that steel imports will cost around $9bn more a year, which assumes that domestic producers i) don't fill the demand and ii) prices don't change. We don't know the answers to the first yet, but the share prices of Nucor, AK Steel and U.S. Steel all rose by between 7% and 11% so one assumes more demand is coming their way. Steel prices are up 32% this year and jumped 4% on Thursday…although we’ll admit delivery and futures prices may not be well connected.

On the demand side, stocks like Caterpillar, Ford, GM and Boeing all had a very bad day. The steel industry is not particularly big. It employs around 85,000 and is about 0.05% of the workforce. Both numbers are a third of what they were 25 years ago. Companies that use steel employ many, many times more.

Here's the full Commerce Department findings. The announcement came under Section 232 of the Trade Expansion Act of 1962, which cites national security as a reason for tariffs. The largest source of steel imports are from Canada and Mexico, which, I dunno, don't normally come to mind when thinking of security risks.

And that’s the rub. This is the sort of irresponsible policy markets fear. For many years, we have not seen any major policy errors. This may be the market adjusting to a new reality.

2.     Buybacks in the news: Again. Some 75% of companies have reported for Q4 and the lower corporate tax and other tax-related savings were much on their mind. The most common responses for how they would use the savings were i) invest for growth and ii) “cash return to shareholders,” which will almost inevitably be share buybacks. Now, we have a problem with buybacks, namely:

  • Management says they're going to do it but don't
  • The timing is nearly always off
  • It adds no value

On the first, management can announce a big repurchase program but is under no obligation to carry it through. On the second, there were no buybacks at the bottom of the market in 2009 and plenty on the way up. For insiders, they're none too good at valuing their own companies. And on the third, shrinking the float by 10% may increase the share price but a firm’s value remains unchanged. No surprise, CEOs tend to be paid on price return h/t to 13D Research.

It’s a very big part of stock-market action. There have been some $4 trillion of buybacks since 2009 on an average market capitalization over that period of $14 trillion. It's accounted for some 70% of earnings-per-share growth since 2012 and it explains a lot of the higher levels of debt that companies carry to finance the buybacks.

Some 305 companies in the S&P 500 have repurchased shares in the last year and since the tax changes, they have announced another $215bn worth. In February alone, this was $153bn or nearly three times the January level.

How’s that worked out? Well, we looked at the performance of some of the largest dollar buybacks (green line) and the largest as a percent of market cap (black line, where the winner is Sealed Air, which bought back some 7% of its stock).

Over three years, both groups have underperformed the S&P 500 by a considerable margin. Even the ETF specializing in buybacks (you knew there'd be one) has underperformed the S&P 500 by 50% in the last few years. And that's not all:

  • Some 125 of the 305 companies bought at a premium to the current price, in effect wasting shareholder money by buying a falling stock
  • The average discount was only 2%, which suggests a lot of fire power to achieve very little
  • Financials accounted for 26% of the total, or 29% if one excludes Apple’s monster $10bn buyback. And if you're like me and think banks should be well capitalized all the time, this should worry you

Many of the companies took on additional debt to pay for the buybacks. We would expect lower levels of buybacks if market volatility continues and rates increase. Meanwhile, if you hear more about increased buybacks from the likes of Cisco, Metler Toledo and Amgen, well, count us skeptical.

Bottom Line: With earnings over, we’re now at point of anxiety. We expect the trade issues to become front and center for a while. Stocks are now flat for the year. At the end of January they were up 8%. Emerging Markets are still positive. Get to know the name Cecilia Malmstrom, the EU trade commissioner, because the EU will almost certainly challenge the U.S. at the WTO and impose counter tariffs. Also, mug up on these guys.

And in some good news. Carol Kaye will be 83 next week. You may not know her but you've heard her many times. Happy Birthday, Carol.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

T. Boone Pickens now has an ETF

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--Christian Thwaites, Brouwer & Janachowski, LLC

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.
All charts from Factset unless otherwise noted.