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trade wars

Apple adds a zero

The Days Ahead: Big 10-Year Treasury auction. Inflation numbers.

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One-Minute Summary: One of those weeks when you think lots of stuff happened, markets must be going bonkers. But stocks had a good week. Earnings continued to do well and of course, Apple, had a strong week. It’s now 4% of the S&P 500 and $1 trillion. It’s an even higher weighting in 8 out of 10 of the largest ETFs, ranging from 4% for an S&P 500 tracker and 15% in the Technology Sector fund (ticker XLK). Not to spoil the party, but we’d remind readers that Altria has been a much better stock since Apple’s IPO back in 1980. One hundred dollars invested in Apple back then is worth $55,000. For Altria it’s $88,000. The slow and steady increase in Altria along with dividends was a better investment than the long no-dividend policy of Apple and the 17 wilderness years. Still, great company and justifies much of the run-up in the S&P 500 in the last few weeks.

Trade was front and center again. The U.S. Trade Representative raised the stakes by increasing tariffs on $200bn of goods from 10% to 25% but not until September. The Chinese shot back announcing yet unspecified tariffs on $60bn of U.S. imports. The U.S. exports around $120bn of goods to China every year so, yes, the Chinese may be running out of retaliatory measures.

There’s a sort of trade truce with the EU right now so expect more on the China trade for a while. If markets seem numb to the trade issues it's because there’s still a big gap between what’s been threatened and what’s been implemented. However, the Yuan/$ rate is getting a lot of attention. The Yuan has weakened by 8% since April, negating much of the effects of higher tariffs. That's one reason why we’re a little cool on Emerging Markets right now and taking protection.

Elsewhere, the job numbers were lower than expected and average hourly earnings didn't move much. The numbers won't change the Fed’s mind on a September hike. The 10-Year Treasury broke through 3% for one day and settled back to 2.95%. If a 3.9% unemployment rate isn't enough to push yields higher, what is? We'd say earnings and wages (not increasing), a better trade deficit (no), more confidence from the Manufacturing and Non-Manufacturing sector (no), more aggressive talk from the Fed (not there either), or higher inflation (see next week but probably not).

1.     Should we care about the budget deficit? Yes, but not yet. One of the ironies of the last year is that the normally fiscally disciplined politicians signed on to a very big tax cut in the last stages of an economic cycle. The argument for such a move was that lower taxes would spur investments spending, growth, productivity, all sorts of good things and, of course, lead to higher tax revenue. So:

Step 1: Cut taxes

Step 2: Wait

Step 3: Higher growth and more tax revenue

Tax revenue is down $150bn in Q1. It will be more in Q2. Corporate tax receipts are down 48% and, as a percent of GDP, at a 70-year low. The OMB announced that the deficit in 2019 is now $1 trillion or around 5% of GDP.

We'll stay away from the soundness of such a policy and point to two things.

First, here’s a chart of the deficit and unemployment since 1948.

We've inverted the unemployment rate to show the relationship. As the economy enters a recession (the shaded bars), unemployment rises and deficit spending increases to make up the shortfall. There’s a drop off in tax receipts, of course, but the general approach is to smooth out demand when the economy most needs it. Once the recession eases, stimulus is removed and the deficit improves.

What's remarkable about the last year is that the two lines have gone in wildly different directions. This means that if there is a recession, there’s little scope to increase spending when it's most needed.

Second, there’s the increase in borrowing. The Treasury just announced funding needs for Q3 and Q4. It’s a very big number. In Q3 the Treasury expects to borrow a net new (i.e. after funding maturing debt) amount of $329 bn, up $56bn from April estimates. And in Q4 it expects to borrow $440bn. Again, net new. That compares to $72bn in Q2 and $192bn and $204bn in the same time last year.

The Treasury is doing all it can to help the process. They're introducing 2-month bills for the first time. They’ll come in November at a rate of $25bn for seven weeks. They increased the amount of 5-Year Treasuries by $1bn a month and the amount raised from bills (so less than 12-months) from 18% to 27% of the total. That should make it easier to absorb and keep longer-term rates from rising as fast.

What does it mean? One, we like the short end of the Treasury market. It’s a strong risk adjusted place to be in the yield curve. Two, we also like medium term (7-10 year) Treasuries as we think rates will peak some time in 2019 and not affect the middle of the yield curve.

2.     Why are asset managers not good investments? I mean, you know, they manage money for a living so you might say to yourself, “these guys know what they're doing, I’ll buy the stock and get a nice alpha-laden return on the S&P 500.” But no. The public fund companies have been pretty awful investments. Here’s a composite of some of the biggest (we left out Invesco and Blackrock but they are not the exception…we just ran out of names):

Over the last 10 years, an investment in some leading asset managers underperformed the S&P 500 by about 45%. It doesn't get better if we change the dates. Year to date, three, five and 15 years are no better. Are they just bad managers? Erm…no, but they're in a tough business. What has been investors’ gain in the form of low cost index funds has been asset managers’ loss. Many are caught between low cost providers, like Blackrock, State Street, American Funds and Vanguard and specialist hedge, private equity and venture funds. ETFs and low cost funds are now around 20% of all managed funds and take an even greater share of flows.

Many will adapt. Either by merging, shrinking or finding new areas of growth. But for now, it’s probably more disruption and declining margins.

 Bottom Line: Earnings are still doing well. The Yuan, trade and  macro numbers will drive sentiment. Meanwhile, stocks, as we’ve mentioned, stocks are trading on forward P/E of 16.6 cheaper than all of 2016 and 2017.

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Charlotte takes on the world

 --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.

Friday Music: DIscover India

Stocks staying ahead despite trade

The Days Ahead: More corporate earnings. Industrial production.

One-Minute Summary: We’re in earnings season and it’s going to be a cracker. In most earnings seasons, companies “beat” expectations because that is how the game works. Analysts put out an estimate early in the season, the CEO (well actually normally the IR guy) sucks their teeth and says, “dunno about that…”, the analyst revises down (this can repeat a few times with knowing winks), and then the company comes in and beats. Everyone happy. That’s why 70% of companies beat every quarter. It’s not that CEOs are great or analysts incompetent. It's just how it’s played.

Anyway, if you're a CEO of an S&P 500, 400 or 600 company, you didn’t even have to show up in the first and second quarter and you would have a 10% to 15% gain in earnings just from the lower corporate taxes. But if you did show up and threw in some growth and buy-backs, then your earnings will be up 22% YOY this quarter.

So, we’re celebrating a great earnings season. But most of that was in the price of the S&P 500 seven months ago, which is why stocks haven’t moved much so far this year (although up 7% from the February mini-crash). Yes, small company stocks and growth had another good week.

There were good economic numbers as well. Job openings were strong, inflation moderate, producer inflation in control but the headlines were dominated by the latest round of tariffs, which now includes onions, buffalos and maleic acid (no idea, sorry) but not cell phones or computers. And of course NATO and BREXIT. Normally, when these stories dominate the fireworks are in FX markets and that was somewhat true last week. It seems as if markets are “What’d he jus’ say? He can't mean it. We hope he doesn't mean it. He doesn't mean it.” That cycle takes about two hours these days. Tailor made for neurotics.

Stocks were broadly higher here and in Europe but on summer trading, which always has a torpid feel. The 10-Year Treasury was flat but 30-Year Treasuries strong.

1.     The next recession. One of our favorite commentators over at Financial Intelligence asked this question recently.  One lore is that recessions do not die of old age; the Fed murders them.  Which is nonsense. Recessions are normally preceded by over leverage, inflation and crisis of confidence. The Fed is merely the instrument that starts the rate cycle.

 The Fed started hiking rates in 1972, 1976, 1986, 1993 and 2004, all without triggering a recession. And in some cases, as in 1973, 1984 and 1994 they started to lower rates some two years before a recession. And that points to another problem: insufficient data. Whenever you hear someone say “a recession always come when…” you can quietly muse that there have been eight recessions in the last 64 years (so 12% of the time) and 18 in the last 103 years. If a researcher from one of the hard sciences showed up with a theory based on 18 data points, you might politely sigh.

Anyway, here’s what we think might cause some problems:

  1. Politics and trade
  2. The fiscal stimulus from the 2017 tax changes running out sooner than expected
  3. High federal debt
  4. Corporate leverage

We don't really think the consumer is a problem this time round. Yes, things like student debt are off the charts and consumer and mortgage debt are at all-time highs in absolute terms. But so is GDP and we’re fine with personal debt growing in line with nominal income. Consumer and mortgage debt is now around 70% of GDP from a 2009 peak of over 90%. Also, we’ll stick to our belief that the forces causing the recession last time don't get to do it again. So, the consumer gets a pass this time round.

Corporate debt is a different story. Here it is:

This shows corporate bonds owed by non-financial companies (blue bars) doubling from 2008. But they've also increased cash so the net borrowing is around $4.5 trillion. That reached a record level of over 20% of GDP two years ago and has since plateaued (bottom graph).

We've excluded other corporate debt, like bank loans and payables. We'd add that not all these companies are financially stretched. Still, it’s a high number and at some point, rising rates, if only at the short end, are going to make life difficult for companies. That’s why we've been lightening up on corporate credit for the last few months.

2.     What's inflation up to? Not much. Last week’s report showed headline inflation at 2.8% and core (so knock out food and energy) at 2.2%. This is above the Fed’s goal but i) the Fed uses the broader PCE measure of inflation and that’s at 1.9% and ii) there are some important base effects going on, that we've written about. The main one is cell phone rates, which fell sharply last year when Verizon cut prices, and used cars, but both are pretty much done. The Fed’s, rather difficult, job is to differentiate between temporary and entrenched inflation.

The Atlanta Fed tries to do this with its Sticky and Flexible measures of inflation. Sticky prices are ones that don't change too much. The classic example is coin-operated laundries, which change their prices once every six years. The list also includes fees, rent and medical costs. Flexible prices are those that change a lot. So things like vegetables, gas and clothes change prices every few weeks. This is what’s going on with the two:

As you would expect, Flexible prices are volatile with prices swinging from -3.0% to 3.5% in the last year. Sticky prices are moving much more slowly and haven’t changed their rate of growth much in the last four years. We think it's likely to stay that way. And as for wages?

They're not keeping up with inflation (black line). To some, this is a puzzle. Low unemployment, low participation and a tax change trumpeted as good for workers and their wages should lead to wage increases. But, no. There has been some increase in hours worked, so take-home pay is up. But it's by a very small amount. For us, real wages have to increase to push inflation up meaningfully and, so far, ‘aint ‘appening.

Bottom Line: More good earnings numbers coming up. Stocks are within a whisper of all time highs but, if companies report concerns about tariffs, expect some weakness. We still favor small company stocks

Please check out our 119 Years of the Dow chart  

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SEC drops whistleblower prog

Young billionaires

 --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.

Detectorists

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.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

NIMBYism San Francisco style

Rodents in ATM

 --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.

Dreams