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The U.S. earnings machine.

The Days Ahead: Earnings with Apple on Tuesday close. Fed meeting.

One-Minute Summary Good earnings week. The ECB committed to lower rates. They’re worried about the lack of inflation and slower growth. They should be. Government bond yields of six major economies in Europe are negative. There isn't a single country in Europe that pays more than a U.S. Treasury. That includes Greece, Italy, Spain and Ireland, all given an undeserved acronym a few years ago. European markets were up around 1.3% with Germany leading the way.

The U.K. got its third Prime Minister in three years. Boris Johnson was elected by the party, not the country with a mandate to exit the EU by October 31st. Despite his bluster, we'd put the odds as follows:

60% - Prolong the negotiations

10% - Hold another referendum

10% - Hold an election

20% - No deal exit

We've been out of the U.K. since 2016 and see no upside in equities or sterling.

The S&P 500 hit another record high. It's now up 21% for the year but, lest we forget 2018, up 6.5% over 12 months and only up 10% since January 2018. As we've noted, the market is not expensive and lower rates help valuations.

The dollar continues to strengthen. That’s bad for Emerging Markets and good for inflation. The Administration came out on Friday to say they would not try to intervene in the FX markets to drive the dollar lower. We'd stress that the Fed has no mandate or public view on the dollar. That’s the Treasury’s job. If they want to weaken the dollar through intervention, it would take massive cooperation with other central banks to make that happen. It won't. 

1.     How’s the trade war going? No not that one. That one is all about “talks are going ahead, not going ahead” and which bureaucrats are in Beijing this week. No, there’s another trade dispute between South Korea and Japan. And it’s getting quite serious what with one country evoking “national security” issues to stop trade. It’s what the Administration said about steel tariffs last year and is a time-honored way to dodge Article XXI of the GATT.

So, what’s it all about?

 It goes likes this:

  • In 1965, South Korea and Japan signed the Treaty of Basic Relations and agreed on war reparations. All claims were“settled completely and finally”. However, South Korean courts ruled it applied only to governments, not to individuals. So victims of forced labor could still apply for compensation.

  •  Japan disagreed and asked for arbitration. South Korea refused. In late 2018 the Korean Supreme Court said it was ok to confiscate Korean assets of Japanese companies to repay victims. So the stage was set. Meanwhile…

  • South Korea is the world’s third largest supplier of memory chips. Two Korean companies, Samsung and SK Hynix, make 70% of the DRAMs used for temporary storage of data so your smart phone, PC and servers work. South Korea also makes 50% of NAND chips, used for storing photos and videos. Unlike DRAMs they don't need power to retain data. In memory chips South Korea has 60% of global revenue.

  • To make memory chips, you need specialty chemicals (fluorinated polyamide, photoresists and etching gas, since you ask). Japan is the leading producer of all three.

  • Japan exports stuff to South Korea on a “white list” basis, which means Japanese companies don't need an export license. Japan has said it intends to remove South Korea from that list. That would require a lengthy bureaucratic process for companies to sell to South Korea. The reason they gave was that some of the chips made their way to North Korea. But no one’s really buying that…it's  a good old fashioned tit-for-tat.

  • In the world of highly complicated supply chains, we now have the prospect of South Korea unable to produce semi-conductors. And to add more knock-on effects, 25% of South Korea exports go to China. They fell 24% last month. Prices for semi-conductors also rose 12% in the last few weeks as smartphone, PC and computer companies scramble to keep their supply coming. If this isn't settled expect price increases.

So all a bit of a mess. Right now, both countries are at the WTO in Geneva trying to sort it all out.

We've gone into some detail here because we think this highlights two things. One, that a small change in supply chain logistics can have far-reaching consequences. Two, that South Korea is a highly important conduit to world and Emerging Markets trade. If it’s not doing well, chances are that most of Asia isn't either.

Recent trade between the two countries is down 12%, which is rare outside a recession. Last week, the Bank of Korea cut rates for the first time in three years. We think South Korea is a very good bellwether for Emerging Markets. This recent news isn't helping.

2.     How’s U.S. GDP? Slowing but not bad. Second quarter GDP rose by 2.1%. The first quarter was 3.1%. Most people were expecting more but there were some outliers. Nondefense government spending rose 16% and consumer expenditures were up 4.3%. It’s the last one that's important because the U.S. consumer accounts for 69% of GDP. So nice beat and here it is:

So why is the Fed easing?  Because the corporate sector is hurting. Inventory wind down detracted 0.86% to the 2.1% growth and net exports another 0.63%. Without those, GDP would have risen 3.6%. Investment in non-residential structures (so, retail, offices, plants etc) decreased at a 10% rate.

And that's the basic story. Personal side and government ok…anything to do with business, manufacturing, capex, not ok. The Fed is trying to help the latter to keep the whole thing going.

Meanwhile, the Fed’s chosen measure of inflation came in lower than expected at 1.8% and Q1 was revised down to 1.1%. That also gives the Fed the reason it needs to cut next week.

3.     How are earnings going? Well. Earnings are lower than last year but we've had some monster beats by some very large companies. Of the top 10 companies, seven have handily beaten estimates. And not through EPS manipulation. Amazon, Microsoft and Google showed between 12% and 19% revenue growth… remarkable for three out of four of the world’s largest companies. Nearly half of the S&P 500 companies have reported, showing average growth of -2.6%. Three quarters have “beaten” estimates.

As expected, those companies with overseas sales have underperformed those with a U.S. base. Mostly in the tech, materials and energy sectors. But investors expected that so we’re not seeing big revisions down. 

Bottom Line: The Fed will lower rates. We'll watch for any language that may hint they’d go more than 25bp this year.

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