The Days Ahead: A short week and welcome break. EU and Brexit.
One-Minute Summary: U.S. stocks held up well for a very eventful week. We often talk in macro and market sentiment terms here but sometimes specific stock stories can change markets. We'd point to GE, down 15% and down 55% in the last year. Its bonds are even down 27% and it was recently downgraded to one level above junk. There’s a likelihood that the company is about to go into freefall. Next was Apple and fears that we’ve reached peak iPhone. Suppliers have been put on notice and Apple-related stocks (e.g. ,Dai-ichi, Hon Hai, Foxconn) have been hit hard. The $175bn market-cap loss in Apple is greater than all but the top 25 companies in the S&P 500. And then there’s Goldman Sachs, which is the third largest component of the Dow Jones Industrials simply because it has a high price stock. Goldman is caught in the middle of one of its periodic scandals.
This is what is hanging over the markets:
Fear of peak earnings: corporate America’s margins are threatened by higher import costs, trade and possibly higher wage bills
Trade: last week we had China trade talks are on (Trump), the tariffs are on hold (Lightizer), on again (Ross), talk tough to China (Navarro) and no don’t, it’s all going fine (Kudlow). One may forgive the market for thinking it’s all a bit up in the air.
Fed and rates: Powell and other Fed governors are talking up rate increases in December and into next year. Yet Treasuries have rallied.
Economic data: retail trade, industrial production and inflation all slowed from prior peaks.
Geo stuff: China, Italy, Brexit, Mexico, Brazil. All out there and with no clear path.
Stocks are probably over estimating the weakness in the economy but all the signs are there. It’s going to be tough to see a positive sentiment for risk assets coming. We still like Treasuries especially as some cracks are beginning to appear in credit.
1. How’s Brexit going? We've stayed away from this painful subject pretty much since the vote in the summer of 2016. Painful because it seemed like the U.K. was throwing away 40 years of trade advantage and close EU integration in return for promises of more growth, better healthcare for all and a return to imperial glories. It was a divisive vote and pitched experts against populists culminating in a Tory minister saying, "I think people in this country have had enough of experts". Ok, then. The vote went through, the Prime Minister resigned, a new Prime Minister took charge and quickly realized that the EU had very much the upper hand in negotiations.
Much of the discussion centered on treatment of the Irish border. The Republic of Ireland is in the EU. Northern Ireland, part of the U.K., is not. Both sides wanted freedom of movement between the borders and an agreement was hammered out that was shown to the U.K. Parliament this week. It did not go well. As of writing, the Prime Minister has lost several cabinet members, Parliament is furious and many feel that the whole deal is “Brexit in name only” or BINO. There are now three options:
The U.K. accepts the terms, pays an exit fee and keeps many of the trade agreements or…
It rejects the agreement, which means no deal will conclude before the hard exit option comes into play in March 2019, or…
It holds another referendum
We have no idea which way it will go. Meanwhile sterling has fallen. It’s down 13% since the referendum. So have stocks. Here’s the performance of the U.K. stock market for a U.S. investor over the last two years relative to the S&P 500:
And so has the economy. The IMF shows the U.K. economic growth falling from top of the G7 list to bottom; see their report in “U.K. outlook in six very ugly charts”
The most common international benchmark for U.S. investors is the MSCI-EAFE index. It has about an 18% weight in the U.K. down from 25% ten years ago. We've avoided the U.K. for over a year now and there’s not much to entice us back.
Unfortunately, this is not just a local affair. The U.K. is still the world’s fifth largest economy and a major trading partner. Combine Brexit with Italy, trade, China, Mexico, Brazil and general tensions and the whole global growth story looks shaky.
2. What’s the oil price telling us? We're not commodity experts but a moving oil price will come down to a demand or supply question (I know, duh, as the teenagers would say). It’s not clear right now. The supply guys say, well, the Iran sanctions are leaky, Saudi will pump to keep in with the U.S. and eyes away from Khashoggi, Mexico and Russia can’t reduce supply and U.S. shale is back on line. The demand guys say look at world output, China slowdown, energy alternatives, slower economic numbers and there is your answer.
We saw wild swings in the oil and natural gas prices last week. Here’s a chart of both and the ratio between the two over the last 12 months:
Oil is now in a bear market and that matters for the U.S., which produces 12m barrels per day, compared to Saudi Arabia at around 9m. The big moves last week were probably large positions being unwound. The price of natural gas does not normally climb 20% and then fall 10%. The ratio between the two had also settled into a range of 22:1 for the last few years and suddenly halved to 11:1.
So, we’re not sure that last week tells us as much about the state of the economy as it does about volatility in asset classes. Make no mistake, traders and hedge funds have not had a great year and the oil/gas spread is a classic risk trade (h/t Cameron Crise). It looks like some of those trades went badly wrong. We’d give it more time to settle down.
On a very rough guess, it looks like the oil price fall drops oil production revenues in the U.S. by $60bn a year. The U.S. consumer spends about $45bn a month at gasoline stations (not all of it on gas, we know) so it may free up some additional $5bn of increased spending. Over on the corporate side, we’d say that the lower prices come at a very good time for businesses.
Bottom Line: The Fed is clear that there is nothing standing between them and rate increases. Speeches last week made no concessions to stock market weakness, slowing U.S. or overseas growth or trade. That could change but then Powell could be seen to be giving into Trump pressure. That’s a heck of a dilemma for the Fed and it will play out in the next few weeks.
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--Christian Thwaites, Brouwer & Janachowski, LLC
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