Tit For Tat Tariff Terror

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Posted: Jun 22, 2018 11:28 AM
Tit For Tat Tariff Terror

Markets predictably resumed downward pressure this week as the U.S. tit-for-tat tariff war with China exacerbated into this week.  Markets remain well over 1,000 points higher than they were a couple months ago, when arguably the trade war had not yet grown this bad, a testament to how strong other economic news has been apart from this unforced trade war error.  But much more needs to be said this week, and I say it all (from the trade stuff, to capex, to Japan, to so much more).  With all that said, let's get into it!

Tariff terror

In what must surely be one of the least surprising things, ever, the Chinese retaliated against the U.S. declaration of tariffs ($50 billion worth), provoking President Trump to say that he would retaliate against the retaliation (and so forth and so on).  It is hard to play out where this will go from here.  The consensus view (and hopeful one) is that there is plenty of posturing and flexing and negotiating behind all of this, and the actual impact on prices and consumers via these voluntary tax hikes will be minimal.  The problem, of course, is that no one knows exactly how this plays out, or in what timeline.

There is a game of chicken going on, and investors are wise to not like it.  The underlying market volatility we are experiencing now is highly unlikely to subside as long as this issue lingers.  The President's bet is that the economy is strong enough, he has wiggle room to play this out and see how much of an impact a trade war has.  Skeptics say that to launch such an experiment with 3-4% anticipated GDP growth risks losing much of the lift that led to 3-4% GDP growth.

My own view is that the most likely thing to reverse course from this desired path in trade and tariff discussion will be a meaningful drop in equity prices.  That hasn't happened, so we continue in this directionless limbo.  The tariffs are creeping higher.  The retaliations are moving into more and more sectors.  And then retaliations are being launched against retaliations.  The market is not loving it, but the market is not panicking.  Yet.  More on this in the Politics and Money section below ...

Investing by Valuation

We like to avoid over-valued securities, and we like to buy under-valued securities.  That is not as obvious or routine as it may sound; many feel that under-valued stocks get more under-valued (they often do), and over-valued ones get more over-valued (they certainly often do).  We don't view the momentum, trend-driven approach as viable, due to the violence and rapidity with which trends can be broken and momentum disrupted.  We liken that approach to gambling, and we feel strongly that investing should be done with more rationality and coherence.  But being valuation-conscious does beg the question as to how one can identify what is over or undervalued.  It's a fair point.  Our argument has always been, borrowing from the legend, Benjamin Graham, that we don't need to guess exact weight to know what is overweight.  And we don't have to know exact age to know if one is old or young, etc.  Yes, a lot of "middle ground" exists, and much investment controversy and difficulty can exist in that gray area of valuation.  But broad labels are possible and warranted, even apart from exact weight and age.

Click here to view the chart.

Why aren't long-term rates going higher?

As the Fed has slowly but surely increased the short-term interest rate higher over the last 18 months, we have seen the ten-year bond yield creep from 2.6% to just 2.9% or so, and we have barely seen the 30-year bond yield move at all.  The result is, obviously and just plain mathematically, a flatter yield curve.  But with economic growth so much better, and supposed inflation fears, why are long-term rates not, in fact, moving higher?  My thesis has long been that the bond market doesn't believe the inflation theme - that whether or not headline or transitory inflation "chatter" increases in the short term, a pick-up in structural inflation is simply not believed in the bond market (evidenced by the low long-term rates).  However, another factoid that really warrants more consideration in the overall milieu of this macroeconomic context, is that our long rates are being held down by Europe.  Europe's challenged growth and heavy monetary intervention of anchored their rates down, and it is hard to believe the U.S. bond yields could widen much with Germany anchored so low (and Japan deserves an honorable mention here, too).

Fixed Income (BONDS) updated

We are looking to increase emerging debt in our bond portfolio on a valuation basis, and likely take that increase from a slight decrease in floating-rate bank loans. We also are looking at short-term TIPS (inflation protected treasuries) given the state of headline level inflation. Duration is running short (~3) – and that is primarily because we see opportunity for total return there, not because we are afraid of long-term rates jumping.

Europe updated

What should we expect from European markets in the months ahead, not just their bond spreads, absolute yield levels, equity markets, but also broad economic metrics?  My best guess is that Europe will not be monolithic in the months and quarters ahead - that Germany's health will look different than Italy's - etc.  But I do believe that investors should understand this: Over the last four years, the European Central Bank has purchased 2.4 TRILLION (yes, with a "T") euros of debt.  €2.4 trillion euros of bonds, bought by the central bank, with money that doesn't exist.  They have slowly wound down these monthly bond purchases, and have announced they will stop this measure entirely in September.  The question is whether or not the tepid economic growth they have now, with this bazooka of monetary stimulus, will be hurt by the cessation of this aggressive monetary intervention, or will it help (to be on the other side of monetary training wheels).

Japan updated

One of my biggest frustrations is when people interpret my decision, 20 years into my investing career, to take a position in Japanese equity markets, as me somehow believing their monetary extremism in 2016 "worked."  In fact, I believe it made matters worse, and that most of their monetary interventions over the years served to exacerbate the deflationary pressures that have pummeled Japan since the early 1990's.  That their corporate sector is loaded with cash, enjoys low valuations, and is in screaming need of creating value for their shareholders, are all matters totally divorced from their sovereign finance state.  The dividend payout ratio is incredibly low on a global basis, and we want to capture the secular reversal of that fact.  As contrarians, we do not believe the space is loved (or barely even liked).  The index trades down near Colombia, Poland, and Russia in terms of P/E (market multiple), and we see no rationale which can justify that.  This is a long-term play, and it is not related to "negative interest rates" or a central bank buying shares of index funds (or any other market-distorting shenanigans).

The biggest story in the American economy

No, it is not the iPhone.  This is something that has all happened in the last six years, has been driven by American technology and innovation, has profound implications for both geopolitics and global economics, and has third and fourth order effects that will drastically impact growth in our own economy.

Click here to view the chart.

Tactical soothing

I vehemently contest the idea that the job of an asset allocator is to make sure that at all times the positions of a given diversified portfolio ought to be aligned with what macroeconomic conditions are delivering at this time (i.e. properly predicting and aligning with what the dollar does, the Fed does, rates do, GDP does, etc.).  In fact, asset allocation exists because history has brutalized the investing hubris of those who believed they would (a) Guess those macro events right, and (b) Line up the right solutions with those macro forecasts, and then (c) Be accurate as to how various markets would respond to those macro events.  It is a fool's errand.  Asset allocation exists because we do not know how to do A, B or C with any perpetual reliability (nor does anyone else).  One will note - the U.S. dollar has rallied substantially the last three months.  In that time period, small and mid-cap stocks have done very well.  Emerging markets stocks have not.  One could try to guess on a monthly basis what the dollar will do, or they can hold both growth-oriented asset classes in their thoughtful, long-term portfolio.  We take door #2.

Politics & Money: Beltway Bulls & Bears

  • As mentioned in our TARIFF TERROR section to launch this Dividend Café, it has been a volatile week around the movements and posturing of tariff impositions on China, and theirs back on us.  The soybean industry is in disarray.  Steel and auto producers in the rust belt are frightened.  The politics of the Trump administration's trade/tariff policy have not been problematic, yet.  Should that change, will the administration change?  I suspect they would.
  • From former National Economic Council Director, Gary Cohn, previously president at Goldman Sachs: "If you end up with a tariff battle, you will end up with price inflation, and you could end up with consumer debt … Those are all historic ingredients for an economic slowdown.  You could erase gains to the American economy from the tax law."
  • Ultimately, the benefits in the economy of tax reform are potentially going to a war with the drag from tariffs.  The bullish side is that the market has not appreciated the full weight of tax reform benefit (that is my view).  I do believe the impact of the tax reform bill will be larger than has been anticipated, but much more importantly, I believe it will last much longer than anticipated (based on the thesis of it provoking increased capital expenditures and business investment).  The political impact to markets right now is that: Trade wars are adding to volatility; Tax Reform is adding to long-term fundamental strength.

Chart of the Week

The reversal of the U.S. dollar in recent months coincides perfectly with the increase in market volatility in recent months.  Small cap has done well in this period (less currency sensitive), and emerging markets have struggled.  The equity markets have seen periods of great growth with a rising dollar, and great growth with a declining dollar, all in the last two years.  The questions for equity investors going forward will not be answered merely by what the dollar does - of this, we are confident.

Click here to view the chart.

Quote of the Week

“All persons ought to endeavor to follow what is right, not what is established.”

-- Aristotle

* * *
 I leave a conference I spoke at in Michigan today to re-join my family in Southern California.  I am excited to spend a whole summer in Newport Beach, free of Manhattan humidity.  The bi-coastal life is a hectic one, but it is what best serves our clients and our business.  And yet to have a prolonged period at one location will be nice.  New summer diets and workout plans begin next week as well - fun things all around.  Let's see if the summer scenery and lifestyle changes bring with them an actual direction to this market.  In the meantime, we shall continue doing what is right.  To that end, we work.

David L. Bahnsen writes at The Dividend Cafe.