Greetings from the SALT Symposium in Las Vegas where the week that all of our fears about the trade war with China came back into our consciousness, many of the top policy and investment minds in the country gathered to pontificate about that which our capital markets (and culture at large) face. It has been an invigorating couple days of meetings, sessions, panels, and discussions - covering everything from the 2020 election, to the state of credit markets, to the future of cryptocurrencies, to the latest and greatest in the hedge fund space, to high frequency trading, to opportunity zone investing, to geopolitics, to various developments in the world of philanthropy ... to so much more. I have packed in a plethora of meetings this week and taken in about as much content and idea generation as my mind can handle, and I am sure I will spend much of the weekend processing it all. I also enjoyed very private and very productive meetings with various politicos, hedge fund managers, and administration officials that fed my view on the current state of affairs immensely. I do plan to record a special Advice & Insights Podcast on it all over the weekend or early next week.
All that to say, it’s been a week, and this kind of intellectual stimulation was needed with what has unfolded on the policy front in the escalating trade tensions with China. Many will be reading this week’s Dividend Cafe wondering why markets declined this week as they did, but I will say right now the real subject of this week’s Dividend Cafe is ... Why didn’t they decline even more?
So with all that said from the city of sin, let’s jump on into the Dividend Cafe!
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When a tweet tantrum becomes a trade war
Last Sunday the President tweeted that China negotiations were breaking down and he was prepared to raise tariffs from 10% to 25% on $200 billion of Chinese imports ... Back and forth rhetoric ensued, there wastalkof negotiation meetings being canceled, they ended up staying scheduled, and here we are.
And so markets revolted, or not really??
As of press time, here is how the markets responded this week. Initially, the response to President Trump’s twitter threats last Sunday to increase tariffs on China dramatically and immediately was an approximately 500 point drop in the Dow. But by the end of Monday that had fizzled to only a 70 point drop or so. Tuesday we got our sell-off, declining 470 points. We stayed flat Wednesday, and as of press time Thursday we are down approximately 100 points. So that is the problem with typing this now knowing you are reading it Friday or Saturday - that markets could move hundreds of points up or down (more likely down than up in this news context) by the time you get this. But let’s just say that markets are, at least at this point in time, down about 600 points on the week.
Is that the sell-off we have been waiting for?
If the markets were pricing in that $200 billion of Chinese imports were going to face tariffs jumping from 10% to 25%, and that such tariff escalation was going to be sustained, it is not my opinion that markets would only drop 600 points. In fact, what we are seeing is a market that doesn’t fully believe that this could unfold as badly as it could. The markets have good reason to believe that a lot of the worst case scenarios will not happen - President Trump has hardly tried to hide the fact that much of the bluster and threats are intended to be negotiating tactics vs. long term policy objectives. And yet, if nothing else, the potential for elevated volatility out of all of this is certainly very present. As of press time, the talks that are scheduled between both sides have not yet started, but by the time you are reading this they have (barring any unforeseen disruption to such plans). Stay tuned!
Where does it likely go?
There continues to be a strand of argument that China has a lot more to lose than the United States does in a prolonged trade war, and as far as certain economic metric measurements go, that is certainly true. But it may not be the relevant issue. China has now election coming in 18 months. The United States does. It is entirely possible that Chinese authorities may feel that they are willing to endure more economic hardship for a period of time out of hopes that they will be negotiating a better deal for them in 18-24 months with a different administration. I will be very surprised if by the time you are reading this all of the tensions that re-ignited this week have been favorably resolved, and yet I also will be surprised if the various actions and threats and so forth that come out of this week’s setback represent a new normal. A scenario where things get worse before they get better, but eventually they do get better, seems most likely to me
What gets hurt the worst in a tariff/trade/tweet war?
Materials, Industrials, and Technology have led the way down this week, with Energy, Utilities, and Consumer Staples being the relatively least affected.
What can China do to us?
Okay, first of all, let’s make one thing clear - the tariffs we impose on China, are something done “to us.” U.S. importers of China products pay the tariffs, and of course pass those costs on to U.S. consumers, so no matter what we may say about China’s retaliatory actions, the initial action itself is actually punishment enough for the U.S. economy. That said, China’s retaliatory tariff options are limited, but greater regulatory tools from patent invalidations to slow-walking approvals and inspections, etc. are the primary tools China will have in their toolbox.
But wait, it’s worse
Okay, first of all, Trade-related drama is not the only political/policy/public flare-up worrying markets this week. Bipartisan support appears to be building for some type of policy intervention into prescription drug prices, and various efforts to pass a privacy bill that would impact several high profile technology companies are advancing as well. Again, markets don’t generally fret over the things most people fret over, because most people fret over things that are not feasible in our system of government. But what needs to be watched for market actors from a policy standpoint are those things for which rare but actionable bipartisan support exists (and of course, those things that do not require legislative action at all but exist entirely in the discretion of the executive branch of government).
So what does someone with a one-month timeline do?
They expand their timeline, or they quit investing in risk assets.
Not quite Deja Vu
If one goes back to the market response to various trade escalations approximately one year ago, it should be remembered that we were not exactly in a similar market or economic state one year ago. The potential for a policy mistake on trade a year ago was happening in the context of a tightening Fed; today we have a sidelined Fed. A year ago there was a great question about the economic growth the corporate tax reform would create; today we have now seen real GDP growth over 3% over the last 5-6 quarters. I really only mean this in the context of sentiment, because fundamentally no economy ever wants to take on something as disruptive as a trade war. But yes, there is a sense in which having a market setback take place in isolation may just be better than in taking place in concert with numerous other setbacks.
Will profit margins trump trade?
It does seem to me that some have been talking about "peak margins" for 7 or 8 years of this 10-year recovery, but there is a sense in which if someone says something long enough it does eventually become true. The idea is that several significant inputs that affect profit margins are low, and highly unlikely to go any lower: Corporate tax expense and cost of capital most substantively. Wages are likely continuing to grow as well, though the impact of that to profit margins has been negated by growing productivity. We are not in the “peak margin” camp, but we do believe profit margin fundamentals reinforce our call for enhanced productivity via capex.
Oh yeah - the rest of the economy
Keep in mind, despite the market’s drop this week, it had advanced quite a bit late last week on the news that 263,000 jobs were created in April, a blowout number resulting in a 3.6% unemployment rate. Wage growth has stabilized around 3.2% year-over-year, which feels to market actors like a “not too hot, not too cold” number. And if the Fed told us anything last week, it was that inflation does not seem problematic to them at this time, and rate cuts are not being considered. All spin aside, the economy is on a strong footing, and the Fed is truly in a pause mode.
Would the Fed really cut?
If the Fed began talking about “concerns over low inflation” or “surprise data indicating inflation below their targets,” then I would take that to be foreshadowing to a potential rate cut. But the Fed has thus far gone out of its way to suggest that the drop off in inflation data as of late is “transitory.” The Personal Consumption Expenditure measurement suggests that inflation has ticked down substantially, yet Chairman Powell went out of his way to point out various outliers in the data that do suggest the inflation environment is not as benign as some have said. There is no question the bond market is acting like a rate cut is happening, but I believe it would potentially be as risky of a policy move as their additional rate hikes in Q4 last year were. Do I think the Fed regrets its December hike? Yes, I do. Do I think they are preparing to undo it? No, I do not.
Politics & Money: Beltway Bulls and Bears
- The idea that the federal government may sell some of its $1.5 trillion student loan portfolio to fund part of its infrastructure aspirations is a legally and politically complicated idea that nevertheless does not appear to be totally unserious. I remain unconvinced that the political will is there to make this happen, but unexpected ideas like this turning into a surprising way to get an unlikely bill passed are the kinds of things we need to be keeping our eyes on. These talks on funding are all the more important because both Speaker Pelosi and President Trump claim they are in agreement about some form of a $2 trillion infrastructure bill. If there really is high-level bipartisan support for such, it would mean that the funding is the only thing standing in the way of it getting done. Senator Chuck Schumer has said much of the 2017 tax cut has to get repealed or the bill is dead, and that is not going to happen. But with things like this, who knows how creative both sides will get to try and force this spending bill through.
Chart of the Week
This chart may look a little "busy" to you, but it is really quite informative. I look at a couple of other charts similar to this, but what they are doing is tracking various categories of conditions that have previously preceded what became a bear market. In past market peaks, all of which were defined as market peaks after the peak was achieved, not beforehand (stop me if I am going too fast), there were various indicators that things were in troubled waters. The chart below monitors where things like valuation, sentiment, economic metrics, etc. all stand now compared to what we now know were past market peaks.
Quote of the Week
“In history a great volume is unrolled for our instruction, drawing the materials of future wisdom from past errors and infirmities of mankind.”
-- Edmund Burke
I hate to leave things there for the week because frankly, things are not being left there. As I type the market has been down 450 points this Thursday morning,and is only down 150 points now. President Trump has just said that he has “an excellent alternative to the China deal” (no idea at this time what that means). This happens sometimes in the reality of a weekly written commentary that markets in certain 24-hour periods (or 24-minute periods) can really render some commentary obsolete, quickly. We will be very communicative and informative throughout this period, and we will make prudent and effective decisions around our client capital. To that end, we work.