This week in the market
We were closed on Monday for the Labor Day holiday, but the market dropped 285 points on Tuesday as the market (a) Digested greater Brexit uncertainty and (b) The onset of new tariffs that became effective over the weekend. On Wednesday the market went up 235 points as Hong Kong finally abandoned its awful extradition provision that has been the cause of so much angst. As of press time Thursday the market is up 400 points as the U.S. and China announced last evening that a trade meeting will, in fact, take place in October. So without knowledge of Friday's action, we look like the shortened week gave us two big up days and one big down day. Volatility continues ...
This week in the trade war
So September 1 came and went and a good portion of "phase 4 tariffs" became effective. The communication matters now - it will likely make the difference as to whether or not each sides detects a "good faith off-ramp" to make it worthwhile to continue negotiations. The absolute level of tariffs expected to be paid by U.S. businesses in full year 2020 (assuming no changes from present levels and present threats) is a stunning $115 billion (higher than the annual benefit of 2017’s corporate tax reform). The Chinese Commerce Ministry announcement last night that an early October meeting has been scheduled with the U.S. (in Washington DC, no less) breathed a fresh round of hope into things.
This week in the rate war
The 95% chance of one rate cut (5% of two rate cuts, so 0% of none) this month has not changed ... The odds remain evenly split between one additional rate cut in December vs. two additional rate cuts. Either way the futures market is debating as to whether or not we will be 50 basis points or 75 basis points lower by the end of the year.
This week in the yield curve
At press time the 2-year was at 1.47% and the 10-year at 1.51%, which as bizarre as it may seem may be the widest we have been in a few weeks ("wide" meaning "UN-inverted"). Yields may be sitting between 1.4% and 1.55% on the ten-year Treasury, but demand is not running low and it would not take much to see this number go lower.
Our belief as to what the most likely message from the yield curve is at this time is the "false positive" belief - that its on-again, off-again mild inversion is distorted by the negative global yield environment pushing inordinate flows into U.S. bonds - and that the Fed will have to rectify the short end in its next couple of Fed meetings. This is not because we do not believe in the impeded growth story - we do. From the trade war to the Eurozone to the never-ending issue of excessive debt, there are drags on growth that are real and disastrous. But that is different than seeing an imminent recession in the yield curve, and at this time, we don't.
So what is this Brexit fuss all about?
On Tuesday the UK Parliament voted to delay Brexit for yet another three months (as opposed to enduring the hard Brexit that Prime Minister Johnson was preparing them for). He then called for a special election in mid-October to re-assert his control and authority in the country, and the effort to secure that election failed. He remains short of a working majority, and the entire future, not just of Brexit, but of UK governance, is up in the air.
That said, it is still entirely possible that they will end up getting the votes to call for a special election, and that Jeremy Corbyn's deserved unpopularity will put some control back with Boris Johnson. No one can say that the EU will let a hard Brexit take place because the UK parliament keeps signaling to the EU that they won't have to. Just know this - the saga will continue, and if I made any investment bet on how this will play out, it would be to go long popcorn, because this movie is one action-packed suspense thriller.
Finally - betting markets now have a Brexit by the October 31 deadline at just 21% (it had been nearly 60%).
ISM not just more alphabet soup
The ISM Manufacturing Survey this week showing that manufacturing in the U.S. is contracting (previously, the positive growth was simply slowing; now, manufacturing levels are going negative) is a big deal. It not only reflects the risk and outcome of the trade war, but it will have a profound political implications for a President who ran on a platform of economic nationalism. New Orders have plunged. Manufacturers cite a total disinterest in new hires.
Some clarity on earnings season
The Q2 earnings season really never got fully summarized or downloaded, because in the midst of the final couple weeks of it all the trade/tariff tumult took off starting August 1 ... But the fact of the matter is that it would have been a big story if the "bigger" story of the escalating trade war had not taken all the oxygen out of the room. 75% of companies reported better than expected earnings (more than a normal average of companies who outperform expectations), and 56% reported a top-line revenue out-performance (though lately that number has been higher).
And it should be pointed out, companies with the least exposure to the elevated U.S. dollar are performing best; companies with the most impact from the rising dollar are experiencing negative earnings growth.
Some clarity on valuation
But here is the thing about S&P earnings guidance for the next year: Based on forward projections, the S&P is trading 16.6x earnings, basically in line with average P/E ratio of the last five years. But of course, the ten-year treasury has been about 2.5% the last five years, not 1.5% ... So the valuation story has changed either from "high" to "normal," or from "normal" to "maybe a little cheap on relative/adjusted basis ...".
Some clarity on August
We know equities declined in August, even though they cut that decline by more than half in the last week of the month. But even with modest 2-3% declines in stock averages, bonds advanced a stunning 1-2% on the month (and municipals even outperformed taxable bonds). The diversification benefit of Alternatives and Bonds were on full display in August for those looking for some neutering of that equity market volatility.
In the sector weeds ...
Best performing sectors in the S&P 500 as the August trade war tumult has advanced ? Utilities, REIT's, Health Care, and Consumer Staples. What do these sectors generally have in common?
Low (and in some cases, no) exposure to China.
Less volatility and beta than other market sectors.
And ... wait for it ...
Dividend yields to sustain performance during periods of market fluctuation.
Where do markets go from here?
It's a trick headline (though hardly "click bait," since you're already in the Dividend Cafe), because we, and 100% of others you may read, do not know. But this chart got my attention this week, not so much for what it says about current economic uncertainty, but for where markets went in the months and year that followed each of these spikes in economic uncertainty .... That is, up, a lot. Not one of these policy events that spiked the economic uncertainty index saw anything less than a +15% move in equities a year later, sometimes more.
A little negative ...
The belief that sustained economic expansion would require a capex boom has faced the reality of declining business investment around declining business confidence (growing uncertainty) since the advent of the trade war. Capex plans are measured a lot of ways, and the combination of those methods has led to an index, which declined substantially last month.
A little positive ...
Just have to reiterate again - the High Yield bond market is reflecting spreads of 410 basis points right now over comparable Treasuries, a textbook "middle of the road" spread level. 410 is nowhere near the 500+ it reached last December, and not as low as the ~300bp spread we saw in the tightest level of 2019. And of course, it is no where near the "blowout" levels we saw in early 2016 (mostly driven by panic in the energy sector).
What does a 4% spread in the High Yield credit market (not to mention just 137 basis points for Investment Grade bonds) indicate?
Well, what it does not indicate, is recession. It indicates calm credit markets, and a strong willingness of investors to boost up credit risk to find higher yield relative to Treasuries. It is not a flight to safety; it is a calm, measured state of affairs in credit. Now, it could be all wrong. It could be calm before a storm. But I have watched credit markets religiously in each significant market disruption of my lifetime, and never have credit spreads stayed calm while other indicators acted huffy if indeed things were imminently turning to the dark side. This warrants continued observation, as it really is a contrary indicator to what many others are focused on.
Politics & Money: Beltway Bulls and Bears
- Is Joe Biden the favorite to win the nomination? The polls have consistently said yes, but the betting markets continue to say Elizabeth Warren will win the nomination (as she is ahead in Iowa and New Hampshire). This looks like a situation where the early states are going to matter, a lot. I think Biden's path right now really requires Bernie Sanders and Elizabeth Warren to substantially split each other up, and allow Biden to sneak through that lane.
- The Quinnipiac poll last week showing, for the first time since President Trump was elected, that more voters say the economy is weakening than strengthening, is a big deal for the 2020 election. Voters do not think about a specific data point or metric when they assess the economy; they work off of narratives. The broad narrative since Trump was elected has been, accurately, that the economy was strong. If more people feel that it is weakening, that is essentially all that matters politically. Much has been written in these very pages on the risk the trade war represented to economic strength, real, and perceived. In politics, those two things are the same.
Chart of the Week
This week's Chart of the Week captures the stunning improvement in the economy that came about when President Trump was first elected, and the stunning reversal of that since the trade war began, as manifested in the industrial economy. The consumer has remained prone to spend (shocking!), and employment and wage conditions remain strong. But the measurement for output in manufacturing, mining, and utilities skyrocketed higher from late 2016 through early 2018, and now has suffered its three straight quarterly decline. 76% of survey respondents point to tariffs as the primary reason.
I would not throw in the towel yet. Capital Goods orders have stayed strong enough that business investment has a chance of recovering if resolution to the trade war is found. But the data has enough signs for concern too few signs of promise to not believe that the business/industrial side of the economy is vulnerable.
Quote of the Week
“We live forward, but understand backward.”
-- William James