Weekly Update: 'This is the first of many'

03-23-2018

One of the key market worries all along has been the potential risk of a trade war. We aren’t there yet, but this week certainly escalated the conversation, sparking a spike in volatility and a significant sell-off. In defending what the Trump administration is doing, U.S. Trade Representative Robert Lighthizer got animated during his Senate committee testimony, highlighting a litany of strategic dialogues with China over many years that he said produced no results. He and President Trump truly believe U.S trade policy has been an utter failure and has led to the hollowing out of the American economy. They think China intends that its companies will become dominant global players in the leading industries of the future by stealing U.S. technology, subsidizing their industries and engaging in a raft of unfair trade practices. When signing yesterday the 301 findings of the Trade Act imposing 25% tariffs on selected Chinese products, President Trump said “this is the first of many.” The Treasury has been instructed to spearhead proposals to block Chinese investment aimed at obtaining key U.S. technologies and the administration plans to challenge unfair Chinese trade practices before the World Trade Organization. Even as the White House further eased off on steel and aluminum tariffs, adding the European Union, Brazil, South Korea and others to a growing list of carve-outs, the actions against China overshadowed what was a relatively dovish Fed meeting (more below). The U.S. has not engaged in large-scale trade wars since the 1930s, a tack many economists believe worsened the Great Depression.

At this week’s meeting, the Fed raised rates and signaled two more hikes this year and three in 2019. No great surprise there. Notable were its projections of almost no inflation going forward, despite the tax cuts and a very tight labor market. The fact that growth in M2—a broad gauge of the money supply—remains very sluggish gives credibility to these forecasts. According to theory, inflation cannot occur without much faster growth in M2, which would free a strong economy to reallocate money to strong areas where prices could rise, causing weak sectors to fail if they were not willing or able to lower prices. This is how the reallocation of wealth occurs between sectors, since prices are often sticky. With much higher government borrowing on the near-term horizon, the Treasury likely will need to borrow more, which in turn should cause money growth to accelerate. But this is unlikely to show up in inflation until mid-2019 at the earliest. The Fed did project a PCE rate above its target in the outer years of its forecast. Not much, only 2.1%. Rhino Trading Partners views that forecast almost as a joke, a cover for the hawkish bond bear narrative. “Everyone wants to call the bond market crash and then have Michael Lewis write a book about him/her and have Ryan Gosling play them in the movie.” Ha! The broader story is that neither the Fed nor central bankers elsewhere appear in any rush to ramp up tightening and quantitative tapering, not with inflation showing signs of rolling over overseas and data in the U.S. remaining below 2%. If anything, the lack of enthusiasm among Fed policymakers for squishing inflation down as soon as it hits 2% is a recognition that many think some allowance should be made for the fact that inflation has been below 2% for many years. This is bullish.

As Q1 draws to a close, about half of S&P 500 stocks are positive and half are negative year-to-date. A trading range in the year’s first half, with the 200-day moving average functioning as support and the early-year highs as resistance, would be a healthy follow-up after 2017’s gains. While the technical underpinnings remain strong, there could be some base building in the weeks ahead, with Leuthold Group’s proprietary trend gauge implying a potential breakout up or down soon after being stuck in neutral for nearly two months. Its momentum component remains moderately bullish but near Brexit lows, while its economic component is among the lowest weekly tallies in the last 4½ years. Since the late 1980s, the forward S&P P/E usually has contracted or compressed during Fed tightening, making the 2017’s multiple expansion somewhat unusual. That said, the real fed funds target rate after this week’s hike is still negative 60 basis points, i.e., the cost of money remains “easy.” This implies higher rates should not be a significant near-term deterrent for equities. Multiple factors have weakened investor confidence—trade war fears, potential government funding stresses, general political uncertainty, etc. This, in turn, is reducing market liquidity in the face of choppy markets, making for challenges. But the recent market drawdown, combined with improving growth and earnings forecasts, have dropped valuations to relatively attractive levels. Ned Davis Research says it wouldn’t be surprised to see an upside breakout soon, perhaps as Q1 results and guidance start pouring in. We’ve had a great run here, with global growth along with easy money and low inflation. At this moment, protectionism is a wild card. Our president has argued for decades that the U.S. is in a trade war and losing. The debate is will the two largest economies in the world escalate into an actual trade war, threatening the beautiful environment we’ve been in. Will Trump “behave himself?” That is the question of the day.

Positives

More signs of more capex U.S. manufacturing activity is robust and may be accelerating, according to the past week’s Empire, Kansas City, Philly Fed and manufacturing production reports. Yesterday’s manufacturing PMI came in at a 3-year high, while a broad-based 3.1% increase in durable goods orders—nearly double consensus—reflected a jump in core capital goods orders (excludes non-defense aircrafts). This suggests real capex rose nearly 5% in Q1.

Has housing’s slowdown bottomed? Existing home sales bounced back a well-above consensus 3% in February, its first increase in three months, while new home sales rose at a 618K annualized rate, well above the preliminary January number. A lack of homes for sale remains a constraint, holding near a record low and, relative to the population, at a record low. Despite rising prices on tight inventories and higher mortgage rates, the Mortgage Bankers Association’s weekly purchase index rose for the third time in four weeks and was up 6.2% year-over-year.

Where are we in the economic cycle? Conference Board leading indicators rose a fifth straight month, led by manufacturing average hours worked and ISM new orders. The 6-month rate of change in the index climbed to 4%, its fastest pace since March 2011. These indicators are consistent with above-trend economic expansion, and signal a strong upside momentum for the economy.

Negatives

Why tightening talk is overdone The Institutional Strategist wonders if a world swimming in debt—the largest 50 countries in the world owe $65 trillion, roughly 90% of their combined GDP—can handle a simultaneous reversal of quantitative easing. It thinks not. Politically, what could politicians possibly cut from government budgets as interest expense crowds out spending on infrastructure, health care, entitlement programs and defense? Not much. This is precisely why the markets don’t believe that the Fed (and other central banks) have the guts to follow through on significant rate increases.

How does this translate into wage inflation? Every day, there’s more anecdotal evidence of tech taking over commonplace tasks, putting further downward pressure on wages. The Navy has replaced $38,000 submarine controllers with $40 Xbox controllers. Agricultural robotics are harvesting everything from strawberries to apples, easing a farm-labor crunch. Robots are taking over brick-laying and hamburger-flipping jobs. Self-driving trucks already have hit the roads in Arizona. And Macy’s plans to add mobile app checkouts to all stores.

This fits with Trump’s trade narrative The current account deficit surged in Q4 to $128.2 billion, its highest level in nine years. As a share of GDP, it represents the biggest gap since Q2 2012.

What else

The internet is everywhere New data from Pew Research Center found that 26 percent of American adults admit to being online “almost constantly,” and 43 percent go online “several times a day.” And it’s not just people who are online. There are now an estimated 8.4 billion connected sensors in the so-called internet of things (IoT), allowing everything from internet-enabled thermostats and cameras to streetlights and measuring systems to “talk” to each other. By 2020, IoT sensor networks could exceed 20 billion, and by 2030, over 500 billion.

Have you been watching bond yields and ‘defensive stocks’ in this latest correction? Fund managers have been reducing equity beta compared to the start of the year. This is not surprising but nevertheless is reducing market liquidity. The volume of the sell-off in the last eight days is lower than that seen during the prior two corrections this year. Moreover, the VIX has not jumped as much as seen earlier this year.

How does this translate to wage inflation? Workers increasingly are demanding "lifestyle" benefits and employers are cooperating as this approach provides greater flexibility with labor costs. As a result, wages have become a shrinking share of total compensation. The shift toward benefits and non-monetary compensation and away from wages in compensation packages is one more factor supporting the slow pace of wage growth in this cycle. It doesn't prevent wages from heading higher but does mean we may have a lower peak for wage growth in this cycle relative to past recoveries.

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