Weekly Update: 'War, what is it good for?'

06-08-2018

There was much huffing and puffing about U.S. trade tariffs at last weekend’s meeting of G7 finance ministers and industry leaders in Canada. Said the CEO of steel fabricator Canam Group: “I just want to scream.’’ Quebec Deputy Premier Dominique Anglade called the export tariffs a “direct attack on our economy.” Over the same weekend, key German media firms such as Der Spiegel were contemptuous of Italy, showing a picture of spaghetti being hung off a fork. The article attached to the picture was worse. Germany, with an 8% trade surplus, was cleverer than other European nations about its economic development/trade plans over the past 20 years or so, utilizing policies best described as “Make Germany Great Again.” With its tariff overtures, the U.S. is just getting started. So how did the markets open the week? They rallied. Apparently investors have read “The Art of the Deal’’ and have come to view the president’s actions simply as hardline negotiating tactics. Indeed, the dispersion among the returns of developed equity markets has narrowed to one of the lowest levels of the last 30 years, with globalization contributing mightily to that outcome. Unlike what happened in the European debt crisis and in the China meltdown-fear period of mid-2015/early-2016, a composite of developed world cyclical manufacturers (i.e., auto, auto parts, tech hardware, semiconductors, machinery, electrical equipment and chemicals) hasn’t been under pressure, indicating the market is not pricing in a real trade war

At an advisor meeting in Pittsburgh this week, we debated whether rising earnings-per-share forecasts are still too shy and the market’s P/E multiple will fall further still. Reported earnings hit record highs in Q1 and this is before the return of some $1.5 trillion of foreign earnings that Yardeni Research estimates U.S. companies will repatriate from overseas. Record earnings and falling multiples—surely something must be wrong! The wall of worry dragging down valuations is led by “this is as good as it gets” (low unemployment, peak earnings growth, slowing global growth, etc.) We are now several months past the peak in global PMIs (more below), putting the markets in the earliest of the risk-off phases. Cornerstone Macro says the weakest links tend to be the first to crack when global growth prospects slow, typically led by the most vulnerable economies abroad. Parts of Europe and the emerging markets have been showing some cracks of late. Then there’s the Fed (it’s expected to raise rates again next week but when will it stop?), inflation (after January’s scare, it’s moderated but how long will that last?) and bond yields (the 10-year has fallen back below 3% but the uptrend appears in place, suggesting the bond bear is here). There’s a lot of what-ifs in that wall and a few more that could arise next week with Fed, European Central Bank (ECB) and Bank of Japan meetings on the docket, the Trump-Kim summit on tap and China imports subject to a tariff due to be published.

The intermediate-term backdrop keeps improving, with a progression of multi-month recoveries across most sectors and sentiment (AAII bulls-bears, Citigroup economic surprise index) low to oversold. Both the Nasdaq and Russell 2000 are trading at new highs, suggesting small caps may be the new leadership, benefiting from White House moves to protect U.S. industry, lower taxes and deregulate. But lack of broader breadth indicates the cyclical bull’s days could be numbered, particularly since it’s been four months since February’s low. Ned Davis believes the market remains vulnerable to additional retests if not a breach of that low, which was spawned by bond-bear worries. What might be the new downdraft catalyst? A trade war that has yet to be priced in? Midterm elections? Suppose we get a summertime correction associated with political uncertainty—wouldn’t be unusual, as an average midterm election year since 1962 saw at least one approximately 18% correction. If at that time we see neither an inflation problem, which would accelerate Fed tightening, nor a recession, than any significant sell-off should be viewed as an opportunity. Historically, the post-midterm period is strong and there’s no reason to think this year will be different … unless there’s a trade war that threatens a recession. FBN Securities posits that while the rhetoric may impede the market’s ascent, simple game theory predicts that after all the back and forth with our major trading partners, it’s going to be all right…. From FBN’s lips to the market gods.

Positives

Accelerating USA The ISM nonmanufacturing index rose in May for the first time in four months to a few points shy of its cycle high, and the separate Markit services PMI hit a 3-year high. Growing backlogs drove the improvement. Elsewhere, the Philly Fed state leading indexes projected economic activity to increase in all 50 states over the next six months, with the consolidated U.S. component reaching a 15-month high. Accelerating activity across a range of industries spurred the Atlanta Fed to raise its GDPNow forecast for real Q2 annualized growth to 4.8%.

Capex may just be getting started Nondefense capital goods orders ex-aircraft, aka core business orders, rebounded, a sign of strength in capital expenditures (capex). And this is before the expected tax-cut boost—a Cornerstone Macro analysis found while 70% of S&P 1500 companies are enjoying lower tax rates, many have yet to spend their tax savings. Based on Q1 earnings calls and a new Evercore ISI survey, a lot of companies expect those savings will end up going to capex once they finish analyzing the tax law’s complex changes.

Trade gap narrows The trade deficit shrank a second straight month in April to its lowest level since last September, and March’s deficit also was revised lower. Still, on a 12-month basis, the trade gap was its widest in nine years and at a record high with China and the European Union. And trade worries are weighing on CEOs—the Business Roundtable’s outlook index fell in Q2 for the first time in seven quarters, though it remained elevated.

Negatives

If we’re ever going to get inflation, this would be the year The JOLTS report suggested further tightening in the labor market, with job openings exceeding the number of unemployed job-seekers for the first time in the survey’s 17-year history. An Empirical Research analysis finds two key industries, transportation and construction, are having a hard time finding qualified workers for openings. Elsewhere, input price inflation in the Markit services survey was its highest in 4½ years, the 12-month average prices-paid ISM component hit a 6-year high and a downward revision to productivity (more below) raised Q1 unit labor costs to a 2.9% annual rate.

The globally synchronized recovery isn’t as synchronized as it was a few months ago The global manufacturing PMI edged down in May to a 9-month low and, after peaking in December 2017, has fallen in four of the past five months. Output matched March’s 8-month low while new orders grew at their slowest pace in nearly a year. While signaling a softening in economic momentum, at 53.1, the index remains well above its long-term 51.5 average and the 50.0 threshold historically associated with global recession.

This is why we need more capex Already anemic Q1 nonfarm productivity was revised further down to a 0.4% annual rate as output was trimmed a notch and hours worked were revised up from the initial estimates. On a trend basis, nonfarm productivity is close to its slowest pace since 1983 and less than half its historical 2% average.

What else

Where are bond yields headed? The outlook in the U.S. and Europe comes down to two questions: Will a rising dollar stop the Fed rate-hike cycle? And will Italian turmoil derail ECB tightening plans? BCA Research argues the answer to both questions is "no." The Fed will continue to lift rates "gradually" toward a neutral level near 3%, and eventually into restrictive territory—a rate path consistent with a cyclical peak in the 10-year Treasury between 3.30% and 3.80%. And it's too early to worry about Italy.

More like a whimper than a wave The generic ballot, which asks voters which political party they wish would run Congress, has a great track record of predicting the number of lost House seats in midterm elections. Pre-tax cut, the generic ballot was suggesting a Democratic wave, with Republicans losing 46 House seats. But the generic ballot lead for Democrats has collapsed, particularly in the month of May, and now suggests the GOP will lose just 7 seats and keep the House. Trump has recently consolidated the GOP with 87% of the party’s support.

There’s a new moon next week Fishermen believe a full moon triggers the activity of fish, making it a great time to go fishing. Interestingly, since its 1957 inception, the S&P 500 has generated annualized total returns of almost 19% when either a full or new moon is close at hand—far above the 10.3% return for the full 61-year period, according to Leuthold Group. What’s more, returns have been the weakest when the solunar calendar predicts fishing to be the poorest, near the moon’s near first or last quarter. With analysis encompassing almost 800 lunar cycles (and more than 15,000 market days), it’s hard to believe these results are pure coincidence.

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