Weekly Update: It's on

07-06-2018

With the U.S. and China trade war officially on, what can investors expect? No one really knows. Applied Global Macro Research seems to think that because the U.S. imports a lot more than it exports, it stands to lose more than other countries in a tit-for-tat tariff war, particularly given this comes at a time when there is limited excess capacity in U.S. labor markets and manufacturing. However, based on their performance over the past three weeks, global markets don’t seem to share this view. Since June 14, U.S. equities are down 2.5% while Germany is down 6.1% and China is down 10.5%. If the likely scenario from a trade war were a zero-sum game in which all suffer and “nobody wins,” one would have expected U.S. and global stocks to post similar performances. More interestingly, Canada’s equities are only down 0.3% and Mexico’s are up 6.7% (although recent elections are helping there) this same period. At a minimum, this is suggesting the risk/reward is more attractive for U.S/North American stocks if the trade spat continues to escalate. It also may suggest that, relative to the rest of the world, the U.S. economy is much stronger. While the latest global PMI gauge slipped for the fifth time in six months (though it did remain comfortably above its long-term average of 51.5), the companion U.S. gauge (more below) jumped above 60, a rare reading. The services PMI was similarly robust, June car sales were strong and this morning’s jobs report for June (more below) was Goldilocks—better-than-expected, muted wage pressure and increased labor force participation.

Still, the risk of a global trade war—along with maturing economic cycles and the stronger dollar—are straining the global picture. An Empirical Research analysis of nations beyond China that could supply U.S. companies with the tech and capital goods products and components subject to the new 25% tariffs found the bulk of non-Chinese suppliers are in the developed world, with Japan, Germany and Canada topping the list. Of the emerging economies, only Mexico is prominent. China has maintained its share of the global export market despite the past decade’s fivefold increase in its manufacturing labor costs by repositioning itself as an alternative to developed-world suppliers. Even now its wages are only a fifth those of that competition. It would be costly for multinationals that have sourced tech and capital goods production in China for good reasons, wage costs being most paramount, to relocate supply chains elsewhere. Tech and capital goods, in particular, have been longstanding beneficiaries of globalization. Indeed, the FAANGs (Facebook, Amazon, Apple, Netflix and Google) have significantly outperformed the broader market this year, making it appear as if investors aren’t taking the prospect of a trade war seriously. What if they are wrong? This could set the market up for a nasty surprise. Pullback fears this week prompted Ned Davis Research to lower equities to market weight for the first time since August of 2015.

With the second-quarter earnings season upon us, the U.S. is the only region seeing more upward than downward revisions to estimates, led by domestically oriented S&P 500 companies relative to multinationals. The earnings tailwinds are many: dollar strengthening (historically positively correlated with earnings momentum); buybacks (Q1 set a record and repurchases remain robust); mergers & acquisitions (global M&A deals are at an historic high); and ample funds for dealmaking (despite the Fed’s continued march toward normalization, the combined balance sheets of it and other major developed country central banks sits at $16 trillion, up $10 trillion since 2011). So while corporate executives may squawk about protectionism’s negative impacts, they’re likely to keep churning out profits at a healthy clip. With forward multiples closer to the bottom of their prevailing range than the top, this could encourage investors to eventually plow excess cash into stocks, helping the rally regain its footing. To be sure, the summer months could be messy—the calendar really doesn’t begin to become equity supportive until October, particularly in midterm election years. And the trade back-and-forth is almost certain to create hiccups. But longer term, fundamentals and valuations remain bullish.

Positives

Jobs, factories humming June job growth surprised to the upside on broad-based increases, and gains in the prior two months were revised up as well. Notably, the unemployment rate rose two ticks to 4% for positive reasons—an expanding labor force as new entrants began seeking work. Among the big increases, manufacturing. It added 36,000 workers on increasing activity. Along with the strong ISM readings (more below), May factory orders rebounded, led by the biggest increase in nondurable goods in six months. On a year-over-year (y/y) trend basis, factory orders were up nearly 9%, their fastest pace in more than six years.

The consumer is all right June vehicle sales surprised, jumping to a well-above consensus 17.4 million annualized rate. Buyers went heavily for trucks and SUVs, eschewing worries about higher gas prices, financing rates and—for now—potential tariffs that automakers fear could derail the momentum. Also this week, the ICSC’s weekly retail chain store sales rose again and, on a smoothed basis, is at its highest level since August 2015. And Bloomberg’s measure of consumer comfort rose a third straight week to levels just short of April’s peak.

Setting up for a solid second half The Philly Fed state leading indexes suggested activity will increase in 48 states in this year’s second half and remain steady, with the majority of state economies to grow 1.5% to 4.5%. Both the monthly and y/y breadth measures picked up to 62%, the latter the highest reading since April 2017 and a sign of likely acceleration across most of the country. The U.S. index was steady and corresponded with 3.2% real growth.

Negatives

A downside to June’s strong ISM prints Driving the ISM manufacturing’s better-than-expected increase to 60.2 was the highest reading in nearly 40 years for supplier deliveries. This came not because demand is so strong that suppliers are struggling to keep up with orders, but because delivery times are being extended on worries supply chains may be vulnerable to negative shocks arising from trade tensions. This was a constant worry in respondents’ comments and was heavily repeated in the ISM services survey, which also rose to near a 13-year high.

Capex cooling? Accelerating capital expenditures (capex) have been a plus for the economy this year and need for improved future productivity, but the momentum may be easing. Following April’s surge, the growth in core factory orders slowed in May to 6.3% y/y. And after a strong start earlier this year, nonresidential investment slipped in May for the second time in three months.

Fed likely to stay on course While concerns about trade spats undermining business confidence was mentioned, policymakers at June’s meeting seemed intent on staying on their rate-hike path, according to this week’s minutes. It would take a material and unanticipated drop in inflation or a significant increase in the amount of imported goods subject to tariffs to force the central bank to turn dovish, an outcome data to date suggest isn’t in the cards.

What else

Illegal immigration’s upside By using fake IDs and Social Security numbers, unauthorized workers pay an estimated $13 billion into Social Security each year while taking out almost nothing. Over the past 10 years, they’ve added some $100 billion to the fund. This makes the current immigration crackdown an issue because, for the first time since 1982, Social Security is paying out more than it is taking in. This gap is likely to grow as it represents half the total income of 52% of Americans; 25% count it as 90% of their income.

Pay for performance? Cornerstone Macro evaluated the 5-year compound annual growth rate (CAGR) for S&P companies from a variety of perspectives: when the chairman was also the CEO, when the CEO’s last name was longer than seven letters, when the CEO spent 20+ years with the company, and the level of CEO pay. Interestingly, highly compensated CEOs was the only one of the criteria whose CAGR did not beat the overall market. Hmm.

I guess there’s a market for this German engineer student Philip Frenzel has designed an airbag for phones, a specialized case that deploys springy, spider-like legs if the phone starts to fall. The legs appear to soften the impact more than an average case, the website Mashable says, making it less likely your smartphone's more fragile bits contact a hard surface. The patented invention is in the process of raising funds to go mass market.

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