Don't go away MAD
Here’s what President Trump has said about trade wars: “They’re easy to win.’’ Empirical Research Partners posits the concept of MAD (mutually assured destruction) is in play again. With the market viewing the administration’s proposal to levy tariffs on a long list of Chinese imports as simply a negotiating ploy, what if it isn’t? Absent market discipline, which has not yet been forthcoming, the U.S. is unlikely to back down. And a trade war is most likely when both sides feel they are in a position of strength, as is the case with the U.S. and China. A trade war could result in higher inflation—and a higher risk premium—for bonds at a time they already are under pressure from rising market rates. It could add to seasonal weakness that tends to be at its worst in August and September, and to market volatility that tends to occur every midterm election year. Historically the midterm year of the 4-year presidential cycle is the weakest of the four, with the worst of it coming in the summer months. One counterpunch may be all the stimulus from this year’s tax cuts and increased federal spending—typically, fiscal policy contracts during midterm years. But higher costs emanating from an escalating trade war could block much of those benefits.
Over the past several decades, globalization has benefited consumers, generated record profits and made the U.S. very rich, especially in the technology, industrial and capital goods sectors. While these industries have been the main source of the market’s operating leverage over the last few years, margin expansion really has been occurring since way back in the early 1990s. This is largely a consequence of wage savings as manufacturers moved production to lower-cost locales with the emergence of China and other Asian countries in the global marketplace, causing global trade to soar and creating a complex, interlocking global supply chain. (To be sure, automation and lower interest and tax rates also played a role in the growth of margins and profitability in these industries.) Roughly a third of China’s exports to the U.S. represent value created outside of China (i.e., imported from elsewhere into China and re-exported to the U.S.). Unfortunately, Empirical thinks these high-margin sectors, with supply chains embedded throughout the Pacific Rim, will be hit the hardest by the proposed tariffs. Indeed, a significant amount of U.S. exports consists of imports from other countries, in particular the auto industry. Trade, in other words, is all about the supply chain, and U.S. trade is basically all about cars. So raising tariffs not only hurts China and its Asian suppliers (primarily Taiwan, Malaysia, Singapore, Korea and Hong Kong), it also disrupts the global supply chain and hurts U.S. companies and, consequently, the U.S. economy.
President Trump clearly is playing to his base. His approval rating on handling the trade issue is much higher than his overall approval rating, and his charges that the U.S. is getting ripped off by China and demands for reciprocity are popular. Almost no one in Congress is challenging his approach to China. I always assume that if I know something, the Trump administration (plus many, many others, OBV) must know too. The market consensus is that Trump’s trade threats are all bluster and political symbolism—and that ultimately he is going to compromise, get something and declare victory. Otherwise, the globalization that has benefitted the world’s economy and the U.S. for decades is at risk of falling apart—which would be BAD! Like the nuclear standoff, what prevents that is mutually assured destruction. That’s what we’re relying upon.
Housing construction robust May starts rebounded 5% to their highest annual rate in nearly 11 years. While permits fell, the two volatile series continue to trend higher, with their 12-month averages at 2008 levels. Year-over-year (y/y), starts have surged 20.3%, the most since October 2016, permits are up 8% and the backlog remains near a decade high. It look as if housing will be additive to Q2 GDP despite disappointing sales (below).
Where are we in the economic cycle? Conference Board leading indicators rose again in May on contributions from seven of 10 components. The y/y increase continued to hover in the 6% range, a sign activity should remain robust. Elsewhere, the Philly Fed capital expenditures outlook rebounded strongly in June, more than reversing declines the prior two months, even as the overall PMI fell to its lowest level since November 2016. Markit’s flash composite PMI rose, led by services as manufacturing moderated. And overseas, the flash eurozone composite PMI increased well above expectations, providing some relief amid concerns about weakening European growth.
No recession in sight, that’s for sure The American Trucking Associations trucking tonnage index rose again in May, up nearly 8% y/y, indicating a robust pace of growth in freight volume. A separate gauge of activity, the Cass Freight Shipments Index, jumped last month to an 11-year high, indicating the U.S. economy is on a strong path. The expenditures component is up more than 17% y/y, the most since January 2012, as demand is exceeding capacity among most modes of transportation. There’s always a downside: this could lead to greater pricing power, adding to inflation concerns.
Builder sentiment slipping Although it remains relatively elevated, the NAHB gauge fell again this month. Among the reasons: record high lumber prices partly due to tariffs—the NAHB says lumber prices alone have added $9,000 to the price of a new single-family home since January 2017—as well as mounting worker and equipment shortages. This indicates it may be difficult for activity to move much higher.
Existing home sales slipping Down a second straight month in May and 3% y/y as the combination of low inventory, rising prices and higher mortgage rates kept prospective buyers off the market. The report adds to the importance of Monday’s report on new home sales, which have been trending higher. While mortgage purchase applications jumped 4% for the second time in three weeks, the underlying y/y trend was negative for a second straight week.
Buybacks’ cautionary signal Total S&P spending on buybacks reached $192 billion in Q1, up 35% vs. Q4, leading to questions about its influence on equity performance (including a conference call with advisors I had this week). Interestingly, over the past 20 years, buyback surges have usually preceded market crises. Gulp. Buybacks are expected to exceed $800 billion this year.
Goldilocks! If real GDP is 3.5% as Evercore ISI surveys suggest, then real output is likely to be 4%. This means if hours worked are up 2%, then productivity would have to be up 2%—its fastest pace since 2004. Finally, if productivity growth hits 2% and compensation rises 3%, then unit labor costs would increase just 1%, arguing for continued restrained inflation and continued elevated profit margins even as pay moves up.
Is 2019 the year we should start worrying about the end of the cycle? The OECD says the share of countries growing above their long-term potential is close to the 71% peak seen before major global recessions, with the output gap in the developed world projected to close this year. A closed output gap typically has preceded global recession by about a year. Why? Because once an economy operates above its potential, resources such as labor have to be lured/secured from someplace else where they are in use. This leads to higher inflation and rates (unless AI and a global workforce makes this time different).
Animal spirits 2-year Treasury yields have done nothing but confirm the ability of the economy to withstand rising rates, while the gap between yields on BB and BBB-rated bonds has remained well contained in its trading range over the last 18-months. (And while many are anxious to call the secular bear in bonds, Ned Davis reminds us that they don’t tend to happen unless the entire yield curve agrees, which it currently does not.) Meanwhile, a gauge of initial public offerings (IPOs) has been making new highs relative to the S&P. All of this is bullish.