The 'yin and yang' on the slow, rocky boat to China
With investors now back from their August break, it’s a good time to evaluate where we are as we enter the sometimes dangerous waters of September and October. This note reviews the key market drivers we see at play—a theme I call the “yin and yang of markets.” While most commentaries do a pretty good job of outlining the facts as we know them—the “yin” if you will—fewer are focused on the “yang,’’ the reaction of various market and economic players to those broadly known facts. At Federated, where we humbly assume we know little more of the “yin” facts than anyone else, our market view tends to focus on the “yang.”
Here is my list of the principle market drivers for the fall voyage, yin and yang alike:
- Trade war impacts global economy; domestic pressures on Presidents Trump and Xi to do a deal increase. Sadly, the news here, the “yin,” is poor. Tariffs on both sides rose over the weekend, and additional scheduled increases seem likely to proceed. This morning’s recently announced policy shift in Hong Kong could be a sign that Beijing in general is getting modestly more nervous about its domestic political standing, which eventually could lead it to exhibit more flexibility on a trade deal. President Trump, similarly, is presumably getting daily briefings on the slowdown in the U.S. manufacturing sector. With the 2020 presidential race coming, more than ever it would help him to get a deal done with China. So, both sides have good reason to produce a “yang” reaction and ink a deal. If they did, confidence broadly and markets globally would soar. Our view: we are still on the slow boat here, but at a minimum, it seems unlikely the trade battle can get much worse beyond what already has been announced. Both sides are entering the “Did we push this too far?” stage, and while finding a way out may take more time, we have probably peaked in terms of the trade war. From here, maybe things at least don’t get worse. This probably removes a potential major downside catalyst for stocks.
- Global manufacturing soft patch deepens; global stimulus measures likely to accelerate. Based on PMIs globally, the manufacturing sector clearly has hit a soft patch. This actually is not news. German industrial production, as an example, has been experiencing negative year-over-year growth since last November. And the U.S. manufacturing ISM fell into contraction territory this week. A sign that this development is a “yin,” however, is that markets largely yawned at this week’s weak data. Perhaps markets already are focusing on the “yang”—the ongoing and probably accelerating level of monetary and fiscal stimulus in the weeks and months ahead. Absent a solution to the trade war, these stimuli may be close to a string-pushing exercise. On the other hand, it probably assures that things can’t get much worse for the industrial side. For example, shares in Caterpillar, a global industrial “canary in the coal mine,” have slid more than 30% since January 2018 and are now trading at key long-term technical and fundamental support levels.
- Dollar strengthening adds deflationary drag on U.S. price gauges; overall impact of tariffs on import prices largely offset by this dollar strength. Another worry of late of the “yin” camp has been the dollar’s remarkable strength, up 3% off its early summer lows. This represents another drag on an export sector already grappling with the China trade war. This in itself may further soften the growth outlook. On the other hand, there is a very important, though little highlighted, positive “yang” effect that should help the consumer and industrial sector offset the impact of rising import tariffs: dollar strength represents an across-the-board price cut on all U.S. imports, which totaled $3.1 trillion in 2018. Its 3% rise over summer is the equivalent of a $93 billion price cut. So even if we eventually get to a 25% tariff on all Chinese imports (we’re not there yet, by the way), that $93 billion would go a long way to offsetting the entire cumulative cost impact of $125 billion from the Chinese tariffs (especially since at least part of that $125 billion is being swallowed by Chinese exporters to try to protect their market share). In other words, the “yang” of the strong dollar is largely offsetting the “yin’’ price effect of the president’s tariff policies.
- Yield curve flat to inverting; Fed likely to cut 50 basis points at September meeting. Off and on over the last several weeks, markets have been in a hysterical panic that the “bond market is forecasting a recession because the yield curve is inverted.” Frankly, I’m not a buyer of the idea that the bond market somehow knows something the equity market doesn’t. After all, these are not separate investor groups operating independent of each other and reading different newspapers. And if the bond market is so sure of a recession, why is the corporate bond market so strong and apparently worry-free? Rather, what I think the bond market is telling us is simply that U.S. yields are way too high relative to the rest of the world. The “yang” here is that the Fed sees this, too, as well as the risks of recession and importantly worsening price deflation that could negatively impact both sides of its dual employment/inflation mandate. The obvious move would be to reverse course quickly and drop rates 50 basis points at this month’s meeting. That’s our base case. But even if policymakers decide to parse the cut across two meetings, we’re still surely heading for a federal funds target rate of 1.50% in the next few weeks, with another cut or two likely shortly thereafter. So much for the inverted yield curve.
- Since last November, 10-year Treasury yield plunges from 3.25% to below 1.5%; a major upward shift in equity valuations is coming. Related to “yin” No. 4, Treasury yields have been sliding all year. Most investors at this point are worried this is pointing to a recession, and with it, a decline in S&P 500 earnings. But what if the “yangs” above—global fiscal and monetary stimulus, the trade war stabilizing and cost decreases from the strong dollar—help the U.S. economy stabilize and eventually re-accelerate? In fact, what if earnings simply flatten out over the next six months, which based on our bottom-up work, appears likely? If so, investors will start to be more willing to raise their valuation target on stocks, given the significantly lower discount rate. This is, for us, the big “yang” that’s out there—a major revaluation of stocks, back to at least the valuation multiples we held in the 2017 period, which would be 2 to 3 P/E multiple points higher than the present level of 17.5 times forward earnings. This revaluation effect alone would be worth a 10-20% move higher in stocks even against flat earnings. Consistent, by the way, with our 3,500 year-end 2020 forecast on the S&P.
There currently are plenty of worries for markets to deal with. The China trade war. Brexit. Hong Kong. The flat yield curve. The global industrial soft patch beginning to leak into the U.S. economy. These are “yins” of which everyone is aware, perhaps to a minute degree. Our focus is on the “yangs:” accelerating global monetary and fiscal stimulus, likely Fed rate cuts of at least 50 basis points over the next two to six weeks, a high probability that the trade war gets no worse and potentially produces a positive surprise, declining import costs due to the strong dollar, and most importantly, a significantly lower discount rate on equities that, sooner or later, should translate into the next broad advance of the averages. Although we think it is a bit too early to get very aggressive again on stocks, we continue to advise clients to maintain modest equity overweights in the event the market starts sniffing out these positive “yangs” earlier than planned. Call us cautious bulls, focusing on the reality that for every yin in life, there’s a yang as well.