Floatation Device

From the HRA Journal: Issue 304

What, me worry? Wall St continues to be remarkably calm in the face of a blow up of China-US trade talks. Trump is now threatening to raise tariffs on ALL Chinese imports to 25%. No one knows if that is just bluster – Wall St seems to assume it is – but that seems like an over-optimistic assumption with this particular President.

Lack of fear and a less accommodating US Federal Reserve continues to weigh on resources and especially on gold. We may see a little more base metal weakness to go with it if the trade war really heats up, I’m not sure new tariffs will really impact base metal demand in China but a lot of traders surely think it will, which amounts to the same thing in practice, in the short run at least. Most of the biggest Chinese exports to the US (like mobile phones) are relatively light users of metals. The actual impact on base metal demand will be smaller than the feared impact, but it’s the latter that will drive trading I’m afraid.

With inflation stubbornly refusing to rise in the US, even a (fairly) accommodative Fed hasn’t led to lower real interest rates. That, plus a strong US Dollar has kept gold prices on the defensive for weeks. I would expect a real pullback in US equities would lend gold some support, though its disconcerting that the higher volatility and lower S&P in the past few sessions hasn’t done much.

If there isn't some obvious sign that the two parties are on their way to a new agreement (other than @realDonaldTrump tweets, that is), I expect we’ll see a few more percent lopped of Wall St indices. If that doesn’t manage to get gold prices back through $1300 then we’re likely to have a cold summer in the resource space.

Eric Coffin
May 8, 2019

Floatation Device

Spring is in the air on Wall St, and traders' thoughts have turned to unicorns, earnings beating (duh) "expectations" and, of course, romantic overtures from an accommodating US Federal Reserve.

Admittedly, Wall St felt a little jilted after the last Fed meeting. FOMC Chair Powell said during the post-meeting presser that the Fed might hold rates steady, rather than cutting them as everyone seemingly expected. Traders don't want to hear that.

Not to worry. Overall, the Fed has done a great job of convincing the market its got their back. Just take a look at the 10-year yield chart, below. The drop from 3.25% to 2.35% from early December to early May had everything to do with this year's S&P rally. It's a direct reflection of the Fed's swing to a dovish posture. That, and hopes of a China trade deal (more on that near the end).

Wall St continued to be bought during late April and early May, briefly (for now) eclipsing the all-time SPX high reached in Q4 2018. NASDAQ put in a similar performance.

US economic metrics have improved in the past month, though not as much as the current level of the SPX might have you think. Most "economic surprise" indices are still negative, indicating economic readings are still coming in below consensus. Just less below consensus than before.

Traders were buoyed by another strong payroll report and a surprisingly strong Q1 growth number for the US. The payroll number was indeed quite good though, again, the wage gains for "the rest of us" were unimpressive, as they have been for the entire expansion.

The GDP number is a little more suspect, or at least less impressive than the headline would suggest. A large chunk of the 3.2% growth is accounted for by inventory additions and a drop in imports, both of which "add" to GDP using traditional National Income Accounting. Both are "legitimate" but they can often be "one offs", especially inventory increases. It's not a good thing if industry is overproducing. That always comes home to roost in the form of later production cutbacks and, perhaps, layoffs.

The chart below shows a 10-year history for quarterly growth in "final sales to domestic purchasers". Some economists prefer this measure because it strips out volatile items that don't measure how the domestic economy is doing right now. You can see that the Q1 measure for this, at 1.3%, is much closer to what many expected and, perhaps, closer to the everyday reality faced by most away from Wall St.

A more general view of most people's "everyday reality" is shown in the graph on top of the next page. And this also ties back to the "rich get richer" theme of the article on stock buybacks in the last issue. This chart shows median per capita

income for OECD countries plotted against the percentage of the population that can be defined as "middle class" within each economy. As you would expect, as median income rises, the percentage of the population that is middle class also rises. It's not a perfect 1:1 relationship but it broadly holds, as you can see from the trend line on the graph.

There are outliers on both sides of the trend line but the country that really stands out, not in a good way, is the US. The data point for the US is highlighted in yellow. It's significantly farther below the trend line than any other economy. The share of US households that can be defined as middle class is about the same as that for Russia and China, both countries with far lower median income.

This chart tells you a lot about wealth concentration in the US and helps explain why this very long expansion isn't generating the growth rates expected. It's a consumer driven advanced economy but the "average" consumer doesn't have the wherewithal to spend at levels that drive stronger growth. I'm not saying there is an easy fix for this issue, but it helps explain some of the reasons US economic fundamentals never seem to live up to the market's promise.

We'll see how things evolve through the remainder of 2019 but I still think there is a good chance the US slips into a mild recession near yearend, especially if the China-US trade war keeps escalating.

Trump is frustrated with the lack of progress in the China trade talks. He showed that by threatening to up the tariffs on $200 billion of imports from China to 25%, starting in a couple of days. He later said he's considering slapping the same tariff on $325 billion of China imports not currently covered.

I suspect this may have been a bluff on Trump's part initially, but the genie's out of the bottle now. I really don't think China wants this trade war, but they are boxed in too. They won't want to appear weak at home. China's no democracy, but its leadership does listen to its large, and growing middle class. That group is just as patriotic as Americans and won't want to be "pushed around". It may be too late to stop at least the first escalation to $200 billion under tariffs, and the full $525 billion isn't out of the question.

This will hurt China more, but it won't be painless for US companies either. It's importers that pay tariffs, something Trump still seems confused about. Even $525 billion isn't a huge amount against the size of the US economy, but it IS enough to squeeze the margins of a lot of US companies. And if the US goes through with it, China is all but certain of retaliating in ways that will hurt a bunch of US exporters, including some of the biggest companies in the market.

This is just one more thing to trouble US management teams that are already uneasy. That may sound silly if you look at how the S&P has performed, but it's not. Look at the chart above. It shows the net percentage of companies guiding earning consensus higher. That measure rocketed higher through yearend 2018, and no doubt helped the SPX rally the way it did. It's been diving hard for the past month as CFOs lower earnings guidance. And that's before the China tariff threat. Expect to see a lot more lowered guidance soon of the tariffs get raised.

Thanks to tons of liquidity and widespread bullishness, we saw nothing but gains on Wall Street. Risk measures were rock bottom. VIX shorts (betting on lower volatility) were at record levels before Trump's tweets.

The China trade issue may turn out to be a tempest in a teapot. Its shaken up traders short term but they may shake that off if there is some sort of agreement before the tariff jump. Even so, I think things like a rapid increase in companies lowering guidance should instill some caution. Companies are seeing something they don't like.

I think the chart on page 2 is a big part of the reason. Wall St arm waving aside, companies are seeing real net sales decline. Yeah, plenty of them "beat" expectations in Q1, but no one but a CNBC host thinks that means anything. You don't get and keep a job as a Fortune 500 CFO if you don't know how to manage analyst expectations. It's arguably the most important part of your job. That's why most companies always beat expectations.

The truth is, there's been a current of unease in the C Suites, even as the market rocketed higher. Companies don't seem to have pricing power, which is why inflation goes nowhere. Inventories have been climbing and balance sheets keep getting more leveraged.

That unease has spread to fund and hedge fund managers. The chart above shows that "smart money" has gotten increasingly cautious as the 2019 Wall Street rally drove stocks higher, while "dumb money" (retail) got more and more bullish. I might dispute the labels, but it's a pretty remarkable dichotomy that will need to resolve itself.

Retail fearlessness and low volatility hasn't helped the gold price. Even after the "trade tweets", bullion has barely moved. That might change in a couple of days if the US follows trough on the threat.

I've been saying for a while that we'll need Wall St to roll over before bullion gets another sustained rally. I don't love that that's the scenario. I'd be happier to see gold and equities moving higher together, but that's not the world we're in, at least not right now.

This backdrop has made funding harder for resource companies and muted, or extinguished, gains from good results. A return of fear, or lower real interest rates and a lower US Dollar could change that. I'd prefer the latter but we may need to see the former to set the market up first.

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