Loose Cannon

From the HRA Journal: Issue 305

Saved by the bell, or the tweet I should say. I was putting this extended version to bed when US President Trump decided he'd go after yet another major trading partner.

That was a little too much for Wall St, and finally generated enough concern to flatten bond yields, again, and generate strong buying that lifted gold prices back through $1300/oz. At this point, it's a bounce, not a trend, but I think gold now goes higher if we don't quickly see a moderation in the multi-front trade war Trump seems committed to.

Gold stocks have a lot of catching up to do. They've been about the crappiest sector of the market for longer than I care to think about. The one advantage the gold (and maybe silver-I'm no silver bug) sector has is size, or rather lack of it. If we see a larger move in gold, it will be magnified in gold stocks as traders seek a piece of a sector that is tiny in relation to the broader market.

It's too early to claim any sort of real victory. Gold has topped out several times in the mid-$1300s. We need to ultimately clear that hurdle for generalist investors to arrive en masse. We're a long way from that but I won't be surprised if the move continues if Wall St can't find a bottom soon.

Keep watching your twitter feed, it could be a more active summer than I expected.

Eric Coffin
May 31, 2019


Loose Cannon

Just when you thought it was safe to go back to the market. The chart below is the VX volatility index, a commonly traded measure of fear or uncertainty. You can see from the right side of the chart that the measure has started rising again in the past few days.

It's still a long way from being extreme. Traders aren't that edgy yet. Maybe they should be though.

As I was writing this editorial, President Trump helped moved the VIX up a little more. He threatened Mexico with across the board 5% tariffs, which would be increased in stages, topping out at 25% by October 1st if Mexico doesn't halt the flow of Central American refugees at the US Mexico border.

Like many things Trump, we are left guessing how serious he is. Illegal immigration is one of Trump's signature issues, so it's safe to assume he'll follow through unless Mexico can mollify him. I'm not sure how they do that though they are going to try.

The action against Mexico means the US now has blanket tariff actions against two of its largest trading partners. We have to wonder if Canada will be far behind as it's none too clear what sets Trump off sometimes. The Toronto Raptors have a decent shot at winning the NBA final. Let's hope Trump isn't a basketball fan...

Like the tariffs imposed on Chinese imports, the Mexican ones will be borne largely by US consumers. Mexico is the second largest trading partner with the US. And most of that trade is intra-company, meaning it involves parts and assemblies that go into final products.

Since most of the trade is companies shipping semi-finished goods among subsidiaries (think auto companies getting sub-assembly done on the Mexican side of the border) there's no ducking the tariff. It's parts of the same company on both sides of the ledger. The Mexican tariffs, perhaps even more than the Chinese ones, are going to squeeze margins and profits of US multinationals.

And what about China? That mess is still evolving. Beijing is scheduled to lay out its official position a couple of days after this issue. They may try to come up with a face-saving exit but I'm not confident about that.

The chart below should be passed around the West Wing, if it hasn't been already. It shows that, while still pretty important, China's exports to the US as a percentage of its economy have dropped from nine percent in 2005 to about three percent currently. Three percent isn't minor. Losing that would hurt the Chinese economy which is already struggling. But it's nothing like the level of dependency most anti-China types in the US imagine. I don't think this trade war is going to end any time soon.

It feels like Trump opening a(nother) new front in the US vs Everybody trade war may finally be shaking the confidence of Wall St. You can see the lower low made through a week of constant selling on the chart below. It's hardly a crash though. Selling is orderly and the VIX as noted on page 1 is still only at moderate levels.

In terms of short-term direction though, all the above is a negative. There's no washout here and no sign of panic selling. Odds are we're going lower still.

Interestingly, non-panic selling in equities was matched by what looks like close to panic buying in bonds. Take a look at the US 10-year Treasury yield index, below the SPX chart. Now, that's a downtrend. 10-year yields are off 100 basis points in seven months.

That is a huge move, and you can see that the tail end of it, after the Mexican tariff announcement, is a clean break lower. We might be getting close enough to panic buying in Treasuries that the drop flattens out soon. As it is, a yield of barely more than 2% for 10-year bonds in what's supposed to be a great and flourishing economy sounds crazy.

That brings us to the next chart, below, a current version of one you've seen in these pages before. The current US yield curve chart is not good news, not at all. Compare the current version (blue) to the curve a month ago (red). Note how the 10-year yield, thanks to the latest dive, has been pulled below the three-month yield. Note too that the 3- and 6-month yields, which had been pretty stable, is now very slightly lower than the 1-month.

This is a classic yield curve inversion. I've said before that these are the most reliable indicator for coming recessions. It's not perfect, and its importance is partially based on longevity. Inverting for a day or two isn't conclusive, but if it stays inverted for a month or more, I'd say my prediction of a recession starting by year-end in the US is pretty safe.

So, is Coffin just going to be "Debbie Downer" again? Well, no. At least not where our despised little corner of the market is concerned. Or part of it at least.

The charts below show the US Dollar gold price and the US Dollar index since the end of November. Gold did fine for a couple of months at the start the of the year then flamed out just in time for PDAC. That's not the most interesting thing for me though. It's not that gold traded "meh" from mid-February until late May, it's that it didn't trade even worse.

The USD has been quite strong for most of this year. There're all sorts of bad stuff going on elsewhere and the US economy is doing better than the rest. Add money pouring into Treasuries, some from offshore, and you've got a strong bid under the USD.

What's interesting for me is that gold has held up pretty well. When you look at the USD chart below it, things could have been a lot worse. On a longer-term chart, gold continues to make higher lows. Of course, it's higher highs that we need. With all the craziness in the market recently, we may finally be setting up for that.

You can see from the right side of the gold chart that it just made a clean break out, though it's too soon to say it's a "real" one. It looks good though and I think there may be more to come. Gold is nowhere near overbought and there is every reason to think the selling isn't over on Wall St.

As long as the selling in the equities markets is orderly it should put more bids under the gold price. The USD is more problematic, because things look as bad or worse offshore. You can see that from the fact the USD hasn't really pulled back yet, even with US bond yields diving.

At the end of the day, it may take the slowing in the US economy I expect to top out the US Dollar. There seems to be an added bid from traders that assume the US will "win" all these trade wars. I'm not sure anyone really wins these things but I know what they mean. I'm not sure I agree this time though. Lower rates haven't cut into the USD's value yet, but increasing awareness that the US may be slowing AND lower rates together may do it.

Wall St has managed to resist heavy selling pressure so far. The current pullback isn't that large, so I'm not surprised equity bulls just shrug. I think that's a mistake this time, thanks to Trump.

All market issues aside, let's think about what's going on here. You've got a US President who is a nationalist and a nativist. Who views every interaction as some sort of zero-sum game where he has to come out on top. He's made it clear from day one that he thinks the US is getting "ripped off" by foreigners.

Always emotional and mercurial, Trump has been even more volatile since the mid-term elections. With the deadlock between the Congress and Senate he can kiss most of his legislative agenda (such as it is) goodbye. He's extremely frustrated he can't "get stuff done".

Now, imagine a President like that, who has a persecution complex and a taste for score-settling, realizing there is one area where the US President can, effectively, "rule by decree". The US President has broad powers to set and change tariffs. The Congress can theoretically overrule him with the help of the Senate, but he can basically make trade pronouncements at will.

My sense is that it's dawned on Trump recently that this is one area where he can impose his will and effect change without answering to anyone. He's no legislative scholar. I don't think this occurred to him before, but now that he's got the idea, it looks like he'll run with it.

Trump loves the idea of stirring things up and he tends to react emotionally at the best of times. Realizing he can (he thinks) force changes across the globe by using tariffs as a cudgel clearly appeals to his ego. Frankly, I think this is a very bad development and I can't conceive of how it's going to end well for the US or world economy for that matter.

This is a rapidly evolving situation. I think we'll see a lot more tariff announcements in coming weeks and months. Remember, the market hates uncertainty and volatility. Look back at the VIX chart on page one. That measure is going to keep climbing if Trump continues to rage trade tweet.

Corporate management hates uncertainty and a shifting commercial landscape too. This won't just impact trade. It will cut into capital investment, growth plans and profits. I see no reason to expect Trump to moderate himself, so get ready for lower growth and lower equities.

Rising fear may keep a bid under the USD but the growing "risk off" environment will help gold prices. It's impossible to predict Trump but he may be giving gold investors a gift for the second half of the year.

That gift won't be shared with base metals, as long as uncertainty persists. Gold explorers and developers are where we need to focus, while still being willing to pick up cheap base metal names knowing the holding period could be longer. I've been moderate to bearish on resources as a sector but the second half of the year could give us a gold market that helps the juniors be outperformers.

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