Dear Valued Clients and Friends,
What happens to market timers after the four negative weeks that followed the breakdown of China/U.S. trade talks: The market has its best week of the year, despite the week of uncertainty around new, unexpected Mexico tariffs. And what happens the week after the best week of the year? As of press time, further [modest] advancements still …
It is not one particular emphasis this week but rather the full overview of all that actually is driving markets, economic question marks, and the investor landscape. The tariffs, the Fed, business confidence, the yield curve, and political landscape – they all are covered, and more – in this week’s Dividend Cafe!
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Fed put vs. Trump call – week #2
The tariff threat with Mexico became obsolete Friday night on Monday as President Trump reversed course and called the tariffs off. The markets rallied on Monday out of the relief that this disaster was averted.
The focus now moves to China, where no official negotiations are scheduled, yet President Trump and President Xi are expected to meet on June 20 at the G20 meetings.
Here is a concept that may need to sink in:
It is entirely possible that a trade deal gets worked out with China in the coming months, that the removal of that economic headwind keeps the Fed from acting on the presently expecting monetary stimulus, and that the end of the trade threat comes too late to stop the decline in business investment. None of those various pieces are assured, or even probable, but all are possible. Balance will remain the name of our game.
Mexico Tariffs that weren’t
The tariffs that were called off Friday night had actually never been processed – no paperwork had been filed – etc. So the camp that believed these were a posturing tactic to secure a different aim (for good or for bad or for cosmetics) were correct. Why would markets not see this as a positive thing? Because it adds to the uncertainty dynamic to know that floating in the toolbox is a sort of permanently accepted possibility that significant taxation threats can be used at any time, with any party. For the sake of economic stability, I am just glad that the tariffs did not happen. For the sake of future market stability, the card has been used enough that markets now know it lingers.
Breaking it down
Why is the Fed offering this “put” (i.e., the rhetorical reaffirmation that they will support economic recovery with aggressive monetary support)? Because of credit market conditions in the business sector. Industrial production has been declining. ISM New Orders have been declining (manufacturing). Small business hiring has been declining. Should the macro trade war fears continue these trends in the business investment category, the Fed believes [knows] it would bring about the end of this economic recovery cycle. The Fed seems to be indicating they want to stave that off.
Will it work?
Mid-cycle Fed activity generally has a renewal effect economically. Pre-recession Fed activity generally makes things worse. So the question as we prepare for what looks like a rate cut or two from the Fed later this summer/fall is whether or not we are in the 6th/7th inning of the economic recovery, and these cuts will have a stimulative effect, OR if we are already in the 9th inning, and these cuts will just worsen trends.
We know that rate cuts “re-price” risk assets (the lower the risk-free rate, the higher the valuation risk assets can trade at). So the market multiple (P/E ratio) in stocks turned higher last week as markets baked in the indications that the Fed is coming to help. I suspect we have gotten a half-turn in the multiple so far and could get another half-turn (17x went to 17.5x, and could get 18x with this monetary cushioning). But do the fundamentals of credit markets and business confidence move higher, or is it just a “re-rating” of risk assets? Sadly, I think monetary support at this level is more the latter than the former, though the former can get a short term boost. There are dozens of data points we have to be watching.
More on China
President Trump and President Xi will hopefully be meeting at the G20 next week. I have little expectations that there will be resolution of anything out of that meeting, but I do believe there is a possibility (I will make up a number and call it 50-50) that they may “make progress” and call for a “cease fire” in new tariffs, buying time in the markets for additional progress towards a real deal. The tone out of China has been different, though, than in prior escalations of the conflict. What was conciliatory late last year has been more confrontational this last month or so. Their ability to use non-tariff leverage has not been fully appreciated by markets (i.e., limiting exports on rare earth metals, restricting the sale of U.S. goods and services, devaluing their currency further, specific company targeting, etc.). So whether the tariffs on the next $300 billion of products happens or not, a lot is on the line at the moment, and this G20 meeting is essentially the next likely catalyst to some development.
The CEO Economic Outlook Index decreased over 6% last month as trade worries intensified, and fears about the tariffs’ impact were cited as the #1 reason for the decreased confidence. This index focuses on 200 CEO’s of very large public companies.
But on the other hand, the small business optimism readings were remarkably positive.
* NFIB, Small Business Economic Trends, May 2019
Destroying a false narrative
There are plenty of things some people believe about investing that are inaccurate, but few things that are completely baked into a narrative that are categorically wrong. Sadly, the idea that “stock buybacks save the market” is a narrative that is categorically and demonstrably false yet widely accepted. Stock buybacks are down 20% from the level they were at through this point last year. The S&P is up ~14% year-to-date this year; it was down ~5% this point last year.
Most share repurchases (not all) offset the shares issued as employee compensation. Net share count only went down 1.1% per year in the decade after the financial crisis, yet buybacks went up $420 billion per year. The difference in stock performance between companies that did and did not see their share count go down has been indecipherable.
Share buybacks refer to a mechanism for returning capital to shareholders after profits have been achieved, and they refer to a mechanical tool for creating the supply needed for employee and executive compensation. They do not create value in and of themselves. A company generating free cash flow out of a defensible business model – that creates value.
Politics & Money: Beltway Bulls and Bears
- Tomas Philipson is being nominated to replace Kevin Hassett as Chairperson of the Council of Economic Advisors. More to come as the news breaks.
- The trade/tariff matter rightly captures the bulk of the “political” news in terms of impact on the economy and markets, and the Democratic primary will surely be a focus in the year ahead. But we are also watching other “peripheral” issues that warrant attention, such as the debate over drug pricing. Progressives are pushing for straight drug pricing legislation (because that always works so well, eh?) and others are looking for a cap on out-of-pocket spending. The latter would reduce costs for seniors but leave the theoretical price in place, even as marginal profits are reduced for drug-makers. President Trump’s proposal is to index Medicare Part B to international rates (who says globalism is always hated, huh?). There are a lot of nuances across the competing plans, and the Senate plan is probably the most favorable for market forces (and least politically destructive). But the next step is seeing the plan Speaker Pelosi puts forward. I could write three pages on the nuances of all the varying proposals, but the whole thing stands to create a substantial impact on the drug sector, and we are monitoring closely.
- I will point out that the odds of the NAFTA 2.0 (USMCA) being ratified did go up with the disaster averted with Mexican tariffs. However, Speaker Pelosi holds the cards, and she has a track record of delaying trade deals in the Bush administration. If she brings it up for a vote, it is highly likely to pass. If she does not, the President may withdraw from NAFTA. The question mark is if she does neither – but rather just “delays” …
Chart of the Week
This week’s chart may seem confusing, but let me unpack it for you … The market is implying a rate cut by September and another one by December (in the futures market). The Fed may surprise the market, but frankly, that has been so outside of their modus operandi (to surprise the market) for so long, it would be hard for any credible investment advisor to believe that was the play to bet on.
Source: Strategas Research, June 12, 2019
Quote of the Week
“Work that orders even a small corner of the world toward beauty and the common good is participation in God’s ongoing work of creation.”
~ Jerry Windley-Daoust
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I am in New York next Monday just for 24 hours for two important meetings, and then head to Grand Rapids, MI for an annual economics symposium I have attended (and lectured at) for many years. This event always means one thing – summer is here! My eldest son graduated middle school this week; my two littles are out for summer, the high school I serve as trustee for has had its graduation ceremony – it’s official. I will be working one month this summer in the NYC office and one month in the Newport office before returning to the standard “75% Newport, 25% New York” split into the fall.
But beyond all the graduations, birthdays, school events, and everything else that makes the first couple weeks of June so dramatic in the David and Joleen Bahnsen household, it is going to be a great summer. We have a couple of weeks for this wild ride of Q2 to wrap up. The markets remain resilient, for now. The trade war remains uncertain, for now. Economic growth remains a question mark, for now. The political environment remains a mess, for now (and for later). But good investor behavior remains primary, for now, and forever.
To that end, we work.
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet