Dear Valued Clients and Friends,
The market sold off aggressively last Friday after a late Thursday night tweet threatening new tariffs with Mexico. Some antitrust investigations rattled big tech companies early this week. But by mid-week was big-time rally mode as the Fed nodded and whispered that they are here to help. So we necessarily take a lot of space in this week’s Dividend Cafe unpacking the latest whammy in the trade war but explain all of it in the context that now absolutely has the Fed sitting in the middle of it.
I also spend a lot of time this week talking about Japanification, a term getting a lot of play right now from all different types of economists, and I think for very good reason. I expand in this week’s Dividend Cafe on what the long term realities of global debt build-up mean for global growth, and how investors ought to be thinking about it all. You may not find my writing on the subject compelling (I hope you do), but I do believe the topic itself is generationally significant.
So jump on in to this week’s very special Dividend Cafe. I am confident you will reap dividends from the experience.
Dividend Café Video
Dividend Café Podcast
Summary of the current investing environment
The macro environment right now is very challenging for a lot of the reasons I highlighted, but also for the push/pull factors that are not entirely clear in their directional bias.
This Fed is very likely to continue a now 21-year pattern of coddling risk assets; I do not believe this will be an exception.
That said, I do think the volatility will continue as the trade stuff has gone from “confidence in the art of the deal” to “complete erratic irrationality.”
The “Fed put” vs. the “Trump call.”
I’m willing to be patient, and let our bottom-up (company-driven) search for growing dividends yield what it yields – [pun intended]
Final earnings tally
Because I am going to be moving on to a lot of negative or at least negative-sounding “stuff” in a moment, I will start with the following: Q1 earnings for the S&P 500 came in at a stunning +2.5% year-over-year growth, stunning because the entire world had been bracing for a so-called earnings recession (not us) and because Q1 of 2018 was such a robust quarter for earnings growth to be now growing off of a year later. Earnings consensus expectations are now +5% for the full year 2019, vs. potentially negative just a couple months ago.
Mr. Tariff Man moves south
What do you do if a trade war with China is not taking enough of your time? Well, a trade war with Mexico, of course. The President shocked markets with an announcement on Thursday, May 30, that we would begin imposing a 5% tariff on all imports from Mexico beginning June 10, and that the number would escalate by 5% per month up to 25%, unless Mexico “put an end to illegal immigration into our border.” Details were limited as to how exactly Mexico was to do that. Mexico is the largest supplier of agricultural products into the United States, including $8 billion of vegetables alone in 2018. The other industries dramatically impacted are:
* Jones Trading Institutional Services, LLC, May 31, 2019
What will this mean?
It is hard to say exactly how this will play out, or what the President’s end game is here. Mexico’s ability to actually end Central American immigration is obviously limited, but it is entirely possible they tweak a few things, and it gives the President a cosmetic victory, and he calls off the dogs. It also could mean nearly $90 billion of taxes being imposed on U.S. businesses and consumers, something that would very much accelerate a move into recession. 67% of what Mexico exports to us are parts used in American manufacturing! In March of this year, we actually imported more from Mexico than from China (first time in fifteen years)!
Special Edition – Mexico and the New Tariff Threat
Are tariffs inflationary?
A popular thought is that tariffs drive consumer prices higher (they most certainly do), so, therefore, tariffs are inflationary. However, this ignores the two most important realities of what tariffs do across an economy – (1) They depress demand, and (2) They alter behavior. The impulse of consumers is to contract, not press further when prices rise in response to higher taxes (tariffs). Because this is happening at a time when manufacturing is now slowing, capital goods orders are turning south, and business confidence is waning, the intermediate term impact will be deflationary, further provoking central banks to try to assist with easing monetary policy.
How far we’ve come
It wasn’t too long ago that investors (including yours truly) were concerned about protectionist policy mistakes from this President in China, in Europe, and in North America. As time progressed, he backed down on European auto tariffs, the Canadian steel and aluminum threat lasted about five minutes, and became clear that serious and constructive talks with China were under way. In three out of three cases, the feeling was that a disaster had likely been averted. And yet now, talks with China have broken down, and tariffs are escalating. While the European auto threat was delayed, few now doubt this President would tweet something in a minute re-igniting that issue. And we now find ourselves taxing what our most proximate neighbor exports to us with this Mexican policy change. We went from three out of three to zero out of three to three out of three again, all in less than a year.
The China issues are likely to escalate before they improve, if they improve at all in the remainder of this administration. The NAFTA 2.0 path is now likely off the table, a stunning removal of a policy victory out of the win column. Betting odds about USMCA’s passage have decreased from 75% in January to 25% now.
The smart view is still that, at some point, a deal is struck with both Mexico and China. But the impossible task is timing when that may happen, and what economic impact may be along the way.
And then the real catch-22: The Fed’s dog-whistle this week that they stand ready and eager to ease monetarily if the economy ends up warranting it. And this is exactly what the market now believes will happen, and this is what 21 years of Fed action has told us will happen.
So here we are – uncertainty and risk in Trumpian trade policy up against a monetary policy that re-rates risk assets positively. Can you see why balance and prudence make more sense than high conviction calls on timing, pessimism, or optimism?
GDP buffer?
A popular retort to concerns about the trade war’s impact on economic growth is that GDP growth has been so strong that we have a “buffer” or “margin” which affords us the flexibility to pursue this path. But under the hood of GDP growth, we see a different story. As the chart below shows, inventories have built up nicely (which gets reflected in GDP growth), but new capital goods orders are now declining (I will not let up on this business investment theme), and with demand declining, will lead to the inventory cycle rolling over. That “margin” in GDP growth can disappear, very quickly.
* TS Lombard Research, June 2019 Chartbook, p. 5
Something to note
The 3-month Treasury and the 10-year Treasury have inverted, yes. But the 2-year Treasury and the 10-year have not. The former is susceptible to “false positives” about economic predictions; the latter has not traditionally been so … One thing worth noting – usually the yield curve inverts because the short rate comes up above the long rate; in this case, the short rate has stayed still while the long rate has dropped. Does it make a difference? Time will tell, but we get paid to pay attention to the details. There is no question the bond market is pointing to the economic growth slowdown.
Japanification
This is a word that is more and more frequently used in my world, a term to describe the long term impact of a balance sheet recession. A cyclical recession is more income driven, where national output slows down (think of it like an individual’s income going down, only a whole country). But a balance sheet recession is one where assets and credit boomed, as they did in Japan in the late 1980s and early 1990s, and then the bubble burst. The result was collapsing asset prices, but debt levels that did not move.
America went through one of its own in 2008, and the results were obvious – a balance sheet recession does not feel the same as an income recession.
So here was the result in Japan’s NOMINAL income generation (i.e., GDP growth) since their asset bubble burst in the early 1990s:
They were left behind by the United States and Europe in terms of growth, and fought through the reality of a debt-deflationary spiral for 25+ years. Now, there are plenty of differences between the debt conditions the United States now faces and the ones Japan faced in yesteryear, so the analogy is by no means a perfect apples-to-apples. An aggressive monetary response (for good or for bad) was immediate in the aftermath of the 2008 financial crisis, whereas Japan’s central bank waited about ten years to respond.
Japanese banks did not recapitalize, whereas U.S. banks were forced to aggressively recapitalize (this is a key distinction in terms of economic capability). And demographically, the U.S. enjoys far greater trends and conditions for the creation of growth than Japan did or does.
So what do we mean by Japanification, and is it a real thing? Whether you are talking about the United States, Europe, or China, the fact of the matter is that excessive debt lies at the root of what hampers organic economic growth (sovereign and municipal debt in the U.S. and Europe; private debt in China). The deflationary pressures in the rest of the world spill over to the United States because our dollar is the world’s reserve currency, and so when other nation’s experience a slowdown in growth, it rallies our dollar (essentially exporting their deflation to our shores). There is no sign whatsoever that our economy is prepared to break away from structurally low-interest rates. So are their differences? You bet. But is the United States facing a generation of low-interest rates and the absorption of deflationary pressures that constrict economic growth from what it otherwise could be?
That is our thesis. And that is what we mean by “Japanification.”
Asset Allocation lesson of the week
See the Quote of the Week. Perhaps not the greatest exegesis I have ever done, but I think the point is valid.
Are things better across the pond?
In case my sober assessment of the impact of the trade wars on our economy, if no solution is discovered quickly, has provoked you to look across the pond for potential economic opportunity – namely, in Europe. If so, I have some additional bad news for you. The banking system in Europe generated a pitiful 6% Return on Equity (ROE) in 2018, meaning earnings are not being retained, leverage ratios are unacceptably high, and credit growth is nowhere to be found. But it also means there is very little to do if economic conditions worsen – there is no margin for a buffer there. The European Central Bank is already at a 0% interest rate, and Italy is in recession. Germany is offering a negative yield in their debt. There is little room for fiscal or monetary policy to do anything, and organic conditions are not good. The common thread is unsustainable debt that has been treated with band-aids. We’d take the U.S. and its trade war(s) over the milieu that is Europe right now.
Politics & Money: Beltway Bulls and Bears
- I am so critical of the President’s trade agenda and so concerned about its impact to our economy, that I may miss the needed kudos on some other economic agenda items taking place (and getting almost no coverage at all). It is almost unbelievable to me that while the Fannie/Freddie takeover of September 2008 was one of the largest political and economic stories of my lifetime, the unwrapping of that mess presently underway is practically uncovered. What is being reported as underway is a recapitalization of Fannie and Freddie with private dollars (likely via a new IPO), then releasing them into the private sector disconnected from government support or implicit government guarantee. More details still need to be released, such as whether or not the companies would have access to some government backstop (Dear Lord, please no!), and if so, what fee they would now pay for such access. But either way, within a year a significant restructuring of one of the great government blunders of the last 100 years is expected to unfold.
- Speaking of the President’s trade agenda, Kevin Hassett, the Chairman of the White House Council of Economic Advisors (CEA) resigned this week. Kevin has been a stalwart pro-markets free-enterprise intellectual in the administration, and will be missed. We will be diligently monitoring the candidates for replacement.
Chart of the Week
Markets corrected over 5% in May after four straight up months. Is this rare? What would be rare is if we only had one or two 5% corrections. Three or four such corrections per year are par for the course.
Quote of the Week
“Two are better than one, because they have a good return for their labor. If either of them falls down, one can help the other up. But pity anyone who falls and has no one to help them up. Though one may be overpowered, two can defend themselves. A cord of three strands is not quickly broken.”
~ Ecclesiastes 4:9-12
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There is a lot to chew on this week, but these are important times. The uncertainty and magnitude of how much it could push one way or pull another is extraordinary. The Fed put vs. the Trump call – if you start hearing that nomenclature elsewhere, just remember this: I made it up first. =)
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com
The Bahnsen Group
www.thebahnsengroup.com
This week’s Dividend Café features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
