Retail sales fall while trade talks stall

Retail sales

Retail sales growth (USA advance retail sales excluding autos and parts) fell sharply in December, indicating that consumer confidence is fading despite strong employment figures.

Advance Retail Sales

The decline in consumer confidence also shows in lower January 2019 light vehicle sales.

Light Vehicle Sales

Trade talks make little progress

Trivium provide a useful update on US-China trade negotiations:

The latest round of trade talks with the US are finishing up as we go to press. There hasn’t been much progress (Bloomberg): “As of Friday afternoon, there had been no visible progress on efforts to narrow the gap around structural reforms to China’s economy that the U.S. has requested, according to three U.S. and Chinese officials who asked not to be identified because the talks were private……Chinese officials are angry about what they see as US efforts to undermine their state-led economy.”

These are issues that will take generations to resolve. The chance of a quick fix is highly unlikely.

Stocks

The stock market continues to rally on the back of a solid earnings season.

Of the 216 issues (505 in the S&P 500 index) with full operating comparative data 154 (71.3%) beat, 51 (23.6%) missed, and 11 met their estimates; 135 of 215 (62.8%) beat on sales. (S&P Dow Jones Indices)

Index volatility remains high, however, and a 21-day Volatility trough above 1.0% would warn of a bear market. S&P 500 retreat below 2600 would reinforce the signal.

S&P 500

Crude prices continue to warn of a fall in global demand.

Light Crude

As do commodity prices.

DJ-UBS Commodities Index

10-Year Treasury yields are testing support at 2.50% and a Trend Index peak below zero warns of buying pressure from investors seeking safety (yields fall as prices rise).

10-Year Treasury Yield

The Nasdaq 100 shows rising Money Flow but I believe this is secondary in nature. The next correction is likely to provide a clearer picture.

Nasdaq 100

My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.

~ Thucydides (460 – 400 B.C.)

Why the RBA shouldn’t cut interest rates

There are growing cries in local media for the RBA to cut interest rates in order to avoid a recession. House prices are falling and shrinking finance commitments point to further price falls. Declining housing values are likely to lead to a negative wealth effect, with falling consumption as household savings increase. Employment is also expected to weaken as household construction falls. Respected economist Gerard Minack thinks “a recession in Australia is becoming more likely”.

The threat should not be taken lightly, but is cutting interest rates the correct response?

Let’s examine the origins of our predicament.

A sharp rise in commodity prices in 2004 to 2008.

Commodity Prices

Led to a massive spike in the Trade-weighted Index.

Australia Trade Weighted Index

And a serious case of Dutch Disease: the destructive effect that offshore investment in large primary sector projects (such as the 1959 Groningen natural gas fields in the Netherands) can have on the manufacturing sector.

Business investment in Australian has fallen precipitously since 2013.

Australia Business Investment

With wages growth in tow.

Wages Index

Instead of addressing the underlying cause (Dutch Disease), Australia tried to alleviate the pain by stimulating the housing market. Housing construction boosted employment and the banks were only to happy to accommodate the accelerating demand for credit.

Leading Index

But house prices have to keep growing and banks have to keep lending else the giant Ponzi scheme unwinds. When house prices and construction slows, the economy is susceptible to a severe backlash as Gerard Minack pointed out.

How to fix this?

The worst response IMO would be to pour more gasoline on the fire: cut interest rates and reignite the housing bubble. Low interest rates have done little to stimulate business investment over the last five years, so further cuts are unlikely to help.

The only long-term solution is to lift business investment which creates secure long-term employment. To me there are three pillars necessary to achieve this:

  1. Accelerated tax write-offs for new business investment;
  2. Infrastructure investment in transport and communications projects that deliver long-term productivity gains; and
  3. A weaker Australian Dollar.

Corporate tax write-offs

Accelerated corporate tax write-offs were a critical element of the US economic recovery under Barack Obama. They encourage business to bring forward planned investment spending, stimulating job creation.

Infrastructure

Government and private infrastructure spending is important to fill the hole left by falling consumption. But this must be productive investment that generates a market-related return on investment. Else you create further debt with no income streams to service the interest and capital repayments.

A weaker Australian Dollar

Norway is probably the best example of how an economy can combat Dutch Disease. They successfully weathered an oil-driven boom in the 1990s, protecting local industry while establishing a sovereign wealth fund that is the envy of its peers. Their fiscal discipline set an example to be followed by any resource-rich country looking to navigate a sustainable path through a commodities boom.

In Australia’s case that would be closing the gate after the horse has bolted. The benefits of the boom have long since been squandered. But we can still protect what is left of our manufacturing sector, and stimulate new investment, with a weaker exchange rate.

I doubt that the three steps are sufficient to avert a recession. But the same is true of further interest rate cuts. And at least we would be addressing the root cause of the problem, rather than encouraging further malinvestment in an unsustainable housing bubble.

Robust US employment but global bear market warning

The US economy remains robust, with hours worked (non-farm) ticking up 2.2% in January, despite the government shutdown. Real GDP growth is expected to follow a similar path.

Real GDP and Hours Worked

Average hourly earnings growth increased to 3.4% p.a. for production and non-supervisory employees (3.2% for all employees). The Fed has limited wiggle room to hold back on further rate hikes if underlying inflationary pressures continue to rise.

Average Wage Rate Growth

History shows that the Fed lifts short-term interest rates more in response to hourly wage rates than core CPI.

Average Wage Rate Growth, Core CPI and 3-Month T-Bills

The Leading Index from the Philadelphia Fed ticked down below 1% (0.98%) for November 2018. While not yet cause for concern, it does warn that the economy is slowing. Further falls, to below 0.5%, would warn of a recession.

Leading Index

Markets are anticipating a slow-down, triggered by falling demand in China more than in the US.

S&P 500 volatility remains high and a large (Twiggs Volatility 21-day) trough above 1.0% (not zero as stated in last week’s newsletter) on the current  rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Crude prices have plummeted, anticipatiing falling global (mainly Chinese) demand. Another test of primary support at $42/barrel is likely.

Light Crude

Dow Jones-UBS Commodity Index breached primary support at 79, signaling a primary decline with a target of 70.

DJ-UBS Commodity Index

China’s Shanghai Composite Index is in a bear market. Respect of resistance at 2700 would confirm.

Shanghai Composite Index

Bearish divergence on India’s Nifty also warns of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

DJ Stoxx Euro 600 rallied but is likely to respect resistance at 365/370, confirming a bear market.

DJ Stoxx Euro 600 Index

The UK’s Footsie also rallied but is likely to respect resistance at 7000. Declining Trend Index peaks indicate selling pressure, warning of a bear market.

FTSE 100 Index

My conclusion is the same as last week. This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

Concessions to adversaries only end in self reproach, and the more strictly they are avoided the greater will be the chance of security.

~ Thucydides (460 – 400 B.C.)

Deal or no deal

Brexit

No one knows what the outcome of Brexit will be but, whatever the outcome, it is unlikely to send global markets into a tail-spin. There is bound to be short-term pain on both sides but the long-term costs and benefits are unclear.

China

Far more likely to send investors scuttling for shelter is a ‘no deal’ outcome on US trade negotiations with China. I would be happy to be proved wrong but I believe that a deal is highly unlikely. There may be press photos with beaming officials shaking hands and tweets from the White House promising a rosy future for all (with or without a wall). But what we are witnessing is not straight-forward negotiations between trading partners, which normally take years to resolve, but a hegemonic power struggle between two super-powers, straight out of Thucydides.

Thucydides wrote “When one great power threatens to displace another, war is almost always the result.” In his day it was Athens and Sparta but in the modern era, war between great powers, with mutually assured destruction (MAD), is most unlikely. Absent the willingness to use military force, the country with the greatest economic power is in the strongest position.

One of the key battlefronts is technology.

“China is now almost wholly dependent on foreign chipsets. And that makes leaders nervous, especially given a series of actions by foreign governments to limit the ability of Huawei and ZTE to operate internationally and acquire Western technology.” ~ Trivium China

“To address this risk, President Xi Jinping aims to increase China’s semiconductor self-sufficiency to 40% in 2020 and 70% in 2025 as part of his ‘Made in China 2025’ initiative to modernize domestic industry.” ~ Nikkei

Xi is unlikely to abandon his ‘Made in China 2025’ plans and the US is unlikely to settle for anything less.

USA

The US economy remains robust despite the extended government shutdown and concerns about Fed tightening.

“Federal Reserve officials are close to deciding they will maintain a larger portfolio of Treasury securities than they had expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” ~ The Wall Street Journal

This is just spin. As I explained last week. Fed run-down of assets is more than compensated by repayment of liabilities (excess reserves on deposit) on the other side of the balance sheet. Liquidity is unaffected.

Charts remain bearish as the market views global risks.

Volatility is high and a large (Twiggs Volatility 21-day) trough above zero on the current S&P 500 rally would signal a bear market. Retreat below 2600 would strengthen the signal.

S&P 500

Asia

Hong Kong’s Hang Seng Index is in a bear market but shows a bullish divergence on the Trend Index. Breakout above 27,000 would signal a primary up-trend. This seems premature but needs to be monitored.

Hang Seng Index

India’s Nifty has run into stubborn resistance at 11,000. Declining peaks on the Trend Index warn of selling pressure. Retreat below 10,000 would complete a classic head-and-shoulders top but don’t anticipate the signal.

Nifty Index

Europe

DJ Stoxx Euro 600 is in a primary down-trend. Reversal below 350 would warn of another decline.

DJ Stoxx Euro 600 Index

The UK’s Footsie has retreated below primary support at 6900. Declining Trend Index peaks warn of selling pressure. This is a bear market.

FTSE 100 Index

This is a bear market. Recovery hinges on an unlikely resolution of the US-China ‘trade dispute’.

War is a matter not so much of arms as of money.

~ Thucydides (460 – 400 B.C.)

‘It could be on the scale of 2008’ | SMH

Harvard professor Ken Rogoff said the key policy instruments of the Communist Party are losing traction and the country has exhausted its credit-driven growth model. This is rapidly becoming the greatest single threat to the global financial system.

“People have this stupefying belief that China is different from everywhere else and can grow to the moon,” said Professor Rogoff, a former chief economist at the International Monetary Fund.

“China can’t just keep creating credit. They are in a serious growth recession and the trade war is kicking them on the way down,” he told UK’s The Daily Telegraph, speaking before the World Economic Forum in Davos.

“There will have to be a de facto nationalisation of large parts of the economy. I fear this really could be ‘it’ at last and they are going to have their own kind of Minsky moment,” he said.

Read the full article from Ambrose Evans-Pritchard at smh.com.au: ‘It could be on the scale of 2008’: Expert sends warning on China downturn

Bullish in a bull market, bearish in a bear market

We are witnessing the transition from a bull to a bear market.

I subscribe to Jesse Livermore’s maxim (emphasis added):

“I began to see more clearly—perhaps I should say more maturely—that since the entire list moves in accordance with the main current…. Obviously the thing to do was to be bullish in a bull market and bearish in a bear market. Sounds silly, doesn’t it? But I had to grasp that general principle firmly before I saw that to put it into practice really meant to anticipate probabilities. It took me a long time to learn to trade on those lines.”

The second part of that quote is equally important. You determine whether a market is bullish or bearish by “anticipating probabilities”. Don’t take signals from the charts in isolation. You have to study general conditions.

Livermore gives a classic example in Reminiscences of a Stock Operator of how he anticipated a bear market in 1906 after the Boer War in South Africa had drained Britain’s coffers and the San Francisco earthquake led to massive insurance payouts, forcing insurers to liquidate large swathes of their investment portfolios. But he was wiped out as the market repeatedly rallied. He persisted and eventually was proved right when large rail stocks announced new stock issues. The fact that the issues were structured as instalment issues, with only a down-payment needed to acquire the stock, alerted Livermore that there was not enough liquidity in the market to absorb the stock issues. His broker extended him a line of credit and…

“I profited by my earlier and costly mistakes and sold more intelligently. My reputation and my credit were reestablished in a jiffy. That is the beauty of being right in a broker’s office, whether by accident or not. But this time I was cold-bloodedly right, not because of a hunch or from skillful reading of the tape, but as the result of my analysis of conditions affecting the stock market in general. I wasn’t guessing. I was anticipating the inevitable. It did not call for any courage to sell stocks. I simply could not see anything but lower prices, and I had to act on it….”

General conditions in the US are still strong.

Credit and the broad money supply (MZM plus time deposits) are growing at close to 5%.

S&P 500

Credit risk premiums are rising but are nowhere near alarming. A spread of more than 3.0% between lowest grade investments (Baa) and 10-year Treasuries would flag a warning.

S&P 500

The big shrink, as the Fed unwinds its balance sheet, is still a myth. Banks are drawing down excess reserves at a faster rate, so that liquidity is rising. The rising green line on the chart below shows Fed assets net of excess reserves.

S&P 500

But charts are bearish.

Market volatility is high and a large bearish divergence on S&P 500 Momentum warns of a bear market.

S&P 500

We need to look at global conditions to identify the cause for market concern: Brexit, slowing European growth, but primarily, a potential trade war with China.

It’s time to be cautiously bearish.

There is no training, classroom or otherwise, that can prepare for trading the last third of a move, whether it’s the end of a bull market or the end of a bear market.

~ Paul Tudor Jones

Get ready for economic slowdown | Trivium China

While we cannot rule out the chance of a large Chinese stimulus, senior officials are talking this down. In 2008/2009, China injected a whopping 19% of GDP to revive its flagging economy, compared to roughly 6.5% of GDP by the Obama administration at the height of the GFC. The size and scope of the stimulus achieved the desired result but had several undesirable side effects, including accelerating the property bubble and rapid growth expansion of the informal shadow banking sector as speculative fever grew.

From Trivium China:

At his meeting with businessmen on Tuesday, Li Keqiang [Premier of the State Council of the People’s Republic of China] also laid out his views on the economy.

In a nutshell: Things do not look good (Gov.cn).

  • “Downward economic pressure is increasing.”
  • “[We must] thoroughly prepare to react to difficulties and challenges.”

But Li stressed (again!) that the government’s response to this slowdown will be different than in the past:

  • “[We] will not rely on traditional measures.”

Instead, Li wants to take a more measured, precise approach:

  • “Macro policies should be stable, precise, and effective in order to counter external uncertainties.”

The top priority will continue to be improving the business environment, with a focus on three areas:

  • Eliminating government interference in business operations
  • Reducing taxes and fees
  • Making financing easier and cheaper to get

Get smart: If you haven’t gotten the message yet, you have not been listening. The government is not going to repeat the massive stimulus that it enacted 10 years ago in response to the financial crisis.

The Aussie economy is quietly falling apart | Macrobusiness

You’d have to be as blind as the RBA to miss the signals. GDP is made up of six components and they are not going well on balance:

  • government consumption is strong and likely to stay that way;
  • government investment is peaking as the NBN rolls off and infrastructure starts fade;
  • household consumption is weakening with car sales and international travel down sharply plus retail looking highly questionable;
  • business investment has been good and the outlook for six months is solid but it will track broader demand and housing investment is about to tumble;
  • inventories will ebb and flow;
  • net exports (volumes) are weak owing to China’s thermal coal blockade and the drought despite the LNG ramp up.

In short, the Australian economy is quietly falling apart and if it does not receive any new juice soon it is going to crater as we enter the Hayne Royal Commission recommendations, the federal election stall and Labor’s reform agenda. I have now downgraded my outlook for domestic demand from what was already bearish:

This is an environment in which unemployment will rise at a decent clip threatening much worse outcomes as that feeds back into asset prices.

That markets and economists are still forecasting rate hikes is ridiculous. That cuts remain off the radar of nearly all is bizarre.

By Houses & Holes (David Llewellyn-Smith). Reproduced with kind permission from Macrobusiness.

Comment: Time for the government to go big on infrastructure spending. Not school halls or pink batts insulation but real infrastructure like transport and communications investments (5G for example) that will boost long-term GDP growth.

Big four banks protest against higher capital

“The big four banks are trying to convince the prudential regulator to reconsider its proposal to force them to raise an additional $75 billion of so-called Tier II bonds to meet “too big to fail” capital requirements.” ~ Jonathan Shapiro, Australian Financial Review

What is APRA thinking? They are deluding themselves if they think that Tier II bonds will shore up capital.

Imagine the panic in financial markets if bond-holders take a haircut. It could lead to a Lehman-style meltdown.

The same applies to Tier I hybrids which banks are happily flogging to retiree investors. Convert their investments into near worthless bank scrip after a financial meltdown and nan and pops will turn up in Melbourne Docklands and Darling Harbour, demanding their money back. I suspect regulators would rather face Ned Kelly.

The only true capital is Common Equity (CET1). Anything else is simply putting lipstick on the pig.

Aussie taxpayers are being duped if they believe that they are covered if there is a financial meltdown and that banks carry enough capital to absorb potential losses.

I would rather see legislation that calls it like it is and provides for government to backstop the banks in the event of a crisis. But at a price that makes their eyes water, as the Swedes did in 1992. It’s the best way to keep the banks honest.

China’s newest export

“Polish authorities have arrested a Chinese employee of Huawei, the Chinese telecommunications giant, and a Polish citizen, and charged them with spying for Beijing, officials said on Friday, amid a push by the United States and its allies to restrict the use of Chinese technology based on espionage fears….
It is not the first time in recent months a Huawei employee has been arrested abroad. Meng Wanzhou, the company’s chief financial officer, was arrested in Canada last month at the request of the United States, where she had been charged with fraud designed to violate American sanctions on Iran….
A 2012 report from United States lawmakers said that Huawei and another company, ZTE, were effectively arms of the Chinese government whose equipment was used for spying. Security firms have reported finding software installed on Chinese-made phones that sends users’ personal data to China.”
From Joanna Berendt at The New York Times

Lack of independence of private companies in China, their use for espionage purposes including industrial espionage, and failure to open Chinese markets up to foreign competitors are likely to throttle attempts to resolve trade disputes with the US. An impasse seems unavoidable.

It is important that the West confronts China over their trade tactics, espionage and ‘influence’ operations. Whether Donald Trump is the right person to lead this, I will leave for you to judge.

I doubt that China wants to rule the world. Dominate, perhaps. But the overriding goal of their leaders is to ensure the survival of the Chinese Communist Party (CCP). They want to make the world safe for autocracy. They don’t seem to understand that this is an oxymoron. Autocracies make the world unsafe because they lack the checks and balances, imperfect as they may be, that ensure stable government in democracies whose citizens are protected by rule of law. If you think the world is already unsafe, imagine Donald Trump as president without the constraints of the US Constitution. History provides plenty of evidence of autocrats — Stalin, Hitler and Mao are prime examples — who abused their power with catastrophic results.

China’s newest export may be a global recession if world leaders are not careful. These two charts from the RBA highlight the current state of play.

Declining growth in retail sales is accelerating. Manufacturing PMI is rolling over and industrial production is likely to follow.

China Activity Levels

Output, on the other hand is surging, as the state attempts to spend its way out of a recession. Cement production is the sole laggard.

China Output

Matt O’Brien at The Age describes China’s dilemma:

…in the depths of the Great Recession, Beijing unleashed a stimulus the likes of which the world hadn’t seen since World War II.

It amounted to some 19 per cent of its gross domestic product, according to Columbia University historian Adam Tooze. By point of comparison, US President Barack Obama’s stimulus was only about 5 or 6 per cent of US GDP.

Aside from its size, what made China’s stimulus unique was the way it was administered. The central government didn’t borrow a lot of money itself to use on infrastructure, but it pushed local governments and state-owned companies to do so.

The result was a web of debt that’s been even harder to clean up than it might have been because of all the money that unregulated lenders – “shadow banks” – were frantically handing out above and beyond what Beijing had been hoping for….

What is new, though, is that this isn’t working quite as well as before. As the International Monetary Fund reports, China seems to have reached a point of diminishing returns with this kind of credit stimulus.

So much new debt is either going toward paying off old debt or toward economically questionable projects that it takes a lot more of it than it used to just to achieve the same amount of growth.

Three times as much, in fact. Whereas it had only taken 6.5 trillion yuan of new credit to make China’s economy grow by 5 trillion yuan per year in 2008, it took 20 trillion yuan of new credit by 2016.

I don’t share Matt’s conclusion that Wall Street fears the broad market will follow Apple (AAPL) into a tailspin as Chinese retail sales decline. I covered this in my last newsletter.

Nor do I think that falling Chinese steel production will plunge the global economy into recession. Though it would certainly affect Australia.

China has $3 trillion of foreign reserves and has shown in the past that it is prepared to spend big to buy its way out of a recession. Whether they succeed this time is uncertain, but old-fashioned stimulus spending will soften the impact.

I believe Wall Street has no idea how the trade dispute will play out. And financial markets have gone risk-off because of the uncertainty, despite a booming US economy.

Earnings ratios have fallen dramatically, back to 17.8, from what was clearly bubble territory above 20 times historic earnings. I use the highest preceding four quarters earnings, to smooth out earnings volatility, so my P/E charts (PEmax) will look a little different to anyone else’s.

S&P 500 PEmax

Market volatility remains high, with S&P 500 Volatility (21-day) above 2.0%. A trough above 1% on the next multi-week rally would confirm a bear market — as would an index retracement that respects 2600.

S&P 500

Momentum shows a strong bearish divergence.

S&P500 Momentum

Similar to the Dotcom era below. It would be prudent to wait for a bullish divergence, as in 2003, to signal the start of the next bull market.

S&P500 Momentum

I repeat the same quote as last week as an important reminder of current market volatility.

What beat me was not having brains enough to stick to my own game – that is, to play the market only when I was satisfied that precedents favored my play. There is the plain fool, who does the wrong thing at all times everywhere, but there is also the Wall Street fool, who thinks he must trade all the time.

~ Jesse Livermore