This week’s doji on the S&P 500 signals hesitancy. Reversal below the mid-point of the previous week’s candle would complete a bearish doji star reversal. Breach of support at 2750 would further strengthen the bear signal, warning of a test of 2400.
Small caps are a lot weaker, with the Russell 2000 (iShares ETF) testing support at 145. Breach would warn of a test of primary support.
“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019
Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. To do so would be admitting defeat. Kow-towing to Trump would totally undermine Xi’s standing in China.
Annual employment growth is falling while average hourly earnings growth remains high. This is typical. Ahead of the last two recessions (gray bars below), average hourly earnings growth (green) held steady while employment growth (blue) declined.
If annual employment growth (blue line on the above chart) falls below 1.0% then a Fed rate cut is almost guaranteed. Not something to celebrate though, as the gray bars and further job losses illustrate.
Declining growth in hours worked points to lower GDP growth in the second quarter.
From Bob Doll at Nuveen:
“China is taking a tough stance toward the U.S. on trade. Chinese officials appear open to ongoing negotiations, but a recently released statement denies the country’s role in intellectual property theft, blames the U.S. for negotiation breakdowns and calls out the damage done to the American economy as a result of the dispute. All of this suggests that trade issues will persist for some time.”
The CCP is upset that they are now being called out for bad behavior when this should have been addressed years ago. Conflict can no longer be avoided and is likely to last for a generation or more.
“On Monday, US President Trump told reporters that he would impose tariffs on an additional USD 300 billion of Chinese goods if Xi Jinping doesn’t meet with him in Japan.” ~ Trivium China, June 12, 2019
Trump is doing his best to kill any chance of a trade deal. He is making it impossible for Xi to turn up for a G20 meeting. Kow-towing to Trump would totally undermine Xi’s standing in China.
Xi wants a trade deal that is a handful of empty promises, so the CCP can continue on their present course. The US wants an enforceable undertaking, so that the CPP is forced to change course. Chances of both achieving what they want are negligible.
Both sides need to guard against economic war (time to call it what it is) slipping into a full-scale conflict. All it takes is a spark that sets off tit-for-tat escalation where neither side will back down.
Proxies such as North Korea, Syria and Pakistan are especially dangerous as they are capable of dragging great powers into direct confrontation (think Serbia before WWI, Korea after WWII).
Wannabe great powers like Russia will also do their best to foment conflict between their larger rivals. Stalin achieved this with the Korean War in the 1950s and Vladimir Putin is more than capable of attempting the same. The world is a dangerous place.
Upside potential for stocks is declining while downside risks are growing. Investors are flowing out of equities and into Treasuries despite minimal yield (10-year yield is negative after inflation and tax).
Stocks are being supported by buybacks but that can only continue for as long as cash flows (from earnings) hold up. Buybacks plus dividends for the S&P 500 exceeded reported earnings by more than $100 billion in Q4 2018.
That is unsustainable. If earnings undershoot, stocks will fall.
The market is excited at the prospect of Fed rate cuts (in response to the US-CCP trade war), with the S&P 500 headed for another test of its earlier high at 2950. A Trend Index trough above zero indicates short-term buying pressure.
Falling bond yields, however, warn of a flight to safety. 10-Year Treasury yields have fallen close to 120 basis points (bps) since late 2018, as investors shift from equities to bonds. Prices are being supported by stock buybacks rather than investor inflows.
The Yield Differential between 10-year (purple) and 3-month (lime) Treasury yields is now negative, a reliable early warning of recession.
Corporate bond spreads, the difference between lowest investment grade (Baa) and Treasury yields, are rising. An indicator of credit risk, a spread above 2.5% (amber) is an early warning of trouble ahead, while 3.0% (red) signals that risk is elevated.
Falling employment growth is another important warning. Annual employment growth below 1.0% (amber) would normally cause the Fed to cut interest rates. In the current scenario, that is almost certain.
What is holding the Fed back is average hourly wages. Annual growth above 3.0% is indicative of a tight labor market and warns against cutting rates too hastily.
Stats for Q1 2019 warn that compensation is rising as a percentage of net value added, while profits are falling. As can be seen from the previous two recessions (gray bars), rising compensation (as % of NVA) normally leads to falling profits and a recession. Cutting interest rates would accelerate this.
Annual GDP growth came in at 3.2% (after inflation) for the first quarter, but growth in hours worked is slowing. GDP growth is likely to follow.
Personal consumption expenditure for Q1 was largely positive, with an uptick in services and non-durable goods. But consumption of durable goods fell sharply, warning that consumer confidence in the medium-to-long-term is declining.
On the global stage, commodity prices are falling, indicating an anticipated drop in demand, especially from China.
Nymex crude is following, and expected to test support between $40 and $45 per barrel.
Short-term prospects may appear reasonable, but the long-term outlook is decidedly negative.
In the short run, the market is a voting machine but in the long run, it is a weighing machine.
~ Benjamin Graham
Realization that we are slipping into a trade war is starting to sink in.
The S&P 500 broke medium-term support at 2800, warning of a correction. The target is primary support at 2400. Volatility is flashing an amber warning, above 1.0%.
Nymex crude is plunging as anticipated global demand falls.
Long-term Treasury yields are falling, with the 10-Year headed for a test of support at 2.0%. The Yield Differential (purple line) is back below zero, warning of a recession.
As I have mentioned earlier, a negative yield curve is a reliable early indicator of recession but trouble is imminent when it recovers above zero. Normally caused by the Fed cutting interest rates in response to falling employment growth. The critical indicator to watch is non-farm payroll growth. When that falls below 1.0% (right-hand scale), watch out!
War is an evil thing; but to submit to the dictation of other states is worse…. Freedom, if we hold fast to it, will ultimately restore our losses, but submission will mean permanent loss of all that we value…. To you who call yourselves men of peace, I say: You are not safe unless you have men of action on your side.
~ Thucydides (circa 400 BC)
From Bob Doll at Nuveen:
“There have been several risk-off phases this decade, triggered by economic threats due to politically induced setbacks. However, the current sluggish global economy and weak trade, coupled with escalating trade tariffs and non-tariff barriers, is a worrisome combination. This is especially true because once protectionism has gained momentum, it may prove difficult to stop or reverse. While many risk asset prices are only off modestly from April highs, there’s an ominous undercurrent in global financial markets.
We have assumed that the pro-growth bias of both the U.S. and China would lead to a trade truce. That premise looks increasingly questionable, although a deal is always possible. Given that financial markets have not reacted more significantly, investors are still generally expecting the global economic expansion to persist.
Despite the longer-term power struggle, the constructive case for a trade deal between the U. S. and China was predicated on President Trump focusing on the short-term win, while the Chinese look to the longer-term. This difference in political time horizons made a deal possible. Now, the focus for both parties has shifted to long-term strategic objectives, resulting in a stalemate. A financial market downturn may be needed to break the impasse. An extended period of churning could develop if trade talks resume, but without signs of a resolution.
The current market weakness differs from prior periods of economic uncertainty during this decade. There has always been a path to a positive outcome for growth and risk assets, primarily via additional policy stimulus. However, the economic and market outcome this time has become more uncertain, and time will not work towards a positive outcome unless trade negotiations improve. Business sentiment will erode if mounting trade roadblocks and uncertainty do not diminish. Protectionism tops the list of recession catalysts, and a permanent deterioration in U.S./China trade relations could have adverse long-term revenue ramifications for global trade and growth.”
My thoughts:
” I am carrying so much cotton that I can’t sleep thinking about it. It is wearing me out. What can I do?”
“Sell down to the sleeping point,” answered the friend.~ Edwin Lefevre: Reminiscences of a Stock Operator (1923)
We are now headed for a full-blown trade war. Donald Trump may have highlighted the issue but this is not a conflict between him and Xi — it should have been addressed years ago — nor even between China and the West. Accusations of racism are misguided. This is a conflict between totalitarianism and the rule of law. Between the CCP (with Putin, Erdogan, and the Ayatollahs in their corner) and Western democracy.
Australia will be forced to take sides. China may be Australia’s largest trading partner but the US & UK are it’s ideological partners. I cannot see the remotest possibility of Australia selling out its principles for profits, no matter how tempting the short-term rewards (or threatened hardships). We have a proud history of standing up against oppression and exploitation.
Disruptions to supply chains and supply contracts in the US (and China) are going to be significant and are likely to impact on earnings. The S&P 500 reaction is so far muted, with retracement testing medium-term support at 2800. There is also no indication of selling pressure on the Trend Index. Nevertheless, a breach of 2800 is likely and would warn of a test of primary support at 2400.
Falling Treasury yields highlight the outflow from equities and into bonds. Stock buybacks are becoming the primary inflow into stocks.
However, corporate bond spreads — lowest investment grade (Baa) yields minus the equivalent Treasury yield — are still well below the 3.0% level associated with elevated risk.
Profits may fall due to supply disruption (similar to 2015 on the chart below) but the Fed is unlikely to cut interest rates unless employment follows (as in 2007). Inflation is likely to rise as supply chains are disrupted but chances of a rate rise are negligible. Fed Chairman Jay Powell’s eyes are going to be firmly fixed on Total Non-farm Payrolls. If annual growth falls below 1.0% (RHS), expect a rate cut.
This excerpt from a newsletter I wrote in April 2018 (Playing hardball with China) is illuminating: “In 2010, Paul Krugman wrote:
Some still argue that we must reason gently with China, not confront it. But we’ve been reasoning with China for years, as its surplus ballooned, and gotten nowhere: on Sunday Wen Jiabao, the Chinese prime minister, declared — absurdly — that his nation’s currency is not undervalued. (The Peterson Institute for International Economics estimates that the renminbi is undervalued by between 20 and 40 percent.) And Mr. Wen accused other nations of doing what China actually does, seeking to weaken their currencies “just for the purposes of increasing their own exports.”
But if sweet reason won’t work, what’s the alternative? In 1971 the United States dealt with a similar but much less severe problem of foreign undervaluation by imposing a temporary 10 percent surcharge on imports, which was removed a few months later after Germany, Japan and other nations raised the dollar value of their currencies. At this point, it’s hard to see China changing its policies unless faced with the threat of similar action — except that this time the surcharge would have to be much larger, say 25 percent.
I don’t propose this turn to policy hardball lightly. But Chinese currency policy is adding materially to the world’s economic problems at a time when those problems are already very severe. It’s time to take a stand.
Krugman (no surprise) now seems more opposed to trade tariffs but observes:
….I think it’s worth noting that even if we are headed for a full-scale trade war, conventional estimates of the costs of such a war don’t come anywhere near to 10 percent of GDP, or even 6 percent. In fact, it’s one of the dirty little secrets of international economics that standard estimates of the cost of protectionism, while not trivial, aren’t usually earthshaking either.”
Trump has to show that he is prepared to endure the hardships of a trade war and not kowtow to Beijing. But the chances of a reasonable response are unlikely.
Men naturally despise those who court them, but respect those who do not give way to them.
~ Thucydides (circa 400 BC)
“On Wednesday, the US Department of Commerce added Huawei – and 70 other companies – to its “Entity List.” …. Huawei cannot buy parts or components from US companies without the explicit approval of the US government.” (Trivium China)
We are sliding towards a fully-fledged trade war. Following straight after the imposition of tariffs by both the US and China, US action against Huawei will be taken as a direct attack on Chinese industry.
The CCP is already stoking nationalist sentiment to bolster public support.
“Last night and today, CCTV replaced regularly scheduled programming with two films about the Chinese army fighting the US in the Korean War.” (Trivium China)
Market response is so far muted. On the daily chart, the S&P 500 correction is modest. Expect another test of 2800. Breach would offer a target of 2600.
The Nasdaq 100 retreated below its new support level at 7700 but Money Flow remains strong.
China’s Shanghai Composite found support at 2900.
Japan’s Nikkei 225 is ranging between 20000 and 24000. Expect another test of primary support at 20000.
India’s Nifty is testing support at 11000. Respect would confirm the primary up-trend.
In Europe, The DJ Euro Stoxx 600 is undergoing a correction that is likely to test support at 365. But Trend Index above zero continues to signal buying support.
The Footsie found support at 7200, with Trend Index again signaling buying support.
10-Year Treasury yields are testing support at 2.40%. One of the few clear signs that markets are growing increasingly risk averse, as demand for bonds drives down yields.
Robert Shiller’s CAPE (Price/10-year simple MA of inflation-adjusted earnings) is at 30.31, the second-highest peak (behind the Dotcom bubble) in 120 years.
PEmax (Price/highest prior 12-month earnings) is far lower at 21.04. I prefer this as a more accurate measure of stock pricing than CAPE. But PEmax is still high relative to the peaks of Black Friday in October 1929 and Black Monday in October 1987.
Forecast earnings for the remainder of 2019 may be slightly optimistic, given recent escalation of the US-China trade war, but the forward price-earnings multiple is lower, at 18.62. The sharp difference between forward and historic PE ratios (as in PEmax) is largely attributable to the earnings hiccup in Q4 of 2018 which is excluded from the forward ratio.
Forecast earnings growth, on the chart below, shows a similar anomaly in Q4 of the current year, caused by comparison to the earnings dip in Q4 of 2018. Forecasts assume that earnings will grow between 7.1% and 7.8% for the rest of 2019, rising to above 11% in 2020.
Their projections seem optimistic.
Year-on-year sales growth is a modest 5.8% for Q1 of 2019 and is likely to continue between 4.0% and 6.0% for the foreseeable future. The spike in sales growth in 2017 – 2018 is a result of recovery from negative growth in 2015 and is unlikely to be repeated.
Operating margins are just as important. Margins recovered to 11.25% for Q1 2019 (89.9% of stocks reported), after a sharp fall in Q4 2018, but it is questionable whether these are sustainable.
Earnings forecasts seem optimistic. With lower sales growth and downside risk in operating margins, long-term earnings growth of between 4.0% and 6.0% is likely. The 30-year average is 6.17% p.a. but low inflation (and a possible trade war) is likely to see us undershoot this.
Forward Price-Earnings ratio of 18.6 is on the high side for expected low earnings growth. A forward PE of 16.0 or less, however, should be viewed as a buy opportunity.
It looks like there will be no trade deal any time soon.
“Trade talks between China and the United States ended on Friday without a deal as President Trump raised tariffs on $200 billion worth of Chinese imports and signaled he was prepared for a prolonged economic fight….. Trump is now moving ahead with plans to impose 25 percent tariffs on all remaining Chinese imports. Those new tariffs could go into effect in a matter of weeks.” (New York Times)
Signature of a document was always going to be more theater than substance. Earlier in Bloomberg:
“U.S. President Donald Trump has good reason to be skeptical about China’s willingness to live up to its commitments in any trade deal. Seasoned foreign business executives on the mainland know that any agreement there represents the start of a bargaining process, not the end….”
Response of stock markets, to signs that negotiations had reached an impasse, were muted. The pull-back on the S&P 500 is modest.
The Nasdaq 100 retreated below its new support level at 7700 but the Trend Index remains strong.
China’s Shanghai Composite is undergoing a correction but this week’s long tail suggests selling pressure is moderate.
The yuan fell sharply, acting as a shock-absorber.
Stocks like Boeing and Apple may be re-rated but the broad view of the market seems largely unchanged.
