Category: US & Canada

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Trade talks: ‘Extend and pretend’

Donald Trump

Donald Trump has been weakened by the impeachment process, with more than half the respondents in a recent Fox News poll wanting the troubled President impeached:

“A new high of 51 percent wants Trump impeached and removed from office, another 4 percent want him impeached but not removed, and 40 percent oppose impeachment altogether.”

Criticism in the right-wing press is growing, with Judge Andrew Napolitano on Fox News:

“A CIA agent formerly assigned to the White House – and presently referred to as the “whistleblower” – reported a July 25, 2019 telephone conversation that Trump had with Ukraine’s President Volodymyr Zelensky. That conversation manifested both criminal and impeachable behavior.

The criminal behavior to which Trump has admitted is much more grave than anything alleged or unearthed by Special Counsel Robert Mueller, and much of what Mueller revealed was impeachable….”

In an attempt to shore up his ratings, the embattled President has softened  his stance towards an interim trade deal with the Chinese.

“President Donald Trump said Friday that the U.S. and China had reached a “substantial phase one deal” on trade that will eliminate a tariff hike that had been planned for next week.

Trump announced the deal in the Oval Office alongside members of his economic and trade teams, as well as Chinese Vice Premier Liu He and his team, who were in Washington for negotiations.

Trump said the deal would take three to five weeks to write and could possibly be wrapped up and signed by the middle of November….”

The deal is likely to be limited in scope, which will suit China. More from NBC News:

“The White House and China are expected to announce that Beijing will buy more agricultural products, particularly pork and soybeans, from the U.S.

“It seems like they’ve already begun to buy pork,’ said Jacob Kirkegaard, a senior fellow at the Peterson Institute for International Economics, pointing out that a swine fever epidemic has decimated China’s domestic pork industry. “They want to contain domestic prices,’ he said. “They’re not doing this just to please Trump. They’re doing this because it suits them.’

While there is little expectation that the Trump administration would roll back existing tariffs, a further delay of two looming deadlines would send a key signal to the markets about the trajectory for future trade relations……”

None of the hard issues will have been addressed and an interim deal is effectively a retreat by the Trump administration:

Thornier — and more fundamental — trade issues pertaining to intellectual property protections, market access and America’s push for China to change its legislation around these and other contentious issues would likely fall by the wayside, analysts said. “There aren’t going to be any of these other issues addressed, unless Trump caves,’ Kirkegaard said. “It certainly doesn’t address any of the structural issues…he went to war for.’

….“It’s a ceasefire. It’s not a peace treaty,’ Kirkegaard said. “It’s what the Chinese wanted all along.”

This was always the likely outcome, with the US economy in a stronger position to withstand a trade war but Xi and the CCP stronger politically and able to absorb more domestic pressure than the fragile Trump administration.

What we are likely to get during Trump’s remaining time as President is more ‘extend and pretend’ — a ceasefire rather than a resolution of the underlying issues regarding protection of intellectual property and reciprocal market access.

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Ultra-low interest rates may lead to a ‘debt trap’

The highly-regarded Stephen Bartholomeusz warns that central bank policies may lead to a ‘debt trap’:

“….With the world apparently re-starting the use of unconventional monetary policies even before central banks have extricated themselves from the legacies of a decade of those policies, there is a real risk that the impacts and the threats posed by their side effects will swell and that the world will be caught within what the BIS has previously described as a “debt trap’’ with no exit.

The other disturbing aspect of the [BIS] report is that it repeatedly says it is too early to assess the longer-term implications of the policies the central banks have employed.

Central bankers respond to the latest data – they respond to short-term signals – but the side-effects of their post-crisis policies have already been building for a decade and will continue to build while they maintain ultra-low or negative policy rates and keep buying bonds and other fixed interest securities to depress longer-term interest rates and suppress risk premia.

How those side-effects are unwound and how the banks extricate themselves from their policies and the legacies of those policies won’t be known until they try, but the potential for another crisis has been increased by the big surge in global leverage and the elevated asset prices the policies have encouraged.

Negative rates and quantitative easing and variations on those themes might, as the BIS report says, be useful additions to central bankers’ toolboxes but the past decade has shown they aren’t by themselves a panacea for economic ills and they bring with them potentially unpleasant side effects the longer they are in place.”

Debt traps occur when the interest rate needed to service the government debt is greater than the growth rate of GDP, according to former Fed governor Robert Heller:

“…In such a situation, debt service obligations grow more rapidly than the economy; eventually, the accumulated debt can no longer be serviced properly. In other words, the dynamics of the situation become unsustainable and a death spiral ensues.”

So far, central banks have responded by driving interest rates to record lows but unintended consequences are emerging, with low interest rates leading to low GDP growth. A feedback loop is emerging:

    • Low interest rates

Australia: 10-Year Bond Yield

    • Low bank interest margins

Australia: Bank Net Interest Margins

    • Low credit growth

Australia: Credit & Broad Money Growth

    • Low inflation

Australia: Underlying Inflation

    • And low economic growth

Australia: GDP Growth

We are venturing where angels fear to tread: central banks trialing new policies without empirical evidence as to their long-term consequences.

Monetary policy should be administered judiciously, intervening only when the financial system is in dire straits, outside the realm of the regular business cycle. Instead monetary policy is treated as a panacea, the constant drip-feed building a long-term dependence on further stimulus.

The problem with ‘traps’ is that they are difficult to escape.

“If you find yourself in a hole, the first thing to do is stop digging.”

~ Will Rogers

[NOTE: I should clarify that Australia has relatively low fiscal debt and is not in any immediate danger of a debt trap. But the ‘lucky country’ would suffer severely from fallout if the US or China were caught in a debt trap.]

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S&P 500 survives but risk is elevated

Our recession indicator, a 3-month TMO of seasonally adjusted non-farm payrolls, ticked up slightly to 0.52%. This reflects a slight improvement in monthly employment data but the indicator remains precariously close to the amber (high risk) warning level of 0.50%. The red warning level of 0.30% would signal extreme risk of recession.

Non-Farm Payrolls Recession Indicator

During the week we discussed the high cost of uncertainty and how this impacts on business investment and consumer spending. Slowing growth in hours worked suggests that real GDP growth is likely to slow towards an annual rate of 1.0%. This would obviously be a drag on stock earnings.

Real GDP and Hours Worked

The S&P 500 retreated from resistance at 3000 but a long tail on this week’s candle indicates buying support. Another test of 3000 is likely. Breach of 2800 is unlikely at present but would signal a reversal with a target of 2400.

S&P 500

21-Day Volatility remains high and the recent trough above 1.0% warns of elevated risk.

S&P 500 21-Day Volatility

The plunge on 10-Year Treasury Yields, testing support at 1.5%, also warns of a risk-off environment.

10-Year Treasury Yields

On the global stage, low manufacturing purchasing managers index (PMI)  warn that Europe is at risk of recession.  DJ Euro Stoxx 600 is retracing to test support at 360/366. Breach would signal a primary down-trend.

DJ Euro Stoxx 600

The Footsie is similarly testing support at 7000.

FTSE 100

Nymex Crude is heading for a test of support at $50/barrel. Trend Index peaks below zero warn of selling pressure. Breach of support would signal a primary down-trend — suggesting a contraction in global demand.

Nymex Light Crude

The outlook for the global economy is bearish and we have reduced our equity exposure for International Growth to 34% of portfolio value.

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The high cost of uncertainty

High levels of uncertainty in international trade, geopolitical outlook, and domestic politics in the USA are likely to have a domino effect on business and consumer confidence.

Business is likely to postpone or curtail new investment decisions. This is already evident in a down-turn in new capital formation, along with GDP growth, in the first half of the calendar year.

New Capital Formation

A similar picture is emerging in construction spending.

Construction/GDP

CEO confidence levels are way down.

CEO Confidence Levels

A slow-down in business investment in turn impacts on employment, causing a decline in payroll growth and average weekly hours worked.

Non-farm Payroll Growth and Weekly Hours Worked

Which in turn impacts on consumer sentiment as employees’ anticipation of future earnings declines.

Consumer Sentiment

The feedback loop will be completed if consumption falls. Retail sales dipped sharply in late 2018 but are keeping their head above water.

Retail Sales

And purchases of durables, like light motor vehicles, have leveled off but there is no significant decline so far.

Light Vehicle Sales (Units)

New housing starts and building permits even kicked up in August in response to lower interest rates.

Housing Starts

Consumers have, so far, continued spending but a down-turn in the stock market would weigh heavily on sentiment and consumption.

The S&P 500 broke its rising trendline, indicating a correction. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure and a test of support at 2800. Breach of support is by no means certain but would offer a target of 2400.

S&P 500

We have reduced our equity exposure for International Growth to 34% of portfolio value because of our bearish outlook for the global economy.

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Fedex breaks support

Bellwether transport stock Fedex (FDX) broke long-term support at 150, warning of a decline with a long-term target of 100. A down-trend on Fedex has bearish implications for the broader economy, signaling that activity is declining.

Fedex

We have been here before: November 2007 – Fedex Warns of Worse to Come.

A down-turn in durable goods orders (adjusted for inflation) reinforces our bearish outlook.

Durable Goods Orders

The S&P 500 is retreating from resistance at 3000. Expect a test of support at 2800. Breach remains unlikely but would signal a reversal with a target of 2400.

S&P 500

With year-on-year earnings growth projected at a low 2.1% for the third quarter, the forward price-earnings ratio remains high at 18.97 times forecast earnings. A rough rule-of-thumb:

  • below 15 is a buy signal; and
  • above 20 is a sell signal.

But when long-term growth prospects are low, then both levels should be adjusted downward.

S&P 500 Forward PE

On the global front, crude has recovered from the attack on Saudi Arabia. Follow-trough below $55/barrel would signal another test of long-term support at $50. Trend Index peaks below zero warn of selling pressure.

Nymex Light Crude

DJ-UBS Commodity Index likewise displays Trend Index peaks below zero. Expect another test of support at 76. Breach would signal a (primary) decline.

DJ-UBS Commodities Index

The outlook for commodities — and the global economy — remains bearish.

We have reduced our equity exposure for International Growth to 36% of portfolio value because of our bearish outlook on the global economy.

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Gold: Reasons for the up-trend

Gold is in a medium- to long-term up-trend. Apart from record central bank purchases of bullion and a weakening Chinese Yuan, real long-term interest rates are declining.

The chart below highlights the inverse relationship between gold and real long-term interest rates (10-year Treasury yield minus CPI YoY%). When LT interest rates fall, gold prices surge.

Spot Gold in USD compared to Real 10-Year Treasury Yields

Treasury yields are falling because the Fed is cutting short-term interest rates but, more importantly, because QE has resumed. With the ECB driving bond yields into the negative, demand for Treasuries is surging.

The Fed has also reversed course, expanding their balance sheet after the recent liquidity squeeze forced them to resume overnight repos.

Fed Total Assets and Excess Reserves on Deposit

Our target for Gold is the 2012 high of $1800/ounce.

A weak rally strengthens the bearish argument for China’s Yuan, suggesting continuation of the primary down-trend.

CNYUSD

The Yuan is in a long-term down-trend against the Dollar that shows no signs of easing. Resolution of trade tensions is unlikely. Trade is merely the tip of the iceberg in a far wider clash between two global powers with conflicting ideologies which is likely to continue for decades.

Gold is testing support at $1495/ounce. Breach would warn of a correction.

Spot Gold in USD

Silver is similarly testing support. Breach of $17.50/ounce is likely and would warn of a correction, with Gold expected to follow.

Spot Silver in USD

The All Ordinaries Gold Index is trending lower. Breach of 7200 would warn of another decline, with a short-term target of 6500.

All Ordinaries Gold Index

Patience is required. Gold remains in a long-term up-trend and a correction may offer a sound entry point.

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The canary in the coal mine

Bellwether transport stock Fedex (FDX) is testing long-term support at 150. Peaks close to zero on the Trend Index warn of selling pressure. Breach of support would warn of a decline with a long-term target of 100.

Fedex

Breach of LT support would also be a bearish sign for the US economy, warning that economic activity is weakening.

The S&P 500 is testing resistance at 3000. Expect stubborn resistance followed by a test of support at 2800. Breach of 2800 would flag a reversal with a target of 2400.

S&P 500

Dow Jones – UBS Commodity Index rallied strongly with the Saudi oil price shock but finished the week with a strong bearish reversal signal. Expect another test of support at 76. Breach would signal a (primary) decline. We maintain our bearish long-term outlook for commodities.

DJ-UBS Commodities Index

We have reduced our equity exposure to 36% of (International Growth) portfolio value because of our bearish outlook on the global economy.

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Robert Shiller’s warning

Nobel prize-winning economist Robert Shiller warns that cracks are once again surfacing in the US housing market.

“We have had a strong housing market for pretty much all the time since 2012. Just after the financial crisis, the housing market didn’t recover, maybe because banking was in disarray and people were still expecting declines after the event. After 2012, it started going up at more than 10 per cent a year nationwide in the US, and has been slowing down since.”

Shiller says that a worrying pattern emerging in house prices is reminiscent of the property market in the run-up to the Great Recession.

The bursting of the US housing bubble in 2006-07 was a key trigger of the financial crisis…… “I have seen this happen before, we’re like back in 2005 again when the rate of increase in home prices was slowing down a lot but still going up.

Case Shiller Index

Growth in the Case Shiller National Home Price Index is clearly weakening but we need to be careful of confirmation bias where we “cherry-pick” negative news to reinforce a bearish outlook. I would take the present situation as an “amber” warning and only a drop below zero (when house prices fall) as a red flag.

Shiller has an enviable reputation for predicting recessions, having warned of the Dotcom bubble in tech stocks and the housing bubble ahead of the 2008 global financial crisis. He is correct that narratives (beliefs) can become self-fulfilling prophecies. If the dominant view is that the economy will contract, then it probably will — as corporations stop investing in new capacity and banks restrict lending. Geo-political tensions — US/China, UK/EU Brexit, and Iran/Saudi Arabia — combined with massive uncertainty in global trade and oil markets, could quickly snowball into a full-blown recession.

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Witching hour on Friday

“Witching hour” refers to the last hour of trading on days, normally the third Friday of the month, when there is a simultaneous expiry of options and futures in derivatives markets. Traders who don’t roll-over into a new contract are forced to cover their positions, which can lead to massive intra-day volatility in underlying markets.

“Quadruple witching” happens four times each year — on the third Friday of March, June, September, and December — when index futures, index options, stock futures, and stock options expire simultaneously. With that level of futures and options expiring, trading volume in equities usually spikes in the last hour.

Spot the June and September witching hours on the chart below.

Witching Hour June & September 2018

Note that June had witching hours on Friday 15th and 22nd. Also note that there was not a lot of price movement despite the heavy trading volumes. That’s not to say that witching hour is incapable of disrupting an already unstable market but it’s unlikely to have a long-term impact if conditions are settled.

After the liquidity squeeze earlier this week, it’s important to keep an eye on this.

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Predicting recessions with payroll and unemployment data

Recessions are notoriously difficult to measure (even the NBER occasionally gets it wrong) and an official declaration of a recession may be lagged by more than 6 months. Economist Claudia Sahm devised the Sahm Rule, using changes in unemployment levels, as a more timely predictor of recessions.

Sahm rule: US Data

But the signal repeatedly lags the official start date of recessions by several months, limiting its usefulness for investment purposes.

In previous articles I observed that payroll growth is a good predictor of recessions. But payroll growth has been declining for decades; so it has been difficult to devise a one-size-fits-all-recessions rule. Until I turned to using momentum.

Twiggs Momentum is my own variation on the standard momentum formula and I applied this to monthly payroll data to arrive at a 3-month TMO.

Sweden: Sahm rule

The orange band on the above chart reflects the amber warning range, between 0.5% and 0.3%, where recession is likely. If TMO crosses below the red line at 0.3%, risk of recession increases to very high.

When the TMO falls below 0.5%, a recession is likely, but there is one false reading at 0.49% in 1986. So I treat 0.5% as an amber warning level.

There are no false signals below 0.3% in the last 50 years. So I treat the 0.3% level as a red warning — that recession risk is very high.

Some of the signals (e.g. 1975) are late but the TMO has a far better record, than the Sahm Rule, at giving timely warning of recessions.

The August 2019 TMO reading is an amber warning of 0.5%.

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