Trump: This is going to hurt me more than it hurts you

The chart below depicts container traffic at the Port of Los Angeles, the largest volume US container port. Loaded inbound containers (blue), measured in twenty foot units or TEUs, have far exceeded loaded outbound units (red) for a number of years. What is noteworthy is that the ratio of loaded outbound to inbound containers has deteriorated from 48% to 38% over the last 6 years.

Port of Los Angeles Container Traffic

Imposition of tariffs has not reversed this. In fact the opposite. Stats for July 2019 show an 8.7% increase in inbound traffic and a 4.0% decrease in outbound traffic, while the ratio of inbound to outbound containers fell to a new low of 34%.

S&P 500: Plan B

The S&P 500 is testing its all-time high at 2950. Bearish divergence on Twiggs Money Flow warns of secondary selling pressure. Respect of resistance is likely and would signal retracement to test support at 2750.

S&P 500

The 10-Year Treasury yield has fallen to 2.0%, indicating that the Fed is expected to cut interest rates in the second half of 2019.

10-Year Treasury yield

Stocks are still running on hope of a deal in the US-China trade dispute. Xi Jinping and Donald Trump will meet this weekend to discuss the way forward. Chinese preconditions for a trade agreement are likely to include the US lifting its ban on the sale of technology to telecommunications giant Huawei and removal of US tariffs on Chinese imports, according to The Wall St Journal. The US is unlikely to accede and chances of a deal are slim to nonexistent.

Trump doesn’t seem concerned: “My Plan B with China is to take in billions and billions of dollars a month and we’ll do less and less business with them……My plan B’s maybe my plan A.” (Bloomberg)

Plan B is the likely outcome, with a moderate impact on US corporate earnings and Fed rate cuts to keep the market on track. Risks rise while the potential upside declines. It’s a good time to be cautious.

We must recognize that as the dominant power in the world we have a special responsibility. In addition to protecting our national interests, we must take the leadership in protecting the common interests of humanity……There is no other country that can take the place of the United States in the foreseeable future. If the United States fails to provide the right kind of leadership our civilization may destroy itself. That is the unpleasant reality that confronts us.

~ George Soros: The Age of Fallibility

No US-China trade deal

“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.

Market uncertainty is likely to persist as US-China negotiations stall | Bob Doll

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:

  • A trade deal was never going to happen. Long-term objectives of the CCP and the US are in direct conflict and headed for a collision.
  • Trump deserves credit for confronting the issues rather than kicking the can down the road as Obama did (Paul Krugman highlighted the problem in 2010).
  • Trump is the least likely President to negotiate a peaceful resolution to this hegemonic struggle. Diplomacy and building trust are not his forte.
  • Trust is low, eroding any chance of a face-saving public accord.
  • An agreement would simply be a band-aid, not a long-term solution (see my first point).
  • The impact on business will not be catastrophic but earnings growth will slow.
  • The market is unsure how to react. Yet. If it does make up it’s mind that this is bad for business, there won’t be enough room in the lifeboats. A down-turn could be sharp and hard.
  • Sell down to the sleeping point.

” 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)

S&P 500 optimism fades

10-Year Treasury yields are testing support at 2.60%. Breach of support would warn of a further decline in long-term interest rates. Declining yields reflect the outflow of funds from stocks and into safer fixed-interest investments.

10-Year Treasury Yields

Volatility on the S&P 500 has fallen close to 1% but a correction from here would be likely to form a trough above the 1% level, warning of elevated risk. Breach of 2600 would indicate another test of primary support at 2350/2400.

S&P 500 & Twiggs Volatility

Average hourly wages, total private, grew at 3.4% over the last 12 months, while production & non-supervisory wages grew at 3.48%. This keeps pressure on the Fed to raise interest rates as underlying inflationary pressures grow. The dampening effect of the trade dispute with China may have bought the Fed more time but a spike above 3.5% would be difficult to ignore.

Average Hourly Wages Growth

Impact of the trade dispute is more clearly visible on the chart below, with growth in total hours worked retreating below 1.5%. Slowing growth in hours worked warns that real GDP growth for Q1 2019 is likely to disappoint.

Real GDP and Hours Worked

China Trade Talks

US-China trade talks have made little in the way of real progress.

BEIJING—The U.S. and China have yet to set a date for a summit to resolve their trade dispute, the U.S. ambassador to China said Friday, as neither side feels an agreement is imminent. (Wall St Journal)

There is opposition to concessions on both sides:

China has a secret program to support the microchip and software industries. That’s according to Wang Jiangping, Vice Minister of Industry and Information Technology. Wang was speaking to CPPCC delegates at the Two sessions on Thursday, but the comments leaked to reporters (FX678):

“Last year, the Ministry of Industry and Information Technology planned the ‘Zhengxin Zhuhun’ project under the leadership of the Party Central Committee and the State Council.”
“The state will give strong policy and funding support, because industries such as microchips and software need to be iteratively developed.”

Wang said the ministry had kept the policy under wraps. That’s presumably because of the recent international backlash to the Made in China 2025 program…..Wang’s comments have already disappeared from the Chinese internet.

Get smart: Given Xi’s self-reliance push in key technologies, nobody really thought China would give up its industrial policies for these sectors. (Trivium China)

Whoever leaked Wang’s comments was not trying to make trade negotiations any easier. Impact of the trade dispute is starting to emerge in both economies but resolution and enforcement of a trade agreement is a long and tenuous path.

Hope is an expensive commodity. It makes better sense to be prepared.

~ 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.

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

Australia: Good news and bad news

First, the good news from the RBA chart pack.

Exports continue to climb, especially in the Resources sector. Manufacturing is the only flat spot.

Australia: Exports

Business investment remains weak and is likely to impact on long-term growth in both profits and wages.

Australia: Business Investment

The decline is particularly steep in the Manufacturing sector and not just in Mining.

Australia: Business Investment by Sector

But government investment in infrastructure has cushioned the blow.

Australia: Public Sector Investment

Profits in the non-financial sector remain low, apart from mining which has benefited from strong export demand.

Australia: Non-Financial Sector Profits

Job vacancies are rising which should be good news for wage rates. But this also means higher inflation and, down the line, higher interest rates.

Australia: Job Vacancies

The housing and financial sector is our Achilles heel, with household debt climbing a wall of worry.

Australia: Housing Prices and Household Debt

House prices are shrinking despite record low interest rates.

Australia: Housing Prices

Broad money and credit growth are slowing, warning of a contraction.

Australia: Broad Money and Credit Growth

Bank profits remain strong.

Australia: Bank Profits

But capital ratios are low, with the bulk of profits distributed to shareholders as dividends. The ratios below are calculated on risk-weighted assets. Raw leverage ratios are a lot weaker.

Australia: Bank Capital Ratios

One of the primary accelerants of the housing bubble and household debt has been $900 billion of offshore borrowings by domestic banks. The chickens are coming home to roost, with bank funding costs rising as the Fed hikes interest rates. In the last four months the 90-day bank bill swap rate (BBSW) jumped 34.5 basis points.

The banks face a tough choice: pass on higher interest rates to mortgage borrowers or accept narrower margins and a profit squeeze. With an estimated 30 percent of households already suffering from mortgage stress, any interest rate hikes will impact on both housing prices and delinquency rates.

I continue to avoid exposure to banks, particularly hybrids where many investors do not understand the risks.

I also remain cautious on mining because of a potential slow-down in China, with declining growth in investment and in retail sales.

China: Activity

Does China have the ‘financial arsenic’ to ruin the US?

The media has been highly critical of Donald Trump’s threatened tariff war with China, suggesting that China has the stronger hand.

Twitter: US-China trade deficit

I disagree on two points:

  1. Trump is right to confront China. Even Paul Krugman, not a noted Trump supporter, called for this in 2010.
  2. China’s position may not be as strong as many assume. Ambrose Evans-Pritchard sums this up neatly in The Age:

The Bank for International Settlements says offshore dollar debt has ballooned to $US25 trillion in direct loans and equivalent derivatives. At least $US1.7 trillion is debt owed by Chinese companies, often circumventing credit curbs at home. Any serious stress in the world financial system quickly turns into a vast dollar “margin call”. Woe betide any debtor who had to roll over three-month funding.

The Communist Party leadership will not kowtow to Donald Trump.

Photo: Bloomberg

The financial “carry trade” would seize up across Asia, now the epicentre of global financial risk. Nomura said the region is a flashing map of red alerts under the bank’s predictive model of future financial blow-ups. East Asia is vulnerable to any external upset. The world biggest “credit gap” is in Hong Kong where the overshoot above trend is 45 per cent of GDP. It is an accident waiting to happen.

China is of course a command economy with a state-controlled banking system. It can bathe the economy with stimulus and order lenders to refinance bad debts. It has adequate foreign reserve cover to bail out its foreign currency debtors. But it is also dangerously stretched, with an “augmented fiscal deficit” above 12 per cent of GDP.

It is grappling with the aftermath of an immense credit bubble that has pushed its debt-to-GDP ratio from 130 per cent to 270 per cent in 11 years, and it has reached credit saturation. Each yuan of new debt creates barely 0.3 yuan of extra GDP. The model is exhausted.

China has little to gain and much to lose from irate and impulsive gestures. Its deep interests are better served by seeking out the high ground – hoping the world will quietly forgive two decades of technology piracy – and biding its time as Mr Trump destroys American credibility in Asia.

Trade Wars: Playing hardball with China

Remember North Korea and the imminent nuclear war? With leaders trading insults on Twitter and bragging: “My nuclear button is bigger than yours.” It may resemble a WWF arena more than international diplomacy but that is how Donald Trump conducts foreign affairs.

The current Twitter war over trade tariffs is no different. Threat and counter-threat of wider and deeper trade tariffs are likely to bounce back-and-forth over the next few weeks. Xi Jinping thinks he has the upper hand because he doesn’t face criticism from a hostile media at home. Nor does he need to front up to a hostile domestic opposition. They’re all safely tucked away in jail. His stock market has already crashed, so there is not too much to worry about on that front either.

Shanghai Composite Index

Xi will do his best to undermine Trump’s shaky support. Targeting Trump’s electoral base with tariffs on soy bean imports (farming states) and steel tubing (Texas) in order to undermine his support. Targeting technology companies like Boeing and Apple, where China is a large slice of their global market, is also likely to elicit strenuous lobbying in Washington. As are well-timed tweets aimed at undermining stock support levels, threatening a major stock market rout.

Dow Jones Industrial Average

Trump probably recognizes that China can withstand more pain, but figures that he has the capacity to inflict more pain. The US has a large trade deficit with China.

Twitter: US-China trade deficit

And exports comprise a larger percentage of China’s GDP.

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.

I believe that Krugman’s original 2010 argument is still valid and that Trump is right in confronting China. The gap between imports and exports of goods is widening, especially since 2014, not shrinking.

Exports and Imports: Value of Goods for China

But let’s hope that Trump has done his homework. At this stage this is just a Twitter war rather than a trade war, intended to soften up your opponent rather than inflict real damage. But for Trump to succeed he must demonstrate that the US is prepared to endure the pain of a lengthy trade war if needed.

Men naturally despise those who court them, but respect those who do not give way to them.

~ Thucydides (circa 400 BC)