The Three Big Issues And The 1930s Dialogue – A Safer Market Commentary

Hedge fund titan, Ray Dalio, has another think piece out, and it’s as important as his others. Dalio’s clear, unemotional, math-based analysis describes three big issues we face and how they combine to make today look much like the 1930s. This has important consequences for gold, bonds, and stocks.

Key Points:

• Dalio says three forces explain today’s economic situation.
• First, we are deep in a long-term debt cycle in which central banks have limited ability to stimulate further growth.
• Second, there is a large, growing wealth and income gap within western economies.
• Third, a rising power (China) is challenging the US for global leadership and economic dominance.
• The last time we saw this combination was in the late 1930s.
• We can expect central banks to keep pushing rates lower and buying assets with QE, but it won’t work well.
• Today’s blow-off bond rally is the reciprocal of the 1980-82 blow-off in gold.

Bottom Line: None of this is comforting, but Dalio is not saying we should panic. He says that protecting ourselves from these paradigm shifts will be easier if we understand what caused them and how they work.

Friday’s Jobs Report

Friday morning’s jobs report came out a little weaker than expected and did nothing to dispel recession fears. But, possibly more important is what it tells us about the Federal Reserve’s next move. Peter Boockvar’s flash comments have one answer.

Key Points:

• Labor Department data shows the US economy added 130,000 jobs in August; 30,000 less than economists expected. This report also revised the prior two months lower by combined 20,000.
• The unemployment rate held steady at a historically low 3.7% as job growth matched an increase in the labor force.
• Average weekly earnings rose as both hourly earnings and hours worked showed increases
• Manufacturing job growth slowed while retail continues to bleed jobs.
• Federal government hiring was a big factor (25,000 temporary Census workers hired last month) as well as education/health and leisure/hospitality.
• Between slowing economic growth and trade war worries, businesses seem to be taking a time-out on hiring. But, they’re also hopeful things will get better and are trying to retain their existing workers with higher pay.
• Today’s report probably locks in another rate cut (if there were any doubt), but the Fed can’t print jobs.

Bottom Line: Taking out the government hiring, private sector job growth has averaged 136,000 in the last six months, 165,000 in the past year and was 215,000 in 2018. The trend is clear.

Just How Long Will Markets Keep “Buying It?”

“The biggest reason for last week’s torrid stock market rally was rekindled “optimism” that the escalating trade war between the US and China may be on the verge of another ceasefire following phone conversations, fake as they may have been, between the US and Chinese side. This translated into speculation that a new round of tariffs increases slated for this weekend may not take place or be delayed.” – MarketWatch

However, the “ceasefire” did not happen, and at 12:00 am on Sunday, the Trump administration slapped tariffs on $112 billion in Chinese imports. Then, one-minute later, at 12:01 am EDT, China retaliated with higher tariffs being rolled out in stages on a total of about $75 billion of U.S. goods. The target list strikes at the heart of Trump’s political support – factories and farms across the Midwest and South at a time when the U.S. economy is showing signs of slowing down.

Importantly, the additional tariffs by the White House target consumers directly:

“The 15% U.S. duty hit consumer goods ranging from footwear and apparel to home textiles and certain technology products like the Apple Watch. A separate batch of about $160 billion in Chinese goods – including laptops and cellphones – will be hit with 15% tariffs on Dec. 15. China, meanwhile, began applying tariffs of 5 to 10% on U.S. goods ranging from frozen sweet corn and pork liver to bicycle tires on Sunday.

The slated 15% U.S. tariffs on approximately $112 billion in Chinese goods may affect consumer prices for products ranging from shoes to sporting goods, the AP noted, and may mark a turning point in how the ongoing trade war directly affects consumers. Nearly 90% of clothing and textiles the U.S. buys from China will also be subjected to tariffs.” – ZeroHedge

This is only phase one. On December 15th, the U.S. will hike tariffs on another $160bn consumer goods, and Beijing has vowed retaliatory tariffs that, combined with the Sunday increases, would cover $75 billion in American products once the December tariffs take effect.

These tariffs, of course, are striking directly at the heart of economic growth. The trade war has ground the global economy to a halt, sent Germany into a recession, and is likely slowing the U.S. economy more than headline data currently suggests.

Yet, “optimism” that “a trade deal is imminent” is keeping stocks afloat. For now.

Fed To The Rescue

There is another level of “optimism” supporting asset prices.

The Fed.

It is widely believed the Fed will “not allow” the markets to decline substantially. This is a lot of faith to place into a small group of men and women who have a long history of creating booms and busts in markets.

Currently, there is a 100% expectation of the Fed cutting rates at the September meeting.

Profit Problem For Stocks

This chart from David Wilson at Bloomberg (Morgan Stanley) shows the separation in market gains from earnings growth, which is not positive for stocks.

A Few Observations:

• The blue line plots the S&P 500 Index. The white line plots U.S. after-tax corporate profits.
• Over time, companies grow their earnings, and investors benefit from that growth. After all, we are investing in future growth.
• However, sometimes the markets price gains get too far ahead of earnings growth, and sometimes earnings growth is ahead of price.
• It is best to buy when prices are undervalued (price below earnings growth) – refer to the line in 2002 and 2009-2012.
• It is best to harvest gains when prices are overvalued (price way above earnings growth), such as we saw in 2000.
• U.S. after-tax corporate profits have been flat since 2010, peaked in 2014, and look to be trending lower. Looking at the blue price line relative to the white profits line on the far right-hand side of the chart. Looks a lot like 1999.
• U.S. stocks have fallen off a cliff over the past five weeks. First, they suffered their worst week of the year, then their worst day of the year, then an even worse day. Stocks managed to claw back a bit of the loss over the past week, but the S&P 500 is still down 3% since July 26.
• Wall Street analysts have underestimated the growth in S&P 500 company earnings growth for a year, one of the longest stretches in nearly 30 years.

According to Morgan Stanley Wealth Management, things are going to get worse. The firm says the outlook for US stocks is “not positive” because corporate earnings have stopped growing. Data compiled by the Commerce Department shows that corporate earnings peaked in September 2014 when the S&P 500 was below 2,000. Since then, stocks have rocketed higher while earnings have stagnated. U.S. small-cap earnings growth estimates have deteriorated sharply.

Potential World Problems

At a time when the world economy is already slowing for cyclical reasons, we face three potential shocks, any one of which could trigger a recession:

• The U.S. – China trade and currency war
• A slower-brewing U.S. – China technology cold war (which could have much larger long-term implications)
• Tension with Iran that could threaten Middle East oil exports

The first of those seems to be getting worse. The second is getting no better. I consider the third one unlikely, because neither the U.S. nor Iran would benefit from military conflict. But, someone could miscalculate.

In any case, unlike 2008, which was primarily a demand shock, these threaten the supply of various goods. They would reduce output and thus raise prices for raw materials, intermediate goods, and/or finished consumer products.

Manufacturing export orders tumbled (fastest decline in a decade).

Investors and traders seem to want to believe:

• They want to believe that the trade talks between the U.S. and China will be real this time.
• They want to believe that there is no “earnings recession” even though S&P profits through the first half of 2019 are slightly negative (year over year) and that S&P EPS estimates have been regularly reduced as the year has progressed. (See above).
• They want to believe stocks are cheap relative to bonds even though there is little natural price discovery as central banks are artificially impacting global credit markets, and passive investing is artificially buoying equities.
• They want to believe technicals and price are truth – even though the market’s materially influenced by risk parity and other products and strategies that exaggerates daily and weekly price moves.
• They want to believe today’s economic data is an “all clear” – forgetting the weak ISM of a few days ago, the lackluster auto and housing markets, the U.S. manufacturing recession, and the continued overseas economic weakness.
• They want to believe that, given no U.S. corporate profit growth, valuations can continue to expand (after rising by more than three PEs year to date).
• They want to believe though the EU broadly has negative interest rates and Germany is approaching recession (while the peripheral countries are in recession) – that the Fed will be able to catalyze domestic economic growth through more rate cuts.
• They want to believe the U.S. can be an oasis of growth even though the economic world is increasingly flat and interconnected and the S&P is nearly 50% dependent on non-U.S. economies.

Transportation Stocks Show Weakening Economy In U.S.

On December 3, 2018, the Treasury yield curve inverted for the first time since the Great Recession that began in December 2007. In late March of this year, the size of the yield curve inversion expanded. The inversion has since widened even more, with the yield on the 10-year Treasury bond falling to its lowest level since July of 2016. The curve inversion—the difference in yield between the 10-year and 3-month Treasuries—now stands at -0.52%.

An inverted yield curve has preceded all U.S. recessions since 1955. So, economists consider it a reliable recession indicator. But, it’s not the only indicator. The transportation sector is sending the same signals, according to David Rosenberg, chief economist at Gluskin Sheff & Associates. Rosenberg cites the 6% year-over-year decline in the Cass Freight Index, the 10% plunge in Port of Long Beach cargo traffic, and the 4% slide in US railway freight car loadings as signs of a looming recession.

Small Business Hiring Keeps Weakening

The Fed

The Federal Reserve is on track to do exactly the wrong thing by dropping rates further as the economy weakens. The Fed also did the wrong thing by hiking rates in 2018. They should have been slowly raising rates in 2013 and after. They waited too long, as I wrote both during and after that period. This long string of mistakes leaves policymakers with no good choices now.

The best thing they can do is nothing, but that’s apparently not on the menu. Hence, they could meet the recession their own policies helped generate with policies that make it even worse. And, the politics surrounding interest rate cuts don’t make it any easier.

Bond Market Insanity

We now have $17 trillion worth of negative interest rate bonds, mostly in the sovereign bond space. That is about 25% of the entire bond market and 43% of bonds outside the U.S.

The nations of the EU cannot afford to pay for their budgets, or their social programs, so the ECB has moved down their borrowing costs to less than zero, in most cases.

Check out their 5-year sovereign debt yields:

Yields in the United States, and the U.S. economy, and the dollar, are taking it on the nose precisely, and specifically, because of what the European Union is doing. There is no other reason for what is happening here except that the nations of the EU have directed the ECB, and now their budgets can be afforded, as they can borrow at less than zero, so they do not have to pay anything for them.

It is not just governments that can borrow at negative yields. Siemens AG, a German corporation, recently sold $3.9 billion worth of bonds at an average -0.3%, and the offering was oversubscribed. Some investors (pension funds) were disappointed they couldn’t buy. Danish banks are selling home mortgages at a -0.5% interest rate. You read that right; they are paying homeowners to borrow money.

How Does The S&P Perform After Yield Curve Inversions?

U.S. – China Trade Agreement

China is playing a very long game. The pressure is on the Trump Administration to conclude a ‘deal,’ not on China. Trump needs a deal done before the 2020 election cycle, and he needs the markets and economy to be strong. If the markets and economy weaken because of tariffs, which are a tax on domestic consumers and corporate profits, as they did in 2018, the risk of electoral losses rise. China know this and is willing to ‘wait it out’ to get a better deal. China is not going to jeopardize its 50 to 100-year economic growth plan on a current president who will be out of office within the next 5 years, at most.

What China has figured out is they can easily manipulate Trump into giving up strategic positioning by offering to ‘talk.’ This continues to be an effective strategy, since they know Trump’s re-election is contingent upon a strong U.S. economy and stock market. By slow-rolling progress and agreeing to ‘talk,’ Trump has given up ground to support U.S. corporations. At the G-20 summit, he agreed to allow companies to sell products to Huawei. Then, he delayed tariffs until December on major consumer goods, which would have negatively impacted U.S. corporations Christmas selling season.

In exchange, China has done…nothing.