The Dividend Cafe - Trade Talks Leaving Fewer Options

Episode Date: May 17, 2019

Topics discussed: The Great Trade Update - Three Options left on the table The HIT to the GDP Growth - it's real and it could be big China's "Nuclear" Option - what are the chances that things go Boom Links mentioned in this episode: TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. Hello and welcome to this week's Dividend Cafe podcast. This is David Bonson. I'm the Chief Investment Officer at the Bonson Group and we are bringing you our weekly Dividend Cafe. Obviously, most things this week seem to be focused around all the trauma and drama of the China trade deal. And to that end, I should point out that our sister podcast, Advice and Insights, which is where we kind of do special podcasts on a particular topic, kind of a singular current event. I did a full dedicated podcast earlier this week to the subject. So if you want kind of a 30 minute dive into all things China, trade, tariff, market,

please do check out the Advice and Insights podcast on that subject. As far as the general overview of this week in the market, that's what we're going to do here today. So keep on listening and we'll cover all those bases and do kind of a broader overview. And in addition to the trade, China stuff, we'll cover a few other things. You know, we're halfway through the month of May and obviously the market activity of May has largely been kind of focused on this very subject. So let's dive into that. The markets did fall over 600 points on Monday of this week. And then they've since recovered a little bit over half of that between the pickup on Tuesday and Wednesday. Now, I'm recording this on Wednesday night.

And so what the markets are going to do Thursday and Friday, I can't say. I'm recording earlier than I normally do this week because of my business schedule with clients on Thursday. But that said, my expectation is that whatever I'm talking about now and whatever is going on when you listen to this, it will be two different things because I'm just sort of of the mindset that each day will create all new bouts of volatility, both up and down. I did not panic and will not allow our clients to panic over the 600 point down day Monday, but nor do I feel particularly encouraged about a couple hundred points up today or a couple, whatever it was, 150 yesterday. And today, as a matter of fact, was actually more than that in the sense that it started down near 200 and then flipped the other way. So you had a 300 or 400 point reversal

from bottom to top on the day. But this is the stuff that enhanced volatility is made of. And this is the stuff that I expect to continue for the foreseeable future. Ultimately, the volatility is a byproduct of uncertainty, and the uncertainty is probably not going away anytime soon. And markets have a very hard time responding in a straight line down with a predictive directional bias. And they have a very hard time with a straight line up with a predictive directional bias in the midst of uncertainty. And so instead, you get gyrations, some of them violent, some of them sudden, some of them unexpected, some of them irrational.

But I believe that we're very likely to continue in that pattern until this gets resolved. And it's a very tricky dynamic because most people believe that there's some version of what the final result's going to be that they can kind of visualize. And they may disagree as to what exactly it will look like. They may disagree as to whether or not it's going to be in a month or three months or six months. But they have a pretty good idea of where they think it's going to go. And the market's likely positive response to that outcome. Yet, you know, they don't want to have to incur the kind of short-term uncertainty

in volatility I'm describing along the way. And yet those two goals are at odds because you probably have, let's call it a month, and it could be longer, of volatility in front of you. And then you probably have a positive market response in, let's call it, three months. Now, the one-month and three-month forecasts are arbitrary, and the exact directional determinations of the market along the way and ultimately are also hypothetical. But the point I'm making is the ability to forecast what you're going to do for a shorter period of time when you have a different conclusion in an intermediate period of time is very hard to do. Most won't do it very well.

The smart ones won't try. Okay. Here's the outcomes that I believe are in front of us. And I'll tell you after I list the options, what I think we're headed towards. Option A is a short-term resolution as the talks and negotiations continue, maybe largely behind the scenes, but nevertheless, they go quick, they go well. China accepts American demands for enforcement mechanisms in the new commitments, and the U.S. lifts the recent escalation of tariffs. Okay, obviously, that would be a very positive response in markets if that were to happen. Now, option B is that this continues back and forth maybe for several months until the

cumulative pain causes one or both sides to break. And this is the option that I think would extend a bi-directional volatility up and down, and maybe for quite a while. And then option C, which I think is least likely, is that President Trump decides to walk away from the negotiations altogether and just take his chances in 2020. That in that scenario, he believes he has less to lose than China does, that the American people are supporting him anyways, that the politics wind up well for him. And so he just bites and walks away rather. And I don't think it's very likely. I don't think that the overall economic impact would be such that it would help boost the economic resume he intends to campaign on. And so I suspect he knows that, his people know that,

and I think that they'll probably be more pragmatic. Now, by the way, I didn't include in these three options the option that's sort of the inverse of option C, which is not that President Trump walks away, President Xi walks away. And this is the theory that they believe he loses the election. And so they just say, look, we're not going to sign a deal now when we think we're going to get a better person to kind of deal with in 2021, whether it's Joe Biden or you pick whoever you want or the other 20 candidates. The only one I think is probably out of the picture is Michael Avenatti. But as far as who else it could be, you know, I'll let you use your imagination. Well, here's the problem with that scenario.

I'll let you use your imagination. Well, here's the problem with that scenario. Of course, China would be right that they are very likely going to have a better leveraging position if they were negotiating with a different president. However, I have a very hard time believing that China believes that they can operate on a risk-reward basis on the premise that Trump will lose the election. Now, I'm not saying he won't lose the election, nor am I saying that China thinks he won't lose the election.

But I am saying that I think that China thinks that Trump has a good enough chance of potentially winning the election that it's not worth that risk to them, which would do extraordinary damage to their economy in the next 18 months and risk not only not better outcome in the end, but in fact, even a worse outcome. My own bet is that we're going to get a blend of option A and option B, that there will be continued volatility. This thing probably is not done in three days or even three weeks, but that at some point post the G20 summit in June, where President Trump and President Xi will be meeting face to face, that you end up getting some kind of a situation in which it leads to the ability to claim victory. And people can debate when it happens and the actual agreement

is finalized, what they think about the agreement, what they like, what they don't like, and all that stuff. And I understand there'll be some politics there and whatnot. I'm only talking right now about the market reaction, that if you believe President Trump is headed to a place where he is going to claim victory, then it's very hard to see a scenario which that victory claim he does is not in some way tied to something the market would be celebrating. Because I believe that he is likely to go to a place of claiming a victory, I therefore believe it will likely be something that the market celebrates with him. If the logic of that is not clear to you, let me know and I'll try to clarify further. But I do think hopefully you can kind of understand what I'm getting at there.

Now, what is my real fear on this? Ultimately, the short-term impact of these tariffs are not the biggest economic threat I'm worried about. I do believe the economic analysis that for every two months, these tariffs alone stick that I believe we're facing a 0.1% hit to GDP growth. If somehow this escalates to tariffs on all $500 billion of the imports that he's threatening, then you would probably have a recession very quickly after that. But I really do doubt that scenario.

I think our stronger economy gives us a little wiggle room, but not to the extent of launching an extended trade war. I simply think that we are so dependent and in need of business investment right now to extend this market cycle. And so much of our GDP growth we've been enjoying has come from inventories and not sustainable quarter over quarter growth that I really do suspect that if this dries up a business investment and it leads to CapEx plans not coming to fruition then I think it will jeopardize even if they end up reconciling and coming to an agreement, the risk is there that they let this thing go too long

and it becomes difficult to put the genie back in the bottle. But as I said earlier, the pickle in all this is that I believe two things at once and that reconciling those two things is the real challenge for asset allocators like us. I believe this will stay in flux for a while, elevating short-term market volatility to a point of discomfort, yet I believe the final deal will be a positive in investment markets. So getting additionally defensive now risks missing that second outcome, but getting additionally opportunistic now exposes one to the enhanced short-term volatility of that first scenario. Bracing for both just cannot be an exact science.

I believe we've intelligently positioned client portfolios with the balance needed for this very tension. Well, how bad can it get economically? Besides the kind of fear I have regarding CapEx drying up, business investment, just from a GDP standpoint, you've got to go to dividendcafe.com this week and see a chart we put from our friends at GAFCAL as far as what the impact to GDP growth would represent on an annualized basis, I think that the level of tariffs we impose is reasonably measurable, how much it would constrict economic growth. I also have a whole section at DividendCafe.com, and I'm only going to do a quick highlight on it now because I'm short on time, about this talk regarding China going nuclear, that China could play the card of them owning $1.2 trillion of United States Treasury debt and flooding the market with it, tanking our debt markets, causing our bonds to collapse and our interest rates to skyrocket and cats and dogs falling out of the sky because of it.

It's not that I don't believe they could theoretically threaten that card, although I actually would be very surprised if they did that. By the way, they haven't done that. To my knowledge, they haven't even really pretended. It's really been more of a media and kind of a internet conversation. I don't think any real serious policymakers are going there. But I list five reasons why I don't think this option is remotely plausible at DividendCafe.com. And I'll give you a couple highlights. First and foremost, you go sell $1.2 trillion of treasuries. What are you going to buy? What are they going to do with the cash? Are they going to go buy euro, which is going to create all different problems? Or are

they going to go buy yen and create that competitive disadvantage with their Asian trading rival. It's absurd. It makes no sense at all. Secondly, I think if they sell treasuries enough that rates jump up, then other global buyers come in and get a carry trade that works to their favor. I think it becomes very opportunistic to buy U.S. Treasury debt at higher prices. So then as those buyers come in, what happens? It pushes the value of the debt back. The yields come down. U.S. is back into the same place they were and maybe modestly impacted. And yet China was the one dimensional loser in what they did. So it would have the impact of hurting China but not hurting the U.S. And I actually think that's exactly what would happen and why China won't go about doing it. There's other issues too about liquidity, the impact of emerging markets. There's a political story that my friends at Strategas Research helped me to understand this week that it would really actually trigger one of the biggest fears the Chinese have, which is remilitarizing Japan.

And it would provide the capital for Japan in a lot of ways, a significant amount of capital to go about doing that. That nuclear option of China doing this is threatening. I don't really like the idea that one particular country, let alone an economic rival, ever owns $1.2 trillion of our debt. But if you need a bottom line summary for me, let me make this as clear as I can. When somebody owes you $1.2 trillion, you do not have the upper hand. They have the upper hand. They have the upper hand. And I think this goes without saying that at the end of the day, China's leverage is very limited in them being a creditor nation because the U.S. has the ability to replace them as a creditor. puts China in a very challenged position for how they would go about managing their own currency exchange and liquidity needs, which, by the way, they're one of the most over-levered

economies on earth. And the $1.2 trillion of treasuries that they would supposedly be trying to dump into the markets, that is the collateral for that leverage across their corporate economy and their sovereign economy. So I think that's enough on that. It's not going to happen. Okay. I've done it a lot on the trade war. Let me speak real quickly, just overall market sentiment, valuation, high yield bond spreads through the midst of this. The market's down right now, I think less than a thousand points from where it was when this trade war stuff re-escalated. It dropped about 12,200 or 1,300. We made about 300 or 400 back. So round figures were down a little less than 1,000 from that Sunday when President Trump

began tweeting. And the high yield bond spread stood at 400 basis points. They were at 550 in December. I always think that 250 to 300 is just cartoonishly low, a total disrespect for risk in our credit markets. And so we're sitting right in that sweet spot. And this is a theme I have about how we approach the trade war, about how we feel about equity markets, about how we feel about risk assets. And as is very often the case, but not always, high yield bond spreads are poetically capturing all of the above. It's a neutral position. It's a balanced position.

It's not screamingly cheap as if we were 550 or 600 basis points wide in our credit spread over treasuries. But it's also not just insanely overpriced in bubble territory with exceedingly euphoric sentiment as if we were 2.5% or 3% spread over Treasury. We're right in that middle range at 400, which I think is a good fair value and calls for the same positioning we have right now, which is even weight to one's risk and reward profile in their portfolio. So I'm going to leave it there for the week. There's a wonderful chart of the week at DividendCafe.com that I encourage you to check out showing the earnings growth in first quarter 2019 S&P 500 for companies that do a very small amount of business overseas versus companies that do a very large amount of business overseas versus companies that do a very large amount of business overseas versus all S&P 500. And what you'll see is that the earnings

growth and the revenue growth are coming from companies which have a far more domestic focus than global focus. And that's important because it speaks to, A, the relative weakness in European and Asian markets compared to US, and it speaks to the impact of the dollar and the currency impact it is having in a lot of S&P 500. So with that said, thank you, as always, for listening to Dividend Cafe. Please do subscribe, if haven't already into your player of choice for your podcast. Give us a review or a star rating, forward to a friend, and we appreciate any support you offer that way. But more importantly, if you have questions or comments on anything we said today, do reach out to us at the Bonson Group. We're always happy to interact with questions. And we

will be coming back to you next week with more on China, trade, tariff, tweet, Trump. You know the story. Thanks for listening to The Dividend Cafe. For thought. Thank you. No expressed or implied representations or warranties as to the accuracy or completeness of the data and other information or for statements or errors contained in or omissions from the obtained data and information referenced herein. The data and information are provided as of the date referenced. Such data and information are subject to change without notice. This document was created for informational purposes only. The opinions expressed are solely those of the team and do not represent those of Hightower Advisors LLC or any of its affiliates.