The Dividend Cafe - When An EasyTrade War Blows Up in your Face

Episode Date: August 9, 2019

Topics discussed: The last peace treaty in this trade war was supposed to be simple enough: The Chinese agreed to buy more agriculture from the United States and the U.S. agreed to lay off Huawei. Not even that was able to last. The intense stock market volatility of the last week is not the most problematic aspect of the trade war from an economic standpoint. We will focus our analysis on: (1) The macroeconomic impact on U.S. growth, and (2) The currency implications for global markets The outlook for U.S. economic growth is falling apart under the pressures of this trade war. Focusing on the far right of this chart, you see the Business Investment aspect of GDP growth (blue line) accelerating significantly after President Trump was elected, in line with the CEO survey on planned capital expenditures (red line). And then you see both collapsing together in response to trade tensions. Links mentioned in this episode: DividendCafe.com TheBahnsenGroup.com

Welcome to the Dividend Cafe, financial food for thought. group. And it has been quite a week. And actually, as fate would have it, I'm recording near the end of the day Thursday versus the beginning of the market day Thursday. So that does decrease the chances of the information I'm giving right now about the action in the market being outdated by the time you're listening to this. And in fact, if I had recorded this morning, I would have been talking about the market getting ready to open up about 100 points on Thursday. And in fact, it's now up 300. But actually, the odds are still very high for something changing on Friday because that's the kind of week that it's been. Let me quickly give you a breakdown of this week. Well, I'm going to start off with last week because I want to give the context coming into the week what we're dealing with. The market was down last Wednesday,

and this is before Trump Twitter trade China. On Wednesday, as the Fed had their press conference, the market went from up a pretty good amount to down 330 points. And then on Thursday, we were up 300. So the market was making back everything on Thursday that it had really kind of irrationally given up on Wednesday around the Fed. And near the end of the market day, I'm going to say with a couple hours to go in trading, President Trump tweeted that we were going to immediately go forward with a 10% tariff on $300 billion more of imports from China. And he basically announced that we had once again had a breakdown in our negotiations. And the market went from plus 300 to minus 300 in a very short period of time.

If memory serves me correctly, we were down a bit on Friday. Not a lot. But then on Monday, we were down 1,000 points at one point and closed the day down 750. And then the Department of Treasury labeled China a currency manipulator Monday afternoon, evening. And our futures market was down 500 more points coming into Tuesday open. But then by the time of the open, we had stabilized a little bit and more particularly, China had stabilized their currency a little. And we actually ended Tuesday up 300 points.

But then on Wednesday, we were down 600 points at one point before coming all the way back. And we kind of ended the day about even now here we are on Thursday up 300. So if you haven't tuned me out yet, pay attention to what I just said about the last five, six market days, plus 300 plus 300 to minus 300 plus or minus a thousand plus 300 minus 600. You know what I'm saying? It's even. You've had massive swings all over the place. And guess what? We are literally down about 100 or 200 points on the week right now.

Net, net, net since Monday. Down 750, up 300. And then about even and then up 300. So, yeah, we're down 150-ish points on the week in what has been certainly the most volatile week in the market since December. So now what I get to do with the next 20 minutes or so of our time is walk you through what is really going on, what the not so good parts of it are, because a lot of times people hear bad news. There's such a massive overreaction and irrational stupidity and panic in the media or in the emotions of human beings. And I come to cool everybody down, calm everybody down, have that rational conversation.

I want to do the same thing today, except for there is some significant concern. There's some significant distress I want to address intelligently, calmly, rationally. Let me tell you this last peace treaty that was basically the result out of the Japan G20 back in June, where markets rallied off of hearing President Trump say, okay, me and President Xi spoke, things look good, we've suspended moving forward with new 25% tariffs, and we are going to lift our ban on doing business with Huawei. And China agreed to buy more agriculture. At the end of the day, the entire treaty basically came down to China said we'll buy more soybeans, the U.S. agreed they'd leave Huawei alone.

That was it. And they'd leave Hawaii alone. That was it. And they couldn't even do that. Even this was not able to be kind of processed effectively. And within four or five weeks, the whole thing blew up. But the intense market volatility is not the most problematic aspect right now, in my opinion, with the trade war. I think there's a macroeconomic impact on growth that is far more concerning to me. And unfortunately, you listening to the podcast cannot see the charts I'm using to illustrate this, but I'm going to walk you through three things that I put into DividendCafe.com this week. One is the most recent survey of business investment. The GDP formula calls it non-residential fixed investment. And it correlates in this chart with the CEO outlook for their capital expenditures.

And both cases, you see this skyrocketing move higher in business investment and in CEO spending plans after the election and going throughout the first couple of years of the Trump, about a year and a half of the Trump administration, and you see both of those numbers turning the exact other way, an upside-down V, since roughly the time that the trade war began. Similarly, the ISM non-manufacturing, up against the real GDP number of the United States. You see that GDP growth. We had been sitting there in the Obama years in the high 1% range of real growth for a long time.

It moved all the way up to the 3% range. Now that number moving back down and in a pretty strong correlation with a total decline in manufacturing new orders and overall economic activity. Speaking of that, durable goods orders, again, similar chart, all three of these available at dividendcafe.com. So the projections for U.S. GDP growth next year are now 1.8%. That's basically about the same level we had in the Obama administration. That is what you call muddle through growth. That is not what we did the corporate tax cut for. That is not supply-side level productivity enhancement. What we are doing is putting something that is worth 3% to 4% of GDP growth in the economy and putting something that cuts out 2% to 3% of GDP growth in the economy

via trade war and offsetting to a very tepid number that, in my opinion, is not robust enough historically to keep us out of a recession. The formula that we want to see that I think is in jeopardy right now as a result of the trade war is the notion of greater business confidence leading to greater business investment, leading to greater productivity, leading to greater economic gains. And by economic gains, I refer to jobs, wages, consumer activity, and of course, profits. So the greater productivity you need to sustain all those

wonderful outcomes has to come out of business investment, business investment under jeopardy because of uncertainty brought about by a global trade war. Now, China's not just going to sit and take this. They fought back. And of course, the best tool they have at their disposal is currency. So I wrote a whole piece at marketepicarian.com this week to talk about what China's tool was in terms of weakening their currency. And for one thing, I want to make the point, China's not intervening to devalue their currency lower. China's been interfering in their currency to keep it higher, and they're laying off of doing

some of that. They're backing down on some of their reverse intervention. So the talk about manipulation, there's a lot of political color around it, but the fact of the matter is they're manipulating their currency higher, and now they're doing less of that, and we're calling it manipulating it lower. So this is, I guess, the postmodern vocabulary applied to global currency. But understand this. Under the hood of our global trade, we import $150 billion a year of electrical machinery from China, $120 billion of industrial machinery, $35 billion of furniture, almost $30 billion of toys and sports equipment, almost $20 billion of plastics. The main thing we export to them is aviation, aircraft, aircraft

parts, and then medical instruments is a fairly robust business. But all in, we buy from them about $540 billion. They buy from us about $120 billion. So they call that a trade deficit. And I won't get into right now why a trade deficit is neither a good or a bad thing in and of itself. The fact of the matter is that when we buy those things we are giving them dollars and then of course they get more dollars from us than we get from them because they are buying they are selling us more things they take those dollars and invest it back in the United States by buying our treasury bonds and there is a significant amount of capital formation that comes out of foreign ownership of our debt. Which brings me to another point. Do you understand that U.S. individuals, banks, households owned about 80% of treasury debt when I was in middle school?

And right now they own about 40%. And that foreign countries such as China owned about 10%, and now own about half. So the fact of the matter is that we have had declining interest rates led by greater global demand for our bonds, because we have to pay for our debt by issuing bonds, and we spend more in our country than we bring in, and has helped fund a massive savings deficit because the United States does not save a lot of money. Now, you could say that's a somewhat dysfunctional structure. There are parts of it that are highly dysfunctional. But my point being that there's not just one piece here like, hey, we could just blow this up

because we'll go get our computer machinery made in Vietnam instead. We talk about supply chain in the manufacturing process. There's a whole economic supply chain going on from the debt to the interest rates to dollar liquidity to capital formation. This is complicated stuff, but it's very important. complicated stuff, but it's very important. And it's why the simplistic assessments of, hey, we can win a trade war easily because we just kind of shake them down. Eventually, they want to sell us stuff, so they'll come in and play by our rules. There's more to it than that. The currency war that we saw break out this week that I wrote the article about at marketepicarian.com,

I try to lay out the fact that, look, I don't think there's a winner in a trade war, and there sure as heck isn't a winner in a currency war. And ultimately, we have limited tools of what we can do without destabilizing global economic conditions, and more importantly, without compressing valuations for our own risk assets. Demand for U.S. assets will be weakened if we interfere to weaken our currency. So there's a lot going on right now. Now, I'm going to switch gears for a second, not to try to do a little, oh, everything's bad and now I'll just throw in a fake good. This is a legitimate point in the glass is half full camp.

Bond spreads have not widened. The BBBs have barely moved at all on the week, which is the lowest quality of investment grade bond ratings. And even in high yield, we saw some widening in our bond spreads, as you probably would expect, but it's been very, very modest, very tame and nothing like what we saw Q4 of last year. very modest, very tame, and nothing like what we saw Q4 of last year. Generally speaking, when Armageddon's coming, the bond market, the high-yield bond market, the credit market tell you first. So where do we go from here? I'm very skeptical that we're going to see resolution in the trade war before the 2020 election. I think China now has ample reason to believe they can wait this out for another year and a half, see what happens after the election. I think the president's decided,

for right or for wrong, that sustaining this fight is actually fine for him politically. So structural reforms, such as dealing with intellectual property theft, seem to be off the table. You know, it is possible that some tariffs will get frozen in place. They'll get suspended. Some of the increase of tariffs that get threatened might get delayed. But the idea of a master agreement or a repeal of the incumbent tariffs that have been put on since this trade war began, I think, is now very unlikely. So that speaks to the very high propensity for greater volatility in the markets. The optimal case, meaning this is about as good as I could see things going here in the short term, is that we just find a place of equilibrium.

The trade war does not accelerate from here, but it doesn't decelerate. And then it sits here until the election and we go from there. That's the optimal case. Now, where do we go from there. That's the optimal case. Now, where do we go from here as far as the Fed goes? Some people are saying, oh, the glass is half full because now we really know the Fed's going to end up cutting rates. And I just don't understand. They're right about that. The Fed futures market is now pricing in a 100% chance of another rate cut next month and an 80% chance of another two rate cuts by December. And there's a very significant pricing in the market for three

more rate cuts. So people would say, okay, well, that really helps come in and bid up risk assets. And it very well might, but I would not take that for granted. You see the bond market, having already priced it in, we saw a 10-year treasury run to 1.6% this week. It was at 3.3% in October. It's come down more than half. That speaks to the bond market pricing in recession, period. Now, the 10-year is backed up here. It's come back up to about 175, 180 here today. There's a lot of volatility in the bond market that could be a false signal because the bond market's highly susceptible to that when you have all this currency action going on and other central bank manipulation. It distorts markets. It's hard to get clear signals.

That's not a cop-out for a money manager. That's a money manager doing what he's supposed to do is tell you the truth. Arrogantly allocating capital with a high degree of conviction when there is a high degree of ambiguity is not what money managers get paid to do. It's not what I'm paid to do in my role as chief investment officer at Bonson Group. It's diligently studying the data and being willing to be patient. You have an assessment of exactly how these things are going to shake out. Both the demeanor studying the data and being willing to be patient. You have an assessment of exactly how these things are going to shake out, both the demeanor of the president and his style of negotiating this in the trade war, and more significantly, the realities of present central bank intervention have created so much distortions in the market that it's imperative that we be humble, slow, patient, prudent, and that we be

grateful that we're starting off from a position of balance in client portfolios. And that's the theme I'll leave you with. We're very big right now on respecting bonds as a deflationary hedge. We don't like them. We don't want them, but we need them as that place to protect capital where things really are falling out from under us. They've done a very good job at that in this last period. For offense, that is maintained and balanced with defense. We truly like our alternative allocation. And then from the vantage point of people who need that income, need growing income, and have offensive juice and long-term horizon in their portfolio. Obviously, our commitment to both dividend growth and even

some other alpha generators, diversifiers with emerging markets and other things like that. That balance of a client portfolio right now, I think, is a very, very important element to one's strategy in navigating through the uncertainty of the trade war. I'm going to leave it there for the week. I really encourage you to reach out with any questions you may have. I do thank you for listening to the Dividend Cafe. We encourage you to subscribe, to sign up, to encourage others to do the same. And if you really like what you hear, to give us a good rating. If you don't like what you hear, to give us a good rating. If you don't like what you hear,

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