Tag Archives: Trade

What We Are Not Being Told About The Trade Deal

Unlike most trade deals where the terms are readily available, the details of the Phase One trade agreement between China and the U.S. will not be announced nor signed in public. Accordingly, investors are left to cobble together official comments, anonymous statements from officials, and rumors to ascertain how it might affect their portfolios.

Based on official and unofficial sources, existing tariffs will remain in place, new tariff hikes will be delayed, and China will purchase $40-50 billion in agricultural goods annually. At first blush, the “deal” appears to be a hostage situation- China will buy more goods in exchange for tariff relief.

The chart below, courtesy of Bloomberg, provides reasons for skepticism. The rumored $40-50 billion in goods is nearly double what China purchased from the U.S. in any year of the last decade. It is over four times what they bought in 2018 before the trade war started in earnest.

The commitment is even more questionable when one considers that China recently agreed to purchase agricultural products from Brazil, Argentina, and New Zealand. 

The following tweet by Karen Braun, (@kannbwx), a Global Agricultural Columnist for Thomson-Reuters, puts the massive commitment into further context.  She claims that the maximum annual totalimport of four key agriculture products, only adds up to $56 billion. As she stresses in the tweet, the figures are based on the maximum amount China bought for each respective good in any one year.

Either China will buy more agriculture than they need and stockpile a tremendous amount of agriculture, which is possible, or they have agreed to something else that is not being disclosed. That, to us, seems more likely. We have a theory about what might not be disclosed and why it may matter to our investment portfolios.

Donald’s Dollar

Given the agreement as laid out in public, what else can China can offer that would satisfy President Trump? While there are many possibilities, the easiest and most beneficial commitment that China can offer the U.S. is a stronger yuan, and thus, a weaker dollar.

The tweets below highlight Trump’s disdain for the strengthening dollar.

A weaker dollar would reduce the U.S. trade deficit by making exports cheaper and imports more expensive. If sustained, it could provide an incentive for some companies to move production back to the U.S. This would help fulfill one of Trump’s core promises to voters, especially in “fly over” states that pushed him over the top in the last election. Further, a weaker dollar is inflationary, which would boost nominal GDP and help satisfy the Fed’s craving for more inflation.

From China’s point of view, a weaker dollar/ stronger yuan would hurt their exporting sectors but allow them to buy U.S. goods at lower prices. This is an important consideration based on what we wrote on December 11th, in our RIA Pro daily Commentary:   

“In part, due to skyrocketing pork prices, food prices in China have risen 19.1% year over year. In addition to hurting consumers, inflation makes monetary stimulus harder for the Bank of China to administer as it is inflationary. From a trade perspective, consumer inflation will likely be one factor that pushes Chinese leaders to come to some sort of Phase One agreement.

Food inflation is a growing problem for China and its leadership. In part, due to the issues in Hong Kong, Chairman Xi benefits from pleasing his people. While a stronger yuan would result in some lost trade and possibly jobs, the price of the agricultural goods will be lower which benefits the entire population.

A stronger yuan is not ideal for China, but it appears to be a nice tradeoff and something that benefits Trump. This is speculation, but if correct, and recent weakness in the dollar suggests it is, then we must assess how a weaker dollar affects our investment stance. 

Investment Implications

The following table shows the recent and longer-term average monthly correlations between the U.S. dollar and various asset classes. Below the table is a graph that shows the history of the two-year running monthly correlations for these asset classes to provide more context.

Data Courtesy Bloomberg

The takeaway from the data shown above is that gold and ten-year Treasury yields have a consistent negative correlation with the dollar. This means that we would expect higher gold prices and Treasury yields if the dollar weakens. Interestingly, the CRB (broad commodities index) and Emerging Equity Markets have the most positive correlation. Oil and the S&P 500 appear to be neutral.

The S&P 500 is a broad measure, so when looking at particular stocks or sectors, it is important to consider the size of the company(s) and the global or domestic nature of the company(s). For instance, domestic large-cap companies with global sales should benefit most from a weaker dollar, while small-cap domestic companies, reliant on foreign sources to produce their goods, should perform relatively poorly.  


From the onset of negotiations, the China-US trade war has been tough to handicap. China has a lot to lose if they give in to Trump’s demands. Trump has leverage as a tariff war hits China’s economy harder than the U.S. economy. China is fully aware that the U.S. election is only 11 months away, and Trump’s re-election prospects are sensitive to the state of the economy and market sentiment. A trade victory should help Trump at the polls.

Our dollar thesis is speculation, but such an agreement is self-serving for both sides. Keep a close eye on the dollar, especially versus the yuan, as a weaker dollar has implications for all asset classes.

Non-QE QE and How to Trade It

“I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.” He then stated: “In no sense is this QE.” –Federal Reserve Chairman Jerome Powell 10/8/2019

Jerome Powell can call balance sheet growth whatever he wants, but operationally and in its effect on the bond markets, it is QE. For more on the Fed’s latest iteration of QE, what we dub the non-QE QE, please read our article QE By Any Other Name.

Non-QE = QE4

It is increasingly likely the Fed will announce an asset purchase operation at the FOMC meeting on October 30, 2019. Given Powell’s comments, the asset purchases will differ somewhat from QE 1, 2, and 3 in that the Fed will add needed reserves to the banking system to help alleviate recent bouts of stress in overnight funding markets. Prior versions of QE added excess reserves to the system as a byproduct. The true benefit of prior rounds of QE was the reduction of Treasury and mortgage-backed securities in the marketplace, which pushed investors into riskier stocks and bonds.  

Since the Feds motivation seems to be stress in the short term funding markets, we believe the Fed will purchase short-term notes and Treasury bills instead of longer-term bonds. QE1 also involved the purchase the short term securities, but these securities were later sold and the proceeds used to purchase longer term bonds, in what was called Operation Twist.

Trading Non QE QE4

In Profiting From a Steepening Yield Curve and in a subsequent update to the article, we presented two high dividend stocks (AGNC and NLY) that should benefit from a steeper yield curve. When we wrote the articles, we did not anticipate another round of QE, at least not this soon. Our premise behind these investments was weakening economic growth, the likelihood the Fed would cut rates aggressively, and thus a steepening yield curve as a result.

The Fed has since cut rates twice, and Wall Street expects them to cut another 25bps at the October 30th meeting and more in future meetings. This new round of proposed QE further bolsters our confidence in this trade.

If the Fed purchases shorter-term securities, the removal of at least $200 to $300 billion, as is being touted in the media, should push the front end of the curve lower in yield. Short end-based QE in conjunction with the Fed cutting rates will most certainly reduce front-end yields. The rate cuts combined with QE will likely prevent long term yields from falling as much as they would have otherwise. On balance, we expect the combination of QE and further rate cuts to result in a steeper yield curve.

The following graph shows how the 10yr/2yr Treasury yield curve steepened sharply after all three rounds of QE were initiated. In prior QE episodes, the yield curve steepened by 112 basis points on average to its peak steepness in each episode.  

Data Courtesy: Federal Reserve

New Trade Idea

In addition to our current holdings (AGNC/NLY), we have a new recommendation involving a long/short bond ETF strategy. The correlation of performance and shape of the yield curve of this trade will likely be similar to the AGNC/NLY trade, but it should exhibit less volatility.

Equity long/short trades typically involve equal dollar purchases and sales of the respective securities, although sometimes they are also weighted by beta or volatility. Yield curve trades are similar in that they should be dollar-weighted, but they must also be weighted for the bond’s respective durations to account for volatility. This is because the price change of a two-year note is different than that of a 5 or 10-year note for the same change in yield, a concept called duration. Failing to properly duration weight a yield curve trade will not provide the expected gains and losses for given changes in the shape of the yield curve. 

Before presenting the trade, it is important to note that the purest way to trade the yield curve is with Treasury bonds or Treasury bond futures. Once derivative instruments, like the ETFs we discuss, are introduced, other factors such as fees, dividends, and ETF rebalancing will affect performance.  

The duration for SHY and IEF is 2.17 and 7.63, respectively. The ratio of the price of SHY to IEF is .74. The trade ratio of SHY shares to IEF shares is accordingly 4.75 as follows: [(1/.74)*(7.63/2.17)]. As such one who wishes to follow our guidance should buy 5 shares for every 1 share of IEF that they short.

Because we cannot buy fractions of shares, we rounded up the ratio to 5:1. This slight overweighting of SHY reflects our confidence that the short end of the yield curve will fall as the Fed operates as we expect.


In Investors Are Grossly Underestimating the Fed, we highlighted that every time the Fed has raised and lowered rates, the market has underestimated their actions. To wit:

“If the Fed initiates rate cuts and if the data in the graphs prove prescient, then current estimates for a Fed Funds rate of 1.50% to 1.75% in the spring of 2020 may be well above what we ultimately see. Taking it a step further, it is not farfetched to think that that Fed Funds rate could be back at the zero-bound, or even negative, at some point sooner than anyone can fathom today.”

Despite the Fed’s guidance earlier this year of one or two cuts and their characterization of it as a “mid-cycle adjustment”, the Fed has already lowered rates twice and appears ready to cut rates a third time later this month. If, in fact, the market is once again underestimating the Fed, the Fed Funds rate and short term Treasury yields will ultimately fall to 1% or lower.

In an environment of QE and the Fed actively lowering rates, we suspect the yield curve will steepen. That is in no small part their objective, as a steeper yield curve also provides much needed aid to their constituents, the banks. If we are correct that the curve steepens, the long-short trade discussed above along with AGNC and NLY should perform admirably.  AGNC and NLY are much more volatile than IEF and SHY; as such, this new recommendation is for more risk-averse traders.  

Today’s Melt Up Triggers Tomorrow’s Melt Down

Since November of 2016, the NDX has soared by 72% and is poised to break the recent all-time high of 8027. Today, it seems that sentiment is shifting back to selling bonds and buying riskier equities with hyped estimates. FAANG stocks have fueled an ongoing rally, via stock buybacks, non – GAAP financial gimmicky, and promises of eventual profitability for many unicorn startups.

Source: Stockcharts.com – 9/12/19

Sentiment has moved prices up as the market has suspended its disbelief of key fundamentals like future earnings, declining sales, job layoffs, contracting world trade, and negative cash flow.

First, let’s look at downward revised earnings forecasts for the rest of the year indicating a decline almost to a contraction level in the U.S.:

Sources: Bloomberg, IIF – 9/10/19

Analysts expect lower earnings and profitability due to declining sales. The pivotal function of any business is sales. The inventory to sales ratio is now at 2008 levels indicating that sales are declining while production is continuing, which is typical of the later stages in the business cycle:

Sources: The Wall Street Journal, The Daily Shot – 9/12/19

Continuing present production levels with flat to declining sales is unsustainable.  Executives are faced with declining sales overseas in part due to tariffs. As such, the number of production shifts must be reduced, as the highest cost for most businesses is payroll.  A key indicator of executives beginning to reduce staff is indicated by an increase in jobless claims in five key manufacturing states starting about when tariffs were first enacted in November of 2018:

Sources: B of A Merrill, Haver, The Wall Street Journal, The Daily Shot – 8/30/19

Markets are underestimating the devasting impact that broad tariffs are having on U.S. corporate sales.  S & P 100 corporations generally recognize from 50 – 60 % of total sales from overseas, and profits of 15 – 25 % or more from emerging markets like China and India.  When tariffs hit U.S. products, there is a cascading effect on small businesses, and throughout the worldwide supply chain. Even if a product is produced domestically, many of the sourced parts come from several emerging markets which now face tariffs. China’s tariffs on U.S. farm products like soybeans have reduced sales by 90 %.  Soybean farmers are looking for new markets, but are having a difficult time replacing the massive purchases that China makes each year.  Tariffs are culminating sales headwinds and investment uncertainty at the fastest rate since 2008.

Sources: CPB World Monitor, The Wall Street Journal, The Daily Shot – 9/11/19

In the midst of all these economic and business headwinds, executives should be running tight finances, right?  Well, not exactly. Due to a surge in debt issuance, corporations now have the highest debt to GDP ratio in history.  However, they may not have learned about how to keep out of financial trouble.  S & P 500 corporations are paying out more cash than they are taking in, creating a cash flow crunch at a – 15 % rate (that’s right they are burning cash) to maintain stock buyback and dividend levels:

Sources: Compustat, Factset, Goldman Sachs – 7/25/19

Source: RIA PRO (www.riapro.net) Chart of the Day -9/10/2019

Unicorn IPO valuations are off the chart, many with unproven business models and large losses. 2019 has seen the highest value of IPOs since 2000, an indicator of high interest in risky investments and soaring investor sentiment. Not surprising, 2019 has the highest number of negative earnings per share IPO companies since 2000 as well.

Sources: Dealogic, The Wall Street Journal, The Daily Shot – 6/18/19

Sources: Jay Ritter, University of Florida, The Wall Street Journal – 3/16/18

The lack of profitability and the number of IPOs ‘to cash out before it’s too late’ evokes memories of the 2000 Dotcom Crash.  Then, investors were looking for ‘high tech growth’ stocks, and as it was assumed that companies would figure out their business model later. 

When?  As an example, Uber just recorded a $5.24 billion loss for the 2nd quarter of 2019.  Lyft lost $644 million in the same quarter.  Despite the popularity of their services, the business models for both ride-sharing companies has yet to be proven. Making profitability even harder for these companies, the State of California legislature just passed a bill recognizing ride-sharing drivers as employees and not contractors. Gov. Gavin Newsom is expected to sign the legislation.  If Uber and Lyft have to pay salaries, benefits and other costs for full-time employees they will incur staggering costs, and may likely never be profitable.  Uber says it is building a ‘transportation platform’ where drivers are delivering food and packages not transporting passengers so they can avoid being labeled a passenger transportation company.  Both firms are planning to put an initiative on the ballot to declare their drivers as contractors to save their business models.  It is still unclear, even with drivers being recognized as contractors, that they have viable business models. Yet investors just didn’t care at IPO time, though both stocks have since dropped in price dramatically since their IPO dates. Ride sharing is just one small industry and one example. There are many other unicorns with questionable businesses that are flourishing in the markets.

The suspended disbelief we see today is similar to the sentiment that sent the NDX up nearly 400% just before the Y2K crash.   We can learn from what happened beginning 20 months before the Y2K crash.  The NDX started in October of 1998 at 1063 and peaked at 4816 in May of 2000:

That astounding move up was followed by a roller coaster ride down to 2897 for a 38 % decline by May of 2000, followed further by a two year decline to 795, or 84 % decline from the 2000 peak.  The NDX would not reach the 4816 level again for another 16 years!  Investors had to wait a long time just to break even.

One similarity to the Y2K related drop in sales we see today is from tariffs. Companies have pulled purchases forward to avoid tariffs. Similar activity occurred in 1999 as IT departments bought new software and hardware to solve a possible year 2000 (Y2K) software bug. Software and hardware purchases were pulled forward into 1999, then as one IT manufacturer CEO put it ‘the lights went out on sales.’  The hard dates for tariff increases a year ago forced corporations to pull up purchases that would otherwise be made later in the year, resulting in an unnatural boost followed by a contraction of business activity.

Consumer products will be hit with 15 % tariffs in October and 25 % in December, so consumer, like businesses, are likely moving up their purchases. We expect consumer spending to show increases in August, and September, and decline after that.  A contraction in consumer business operations is likely to follow pulled up consumer purchases.

Plus, investors need to be cognizant of the huge transformation of the world trade infrastructure into two competing trade blocks triggered by the trade war by the U.S. and China as discussed in my post: Navigating A Two Block Trading World. The forming of two trade blocks will change the character of world trade, and therefore create uncertainty in international sales for all businesses dependent on overseas customers to maintain growth and profitability.

Today, sentiment is set in suspended disbelief that ‘the Fed will cut rates’ and make the economy grow.  Corporations are swimming in low-cost debt, with negative cash flows and flat to falling sales.  If the Fed governors pick up an attaché case with a sales pitch and get sales going again then the Fed might have an impact on corporate profitability. Yes, cheap money may help stave off layoffs or cost reductions, but in the end businesses will have to cut costs to match new lower sales levels.

The market ‘hopes’ that a trade deal will revive the economy as well.  An ‘interim’ trade deal where China gives up very little except a commitment to purchase agriculture and livestock products in return for a suspension of increased tariffs won’t change the broad-based tariff damage to the economy.  Unless broad-based tariffs are ended, as 1,100 economists recommended in a letter to the Trump administration 18 months ago, the hemorrhaging of sales will continue.

So what can we learn from today’s investor sentiment compared to sentiment observed during the Dotcom crash?  When the market finally ends its disbelief and is hit with the reality of business fundamentals, the decline will be fast and deep. The melt up, or whatever is left of it, will trigger a melt down.  The 4:1 return difference in the 2000 melt up versus today’s melt up today is likely due to the 4.7 % GDP rate in 1999 versus the forecasted 1.7 % GDP forecasted for 2nd quarter this year.  In 2000, the economy was simply growing a lot faster than today, and productivity was rapidly growly. This helped sentiment and provided some basis for the melt up.  Further the melt up in 1999 was fueled by the Fed providing excessive liquidity to help ensure that Y2K did not shut down the economy.

The current melt up is occurring at a much lower level of economic activity. Yet, both instances are based on a disconnect between what is happening in the economy and the valuations of stocks. The longer the disconnect with fundamentals, the longer it will take for the reversion to the mean to rebalance the economy. Plus, the further the disconnect the larger reversion to the mean or even an overshoot and it will take longer to get back to ‘even’ – maybe 16 years from the peak as we saw in Dotcom Crash in 2000.

Patrick Hill is the Editor of The Progressive Ensign, writes from the heart of Silicon Valley, leveraging 20 years of experience as an executive at firms like HP, Genentech, Verigy, Informatica and Okta to provide investment and economic insights. Twitter: @PatrickHill1677.

Don’t Worry About Trump; Worry About Earnings

If you’re concerned about President Trump’s influence on the stock market you’re concerned about the wrong thing. That’s not because political leaders – and their problems — don’t influence stock prices temporarily, but because if you own stocks you should own them for their long term earnings prospects (which is why retirees should have reduced stock exposure). Stocks are ownership units of business. And although the political climate influences the business climate, a stock’s price reflects anticipation of earnings far into the future, beyond any politician’s time in office. Procter and Gamble will be selling Tide laundry detergent and Crest toothpaste long after President Trump is out of office. And that doesn’t mean you should own Procter at its current price. It just means, barring any concerns with capitalism or the stability of the country in general, Procter’s current price relative to its  long-term future cash flows is what an investor should concentrate on.

President Trump has been in office for a year and a half, and stocks have shrugged off much of the turbulence that has accompanied his administration. There have been specific policies that seem friendly toward stocks such as the tax cut. But there have also been policies that have been unfriendly to them such as tariffs. No matter, the S&P 500 Index surged nearly 22% in 2017, and is up another 9% this year as of this writing. From taking his time to fill key posts, to feuding openly with his attorney general and the press, to an investigation into his campaign’s contacts with Russia and payments to women with whom he’s had extramarital liaisons, to often betraying a lack of understanding of constitutionalism, to an erratic foreign policy that simultaneously displays abrasiveness but also a diminished role for the United States in global affairs and questionable friendliness toward obvious U.S. enemies, markets have continued rising through it all.

The last week may represent a turning point, but it’s too soon to tell. Trump’s longtime attorney Michael Cohen pleaded guilty to violating campaign finance laws in buying the silence of a pornographic film actress and former Playboy model. In the process Cohen, who taped meetings with Trump when Trump was his client, implicated the president in conspiring with him to commit the crimes.

Moreover, Trump’s former campaign chairman, Paul Manafort, pleaded guilty to 8 counts that included tax fraud and bank fraud. Although Manafort’s trial didn’t touch directly on the accusations that the Trump campaign colluded with Russia to exploit damaging information Russia had on Hilary Clinton, the income that Manafort didn’t report came from advising a pro-Russian political party in the Ukraine. Finally, the chief financial officer of the Trump Organization, Michael Weisselberg, and tabloid executive, David Pecker, were granted immunity by the Southern District of New York regarding its investigation into Cohen.

All of this may or may not lead to impeachment, but the threat looks greater now than ever before. The outpouring of emotion over the death of John McCain, with whom President Trump also openly feuded and mocked for being captured during the Vietnam War, may also push public opinion further against Trump and make impeachment more possible. Perhaps sensing his vulnerability from these recent events, Trump himself said in a recent interview that impeachment would cause the stock market to fall. “If I ever got impeached, I think the market would crash. I think everybody would be very poor. Because without this thinking (pointing to his head) you would see numbers you wouldn’t believe – in reverse.”

But will it? Alex Shepard notes in the New Republic that stocks fell in 1974 when President Nixon resigned from office, but recovered the next year. (The S&P 500 Index lost 26% in 1974 and gained 37% in 1975.) Also, the stock market rose after Bill Clinton was impeached in late 1998. (The S&P 500 Index was up nearly 29% in 1998 and another 21% in 2009.) But Shepard argues that Nixon left before impeachment and that Clinton sailed through his problems with consistently high approval ratings. Trump, by contrast, remains unpopular, and almost certainly wouldn’t leave without a fight. Therefore, Trump’s reaction to impeachment would probably be bad for markets, Shepard concludes.

Interestingly, Trump’s recent poll numbers haven’t moved much. And markets continue to surge, uninterrupted by political concerns or anything else. That should tell investors how hard it is to forecast market moves based on the political climate. President Trump just suffered his worst week in office, and the market’s aren’t registering the problems he’s facing at all.

None of this is to say that the market can’t fall on increasing political problems. But the real problem investors face is valuation – stock prices relative to earnings. Stocks are trading at higher prices relative to past earnings than they have in all but two other moments in history – 1929 and 2000. Often, political tumult can sink a market already vulnerable from high valuations. So far it hasn’t. But if you own stocks, that’s your real problem — the extent to which prices are divorced from past earnings and to which they are anticipating future earnings growth that is unachievable.

The Coming Collision Of Debt & Rates

On Tuesday, I discussed the issue of what has historically happened to the financial markets when both the dollar and rates are rising simultaneously. To wit:

“With the 10-year treasury rate now extremely overbought on a monthly basis, combined with a stronger dollar, the impact historically has not been kind to stock market investors. While it doesn’t mean the market will “crash” today, or even next week, historically rising interest rates combined with a rising dollar has previously led to unexpected and unintended consequences previously.”

I wanted to reiterate this point after reading a recent comment from Jamie Dimon, CEO of JP Morgan, whom, as I have previously written about, makes rather “disconnected” statements from time to time.

“We’re probably in the sixth inning (of this economic cycle), and it’s very possible you’re going to see stronger growth in the U.S. I’ve heard people say, well, it’s looking like 2007. Completely untrue. There’s much less leverage in the system. The banks are much better capitalized.”

First, while he talks about banks being much better capitalized, the interesting question is:

“If banks are so well capitalized, why hasn’t FASB Rule 157 been reinstated?”

As I noted previously, FASB Rule 157 was repealed during the financial crisis to allow banks to mark bad assets to “face value” making balance sheets stronger than they appear. This served the purpose of reducing panic in the system, supported “Too Big To Fail” banks, and kept many banks in operation. But if banks are once again so well capitalized, leverage reduced and the economy firing on all cylinders – why is that repeal still in place today? And, if the financial system and economic environment are so strong, then why are Central Banks globally still utilizing “emergency measures” to support their economies?

Likely it is because economic growth remains tepid and banks are once again heavily leveraged as noted by Zero Hedge:

“It is by now well known that consolidated leverage in the system is at an all-time high, with both the IMF and the IIF calculating in April that total global debt has hit a new all-time high of $237 trillion, up $70 trillion in the past decade, and equivalent to a record 382% of developed and 210% of emerging market GDP.”

However, let me address the leverage issue from an economic standpoint. Rising interest rates are a “tax.” When combined with a stronger dollar, which negatively impacts exporters (exports make up roughly 40% of total corporate profits), the catalysts are in place for a problem to emerge.

The chart below compares total non-financial corporate debt to GDP to the 2-year annual rate of change for the 10-year Treasury. As you can see sharply increasing rates have typically preceded either market or economic events. Of course, it is during those events which loan default rates rise, and leverage is reduced, generally not in the most “market-friendly” way.

This leverage issue is more clearly revealed when we look at non-financial corporate debt and assets as a percentage of the gross-value added (GVA). Again, as above, rising rates have historically sparked a rapid reversion in this ratio which has generally coincided with the onset of a recession.

With leverage, both corporate and household, at historical peaks, the only question is how long can consumers continue to absorb higher rates?

While Mr. Dimon believes we are only in the “sixth-inning” of the current economic cycle, considering all of the economically sensitive areas which are negatively impacted by higher rates, one has to question the sustainability of the current economic cycle?

1) Rising interest rates raise the debt servicing requirements which reduces future productive investment.

2) Rising interest rates slow the housing market as people buy payments, not houses, and rising rates mean higher payments.

3) An increase in interest rates means higher borrowing costs which leads to lower profit margins for corporations. 

4) One of the main arguments of stock bulls over the last 5-years has been the “stocks are cheap based on low interest rates.”

5) The massive derivatives and credit markets will be negatively impacted. (Deutsche Bank, Italy, etc.)

6) As rates increase so does the variable rate interest payments on credit cards and home equity lines of credit. With the consumer being impacted by stagnant wages and increased taxes, higher credit payments will lead to a contraction in disposable income and rising defaults.

7) Rising defaults on debt service will negatively impact banks.

8) Many corporate share buyback plans and dividend payments have been done through the use of cheap debt, which has led to increased corporate balance sheet leverage.

9) Corporate capital expenditures are dependent on lower borrowing costs. Higher borrowing costs leads to lower CapEx.

10) The deficit/GDP ratio will rise as borrowing costs rise. 

You get the idea. Interest rates, economic growth, and credit are extremely linked. When it comes to the stock market, the claim that higher rates won’t impact stock prices falls into the category of “timing is everything.”  

If we go back to the first chart above, what is clear is that sharp increase in interest rates, particularly on a heavily levered economy, have repeatedly led to negative outcomes. With rates now at extensions only seen in 7-periods previously, there is little room left for further acceleration in rates before such an outcome spawns.

As Bridgewater just recently noted:

“Markets are already vulnerable, as the Fed is pulling back liquidity and raising rates, making cash scarcer and more attractive – reversing the easy liquidity and 0% cash rate that helped push money out of the risk curve over the course of the expansion. The danger to assets from the shift in liquidity and the building late-cycle dynamics is compounded by the fact that financial assets are pricing in a Goldilocks scenario of sustained strength, with little chance of either a slump or an overheating as the Fed continues its tightening cycle over the next year and a half.”

Here are the things that you need to know:

1) There have been ZERO times when the Federal Reserve has embarked upon a rate hiking campaign that did not eventually lead to negative economic and financial market consequences.

2) The median number of months following the initial rate hike has been 17-months. However, given the confluence of central bank interventions, that time frame could extend to the 35-month median or late-2018 or early-2019.

3) The average and median increases in the 10-year rate before negative consequences have occurred has historically been 43%. We are currently at double that level.

4) Importantly, there have been only two times in recent history that the Federal Reserve has increased interest rates from such a low level of annualized economic growth. Both periods ended in recessions.

5) The ENTIRETY of the“bullish” analysis is based on a sustained 34-year period of falling interest rates, inflation and annualized rates of economic growth. With all of these variables near historic lows, we can only really guess at how asset prices, and economic growth, will fair going forward.

6) Rising rates, and valuations, are indeed bullish for stocks when they START rising. Investing at the end of rising cycle has negative outcomes.

What is clear from the analysis is that bad things have tended to follow sustained increases in interest rates. As the Fed continues to press forward hiking rates into the current economic cycle, the risk of a credit related event continues to rise.

For all the reasons currently prognosticated that rising rates won’t affect the “bull market,” such is the equivalent of suggesting “this time is different.”

It isn’t.

Importantly, “This Cycle Will End,”  and investors who have failed to learn the lessons of history will once again pay the price for hubris.

China Is Winning The “Trade War” Without Firing A Shot

This past weekend, the Administration announced a tentative deal with China to temporarily postpone the burgeoning “trade war.” While the details of the deal are yet to be worked out, the concept is fairly simple – China will reduce the existing “trade deficit” by over $200 billion annually with the U.S. by reducing tariffs and allowing more goods to flow into China for purchase. On Monday, the markets reacted positively with industrial and material stocks rising sharply as it is expected these companies will be the most logical and direct beneficiaries of any deal.

Unfortunately, there are several reasons the whole scenario is quite implausible. Amitrajeet Batabyal recently explained the problem quite well.

“With China, the U.S. imports a whopping $375 billion more than it exportsHow could it whittle that down to $175 billion? There are three ways.

  • First, China could buy more U.S. goods and services.
  • Second, Americans could buy less Chinese stuff.
  • Finally, both actions could happen simultaneously.

The kinds of Chinese goods that Americans buy tend to be relatively inexpensive consumer goods, so even a dramatic decline is likely to have only a trivial impact on the deficit. And since China explicitly controls only one lever — its imports — it’ll have to buy a lot more American-made things to achieve this goal.

For this to happen, without upsetting other trade balances, the American economy would have to make a lot more than it currently produces, something that isn’t possible in so short a time frame.”

While the Administration will be able to claim a “trade victory” over a deficit reduction agreement, such is unlikely to lead to more economic growth as promised.

If we assume China does indeed spend an additional $200 billion on U.S. goods, those purchases will increase flows into the U.S. dollar, causing dollar strengthening relative to not only the Yuan but also other currencies as well. Since U.S. exports comprise about 40% of domestic corporate profits, a stronger dollar will counter the benefits of China’s purchase as other foreign importers seek cheaper goods elsewhere.

For China, a stronger dollar also makes imports to their country more expensive. To offset that, China will need to “sell” more of its U.S. Treasury holdings to “sanitize” those transactions and stabilize the exchange rate. This is not “good news” for Treasury Secretary Steve Mnuchin who would lose the largest foreign buyer for U.S. Treasuries.  This particularity problematic with the national debt expected to increase by at least one trillion dollars in each of the next four years.

There has been a lot of angst in the markets as of late as interest rates have risen back to the levels last seen, oh my gosh, all the way back to 2011. Okay, a bit of sarcasm, I know. But from all of the teeth gnashing and rhetoric of the recent rise in rates, you would have thought the world just ended. The chart below puts the recent rise in rates into some perspective. (The vertical dashed lines denote similar rate increases previously.)

It is important to understand that foreign countries “sanitize” transactions with the U.S. by buying or selling Treasuries to keep currency exchange rates stable. From 2014-2016China was dumping U.S Treasuries, and converting the proceeds back into Yuan, in an attempt to stem the outflows and resulting depreciation of their currency. Since 2016, China has been buying bonds as the Yuan has appreciated.

If China does indeed increase U.S. imports, the stronger dollar will increase the costs of imports into China from the U.S. which negatively impacts their economy. The relationship between the currency exchange rate and U.S. Treasuries is shown below.

With respect to the “trade deficit,” there is little evidence of a sustainable rise in inflationary pressures. The current inflationary push has come primarily from the transient effect of a disaster-related rebuilding cycle last year, along with pressures from rising energy, health care, and rental prices. These particular inflationary pressures are not “healthy” for the economy as they are “costs” which must be passed along to consumers without a commensurate rise in wages to offset them.

Asia is the source of most global demand for commodities, while also a huge supplier of goods into the US. Asian currencies have followed U.S. bond yields higher and lower since the 1990s, as well as followed commodity prices higher and lower over that time. There has only been one previous period when this relationship failed which was in 2007 and 2008.

With the Chinese financial system showing signs of increasing stress, any threat which devalues the currency will lead to further selling of Treasuries. Rising import costs due to a forced “deficit balancing,” will likely have more of a negative impact to the U.S. than currently believed.

Sum-Zero Game

While much of the mainstream media continues to expect a global resurgence in economic growth, there is currently scant evidence of such being the case. Since economic growth is roughly 70% dependent on consumption, then productivity, population, wage and consumer debt growth become key inputs into that equation. Unfortunately, productivity is hardly growing in the U.S. as well as in most developed nations. Further, wage and population growth remain weak as consumers remain highly leveraged. This combination makes a surge in economic growth highly unlikely particularly as rate increases reduce the ability to generate debt-driven consumption.

With unemployment rates near historic lows and production measures near highs, the problem of meeting Chinese demand will be problematic. As Amitrajeet states:

“That’s because when a nation’s economy is using its resources to produce goods efficiently, economists say that it has reached its production possibility frontier and cannot produce more goods.”

This makes Chinese promises largely illusory given the structural hurdles in China to allow for increased purchases of American exports much less the sheer amount of goods the United States would have to produce to meet Beijing’s demand.

As stated, with the United States economy already running near its full productive capacity, it is virtually impossible to produce enough new goods to meet Chinese demands, especially in the short term.

Sure, the United States could stop selling airplanes, soybeans and other exports to other countries and just sell them to China instead. Such actions would indeed shrink the United States trade deficit with China, but the trade deficit with the entire world would remain unchanged.

In other words, it’s a sum-zero game.

More importantly, if the U.S. cannot deliver the goods and services needed by China the entire agreement is worthless from the start. More importantly, China’s “concessions,” so far, are things it had planned to do anyway. As noted by Heather Long via the Washington Post:

“The Chinese have one of the fastest-growing economies and middle classes in the world. Chinese factories and cities need more energy, and its people want more meat. It’s no surprise then that China said it was interested in buying more U.S. energy and agricultural products. The Trump administration is trying to cast that as a win because the United States will be able to sell more to China, but it was almost certain that the Chinese were going to buy more of that stuff anyway.

What Trump got from the Chinese is ‘the kind of deal’ that China would be able to offer any U.S. president,’ said Brad Setser, a China expert at the Council on Foreign Relations. ‘China has to import a certain amount of energy from someone and needs to import either animal feed or meat to satisfy Chinese domestic demand.’

China has been buying about $20 billion worth of U.S. agricultural products a year and $7 billion in oil and gas, according to government data. Even if China doubled — or tripled — purchases of these items, it won’t equal anywhere near a $200 billion reduction in the trade deficit.”

But where China really won the negotiation was when the United States folded and agreed to suspend “trade tariffs.” While the current Administration is keen on “winning” a deal with China, without specific terms (such as a defined amount of increased purchases from the U.S. and the ability to meet that demand) the “deal” has little meaning. China has a long history of repeatedly reneging on promises it has made to past administrations.

By agreeing to a reduction of the “deficit” in exchange for “no tariffs,” China removed the most important threat to their economy as it will take 18-24 months before the current Administration realizes the problem.

“Yes, it’s good for both sides not to be in a trade war, but the Chinese had more to lose economically from the tariffs. The Trump administration rolling back its $150 billion tariff threat against China is a good ‘get’ for the Chinese.”

As with all things, there are always two sides to the story. While the benefits of reducing the trade may seem like a big win for America, reality could largely offset any benefits. If the goal was simply to be seen as the winner, Trump may have won the prize. But, it will likely be China laughing all the way to the bank.