Stocks Hit New Highs Despite Rotation Into Defensive Sectors

So, forward valuations for our Baker’s Dozen stocks appear to be much more attractive. And with fiscal stimulus boosting what I consider to be a mid-cycle economy that finally seems ready to ramp into a long-awaited boom phase, cyclicals remain the place to be overweighted, according to our model. We have great optimism that as strong earnings reports continue to roll in, if forward guidance remains solid and the trade wars are resolved (especially with China), investor sentiment will fall in line and we will see a risk-on rotation back into cyclicals as the market once again rewards stronger GARP qualities rather than just the momentum or defensive names. In fact, if you look closely at the December Baker's Dozen performance chart above, the brief but significant performance upturn in mid-August – after the announcement that talks with China had resumed – may have provided a glimpse of that potential.

The economy, corporate earnings, and Fed policy:

Next, let’s explore the strength in the economy and corporate earnings, the direction of interest rates, and the likely outcome of trade wars.

Numerous market pundits have been lamenting “protectionist” tariffs, a slowdown in housing, a too-strong US dollar, a spiraling financial crisis in emerging markets (led by Turkey and Argentina, spreading to Brazil, South Africa, and Indonesia), growth deceleration in Europe and China, a hawkish Fed, the yield curve threatening to invert, and a toxic domestic political environment with mid-term elections on tap, et al. And yet the US economy just keeps expanding. The BEA’s second estimate of GDP came in at a 4.2% annual rate in the second quarter (after an advance reading of 4.1%), which is the fastest rate since late-2014. Looking ahead, the Atlanta Fed’s GDPNow model as of September 5 forecasts 3Q18 GDP annualized growth of 4.4%, while the New York Fed’s Nowcast model as of September 7 forecasts 2.2%. Friday’s jobs data was stellar, with unemployment remaining at 3.9%, while year-over-year wage growth clocked in at 2.9%. Consumer and business confidence, household consumption, and industrial production are all strong. ISM Manufacturing report blew away estimates (61.3 vs. 57.7 consensus), with strong production, a surge in new orders, and rising backlogs. Q2 earnings reports showed that 83% of US firms beat earnings estimates, driven by broad-based revenue growth (not just tax cuts) and record levels of profitability (around 12%). In his speech at the Jackson Hole Economic Symposium, Fed chair Jerome Powell said:

“Over the course of a long recovery, the U.S. economy has strengthened substantially…With solid household and business confidence, healthy levels of job creation, rising incomes, and fiscal stimulus arriving, there is good reason to expect that this strong performance will continue.”

Mr. Powell defended the FOMC’s plan for a slow-but-steady rise in the fed funds rate, but he also noted that as long as the unemployment rate remains low and inflation stable near the 2% target, he doesn’t see a need to accelerate the current path of interest rate increases. And St. Louis Fed CEO James Bullard suggested, “The Phillips Curve has disappeared and neither low unemployment nor faster real GDP growth gives a reliable signal of inflationary pressure” such that the Fed should watch the yield curve in deciding monetary policy.

They seem to be leaving open the door to adjustments to the current plan, and I believe these are the initial signals of a potential slowing of Fed rate hikes. Indeed, in contrast to the stated plan for two more rate hikes this year followed by four next year, which would move the fed funds rate from the current 2.00% to 3.50% by the end of 2019, CME Group fed funds futures (which essentially reflect the real-money bets by knowledgeable traders on what the Fed will actually do) suggest that the highest percentage likelihood (62%) by next September is a fed funds rate of 2.75% or less. But in the near term, fed funds futures currently place the odds of a rate hike at the upcoming September meeting at 99.8%, and by the December meeting, there is an 80% probability of another quarter-point rate hike. But for next year, the story might be quite different.

So, why would Powell slow things down if he thinks our economy is so solid? Well, there are a number of reasons. First of all, we aren’t an island unto ourselves, and the divergent monetary policies of central banks mean that Fed tightening has strengthened the dollar to the detriment of emerging markets (who carry dollar-denominated debt but earn their money in weaker local currencies), and rising interest rates can further hurt their ability to repay. Weaker currencies in these markets have contributed to the decline in commodity prices. Moreover, President Trump has made it clear that he will not be a happy camper if Fed tightening messes up our strong economic growth – which Trump is using as “cover” to fight his trade wars. In addition, some strategists would say that we appear to be on the verge of a “Fed inversion” of the yield curve. The 10-year Treasury yield closed Friday at 2.94% while the 2-year T-note is at 2.68%, so the closely-watched 2-10 spread is only 24 bps (less than one Fed 25-bp rate hike). You see, the Fed controls the short-end of the curve, and the 2-year note is heavily influenced by it, but the 10-year is much more market-driven (with Fed QE/QT having lesser impact), and you can bet the Fed doesn’t want to be responsible for inverting the curve.

What are these market dynamics pushing capital into US Treasuries and keeping the 10-year yield under 3.0%? Regular readers of mine know that I have been in the “lower for longer” camp regarding the 10-year Treasury yields for a long time (and lower long-term yields support equity valuations). These dynamics include geopolitical turmoil and aging demographics seeking safe yield, divergent central bank monetary policies and the much higher rates offered in the US (and the resulting “carry trade” from other countries), plus the structure of cap-weighted fixed income indexes whereby the large mutual funds and ETFs whose mandate is to track them must buy these Treasuries, even as new issuance floods the market.

But with the 10-year struggling to rise while the fed continues to raise on the short end, the flattening of the yield curve – according to the Fed chair himself – is essentially the marketplace telling the FOMC that it is already close to the “neutral rate” and may not need to raise much further. (The neutral rate is the level at which the Fed's target fed funds rate neither stimulates nor slows the economy, and Fed officials see it as being close to 3%.) Powell has previously stated that there is a lot of uncertainty surrounding estimates of the neutral interest rate, and that the FOMC therefore “will refer to many indicators when judging the degree of slack in the economy or the degree of accommodation in the current policy stance.”

The trade war with China:

As for the ongoing trade tensions. In my August article, I said that I would talk a lot more this month about China, so let’s have a go at it.

As you know, our President has been using various unconventional tactics to bring our various trading partners to the negotiating table to rework longstanding trade deals he believes have essentially subsidized the growth of other countries at our own expense. In other words, the temporary “hand up” long ago became a permanent “hand out” (aka entitlement) that they no longer need and we can no longer afford. Of course, the biggest offender is China, which has long used state ownership, subsidy, overcapacity, tariffs, forced technology transfer, patent violations, and outright theft of intellectual property (IP) to give their businesses an advantage in the global marketplace, while US businesses have looked the other way so as not to jeopardize their entry into the Chinese market. From China’s standpoint, it is much more expedient to appropriate the technology needed to drive growth than to go through the arduous and expensive process of R&D.

In a search for ways to continue its rapid growth in the face of the “law of large numbers” as an obstacle, the country has embarked upon its Belt & Road Initiative (aka BRI) and created a “Made in China 2025” strategic roadmap. BRI is an ambitious state-backed stimulus package for a slowing economy (and a path to global dominance) made up of a “belt” of overland corridors and a maritime “road” of shipping lanes that connect Asia, Africa, and Europe, encompassing 71 countries comprising over half the world’s population and roughly a quarter of global GDP. China continues to aggressively build infrastructure – like airports, subways, bullet trains, and renewable-energy facilities (including nuclear power plants with stolen technology). It also will allow China to employ its excess capacity while luring many poor countries into a “debt trap” in which China can, for example, acquire land in exchange for writing off their debts. As for the Made in China 2025 initiative, it has the goal of capturing 70% of global production in the emerging industries of the future. This includes seeking to become the global leader in artificial intelligence (AI) by 2030, supplanting the US. To accomplish all of this, I’m sure China’s leaders feel the need to continue appropriating the IP of others rather than to create and pay for it themselves.

But a trade war couldn’t come at a worse time for China, in my view. The country is burdened with a highly-levered and fragile financial system, with some estimates that total debt-to-GDP has risen over the past 10 years from roughly 140% to about 300% – and much of that debt went to build massive domestic infrastructure projects with little to no ROI. And given that it produces nearly 19% of global GDP, the ripple effects are also impacting commodity prices and emerging markets. Now it finds itself with slowing GDP growth as domestic demand and credit expansion has slowed, while new manufacturing data show slowing export orders. But China is better prepared today to deal with this, as it has implemented rigid capital controls, tighter regulation, and improved coordination between policymakers than in 2015 when it was still early in its deleveraging efforts. Thus, the government actually has had some success in navigating its way through the deleveraging process without upsetting aggressive growth targets.

For example, it has restricted the practice of large domestic companies issuing local debt to buy US dollar-denominated assets, which weakened its currency and its consumer purchasing power at a time when it needed to transition to more of a consumer-driven economy (rather than simply dump cheap goods on the world as a disinflationary manufacturing-driven economy, as it had done for so many years). Such capital controls have helped to greatly slow capital flight to other countries, and restrictions on rampant “shadow banking” and “wealth management products” (risky uninsured loans disguised as investments, generally offering high yields and sometimes guaranteed returns) have improved domestic and foreign confidence in the renminbi, thus allowing the currency to gradually depreciate (rather than rapidly plummet), and the People’s Bank of China (PBC) is better able to balance structural financial reform and deleveraging with monetary easing and fiscal stimulus as needed.

Nevertheless, the trade war has renewed pressure on the renminbi, which endured its biggest monthly fall against the U.S. dollar on record in June, when the trade war rhetoric became reality. This led the Chinese government to temporarily reverse its quantitative tightening policies, injecting liquidity back into the system by renewing QE, cutting taxes, and redoubling infrastructure investment. Although this is counter to its goal of loosening up its capital markets and currency exchanges in order to take its “rightful place” among the world’s major financial powers, it had to be done – especially if you look back to the crisis it faced with capital flight in 2015 when it burned through $1 trillion in foreign currency reserves to support the renminbi before finally succumbing to a devaluation. But this time around, capital flight was more contained, and China has not had to resort to a currency devaluation like it did back in 2015. Many experts think that another currency devaluation would likely undermine deleveraging effort, drive unlawful capital flight, ignite inflation, and stanch the growing interest of foreign investors in China’s capital markets. So, I would think another devaluation is a monetary “last resort,” and a strategic “last resort” retaliatory tactic might be the withholding from the marketplace of rare earth metals (which are critical ingredients in high-tech consumer and military electronics, and China is the world’s primary producer).

All in all, with its economy weakening and its stock market mired in a bear market, it seems to me that China can ill-afford any escalation in the trade war with the US. But by the same token, giving up the advantages it enjoys in our existing trade deals would also hurt it. So, it’s a bit of a Catch-22. But on balance, it seems to me that it would be better to appease Trump than let this drag out.

Written By: Scott Martindale