THE DAILY EDGE: 26 AUGUST 2019: 1987?

Trump Says China Called U.S. and Wants to Do a Deal President Trump sought to ease trade tensions with China and struck a more conciliatory note on the final day of the Group of Seven summit, where world leaders have pressured him to de-escalate the trade war

Asked if he would abandon the tariffs, Trump said: “Anything is possible. I can say we are having very meaningful talks, much more meaningful I would say than any time frankly.”

The U.S. president, who at times predicts a deal will happen and at other times says he is happy with the tariff situation, said talks would start again soon and a deal would come.

“I think we are going to have a deal,” he said.

Just Another Manic Friday Trump and Xi see who can take the most trade pain. Everyone loses.

The trouble with trade wars, like shooting wars, is that once they start you never know how they’re going to end. (…) Order? Somebody should tell Chairman Trump this isn’t the People’s Republic of America. U.S. businesses have been trying to shift production out of China to avoid tariffs, but supply chains that have been developed over decades can’t be uprooted overnight. And no other country has China’s huge relatively skilled workforce, infrastructure and network of suppliers.

(…) markets are wondering if we’re heading toward mutual assured economic destruction. Mr. Trump this week also dismissed the risk of a recession, but his continued mauling of Mr. Powell suggests he’s less than confident about the U.S. economy. Perhaps Beijing has taken note and believes its leverage in trade negotiations is increasing. (…)

What was that again about trade wars being easy to win?

Trump ‘hereby’ orders U.S. business out of China. Can he do that? Some see Trump’s command as more than ‘cheap talk,’ saying he has real tools to encourage compliance.

President Trump’s extraordinary edict demanding U.S. companies move out of China — delivered in a series of angry tweets Friday — left industries of every stripe scrambling to understand how seriously to take the order, and how the White House might enforce it. (…)

Trump does not have the authority to “duly order” companies to leave China, according to Jennifer Hillman, a Georgetown University law professor and trade expert at the Council on Foreign Relations.

But under the law he cited, Trump can prevent future transfers of funds to China, she said. First, he would have to make “a lawful declaration that a national emergency exists,” she said.

Congress could terminate the declaration if it wishes, she said.

“Moreover, even if all this happened, it would not provide authority over all of the U.S. investments that have already been made in China,” Hillman said.

Other trade experts said Trump does have powerful tools at his disposal to encourage companies to leave.

They include continuing to hike tariffs on imports from China, as Trump did again on Friday. The White House could also try to punish companies by cutting them out of federal procurement deals, economists said. (…)

• Explainer: What tools could Trump use to get U.S. firms to quit China?

(…) Once an emergency is declared, the law gives Trump broad authority to block the activities of individual companies or even entire economic sectors, former federal officials and legal experts said.

For example, by stating that Chinese theft of U.S. companies’ intellectual property constitutes a national emergency, Trump could order U.S. companies to avoid certain transactions, such as buying Chinese technology products, said Tim Meyer, director of the International Legal Studies Program at Vanderbilt Law School in Nashville. (…)

Another option that would not require congressional action would be to ban U.S. companies from competing for federal contracts if they also have operations in China, said Bill Reinsch, a senior adviser at the Center for Strategic and International Studies think tank.

Such a measure might be targeted specifically at certain sectors since a blanket order would hit companies such as Boeing (BA.N), which is both a key weapons maker for the Pentagon and the top U.S. exporter.

Boeing opened its first completion plant for 737 airliners in China in December, a strategic investment aimed at building a sales lead over its European arch-rival Airbus (AIR.PA). (…)

In the NYT:

(…) Mr. Trump’s tweets on Friday caught most of his advisers and staff by surprise, and prompted alarm. Some of his advisers privately expressed concern that the ferocity of the president’s response could permanently derail the negotiations and could unsettle supporters during an election year.

Michael Pillsbury, a China scholar at the Hudson Institute who informally advises the White House, said that Mr. Trump had been considering more draconian options, but settled on the higher tariffs in hopes that negotiations with China would proceed. He said that he expected the two countries would continue to keep the details of what they had previously agreed to confidential and that the lines of communication between Mr. Trump and Mr. Xi would remain open.

As for Mr. Trump’s attack on Mr. Xi and Mr. Powell as enemies, Mr. Pillsbury suggested that it was not meant with ill will.

“The president often speaks with poetic license to make his point,” Mr. Pillsbury said.

(…) Mr. Trump’s advisers believe he is being urged on by Peter Navarro, a trade adviser who has been the main proponent of continuing down an antagonistic path with China. Mr. Navarro tried to play down the escalation on Fox Business Network, saying Beijing’s response was to be expected and would only galvanize support in the United States for Mr. Trump’s tough approach to China.

“I just think that the way that China is reacting to this whole thing is simply reinforcing America’s perception of China as a bad actor,” said Mr. Navarro, who is considered the biggest China hawk in the administration. “When China tries to bully us, that only strengthens our resolve.”

Mr. Navarro said the new tariffs that China was imposing were just a sliver of the overall United States economy and that they should not affect growth. He said that actions by central banks to cut interest rates were more significant to the global economy than the trade dispute between the United States and China.

David Dollar, a China expert at the Brookings Institution, said that Mr. Trump’s anger appeared disproportionate to the relatively modest retaliation from China that should have been anticipated. However, he said it was notable that Mr. Trump’s order to companies appeared to take a page from Beijing’s playbook.

“It’s definitely outside the realm of a free-market economy,” Mr. Dollar said of the call for businesses to cut ties with China. “It’s typical of the kind of thing we complain about from China and other economies where a government intervenes outside the rule of law.”

Fed Says It’s Trade, Not Rates, That’s Undermining the U.S. Economy

Latest Round in Trade War Set to Hit U.S. Vehicles, Agriculture Hard The U.S. and China raised tariffs on one another, with Beijing extending the levies to almost its remaining U.S. imports.

(…) Items China plans to impose or raise tariffs on include agricultural products, automobiles, apparel, chemicals and textiles.

Major car companies will be hit particularly hard by the increase in tariffs, particularly Tesla Inc. and Ford Motor Co., as well as Germany’s BMW AG and Daimler AG ’s Mercedes-Benz. These companies build a significant number of vehicles in the U.S. for export to China—mostly premium models—and a higher tariff could force them to raise prices and lose sales.

China is the second-largest export market for U.S.-made autos, accounting for $6.2 billion of exports last year, according to statistics published by the U.S. International Trade Administration. For parts, the country was the third- largest market, with 2018 exports worth $3.6 billion. In all, auto makers exported roughly 230,100 U.S.-built cars to China last year, according to forecasting firm LMC Automotive.

U.S. oil exports to China have already fallen this year amid the trade tensions. (…)

“For American farmers, every week the trade-war pain gets compounded,” said a statement from Farmers for Free Trade, a coalition of agriculture producers. “This latest escalation means even higher barriers into a market that not long ago was our second-largest ag export destination.” (…)

John Mauldin:

• Digging a Hole to China

(…) The Chinese government routinely extracts (or steals) trade secrets from foreign businesses that wish to operate in China. Software code, drug formulas, and other information then finds its way to Chinese companies that shamelessly copy it.

Again, this is nothing new. The same thing happened years ago when Chinese merchants pirated all manner of Western consumer goods. More recently they’ve done the same for intangible technology and sent it into overdrive. And the Chinese government does nothing to stop it.

Talks to resolve these and other problems have been fruitless. Beijing agrees to changes then fails to implement them, and gets away with it because the US and other Western democracies have these inconvenient things called “elections.” China’s rulers know they can just wait out the clock until we get a new leader with different priorities.

(…) the trade deficit is not a problem. But even if you assume it is a problem, tariffs won’t solve it so long as the government continues to run huge and growing deficits. No one in either party has any intent of even moving toward a balanced budget. Therefore, the trade deficit is going to grow—with other countries even if not China.

The US is using the wrong weapon to solve the wrong problem and harming our own economy in the process. (…)

Tariffs are hurting US consumers. China is not paying those tariffs, we are, and any economist worth their salt (other than Navarro) knows it.

Get tough with China? Damn Skippy. But don’t make Americans pay for it. If you’re going to fight a trade war then don’t point the gun at yourself.

• The Sources of Chinese Conduct Are Washington and Beijing Fighting a New Cold War?

Great Foreign Affairs article by ODD ARNE WESTAD, Elihu Professor of History and Global Affairs at Yale University. Some excerpts here but well worth reading the whole piece.

(…) Today, China’s economic power relative to the United States’ exceeds what the Soviet Union’s relative power was by a factor of two or three. Although that growth has now slowed, those who believe that China will soon go the way of Japan and fall into economic stagnation are almost certainly wrong. Even if foreign tariffs on Chinese goods stayed high, China has enough of an untapped domestic market to fuel the country’s economic rise for years to come. And the rest of Asia, which is a much larger and more economically dynamic region than Western Europe was at the beginning of the Cold War, fears China enough to refrain from walling it off with tariffs. (…)

But China is not the Soviet Union. For one thing, Soviet ideology was inherently opposed to any long-term coexistence with the United States. From Lenin onward, Soviet leaders saw the world in zero-sum terms: bourgeois democracy and capitalism had to lose for communism to win. There could be alliances of convenience and even periods of détente, but in the end, their form of communism would have to be victorious everywhere for the Soviet Union to be safe. The CCP does not share such beliefs. It is nationalist rather than internationalist in outlook. The party sees Washington as an obstacle to its goals of preserving its own rule and gaining regional dominance, but it does not believe that the United States or its system of government has to be defeated in order to achieve these aims.

Moreover, Chinese society is more similar to American society than Soviet society ever was. In the Soviet Union, citizens generally accepted and conformed to socialist economic policies. Chinese, by contrast, appear to be interested above all in getting ahead in their competitive, market-oriented society. For the vast majority of them, communism is simply a name for the ruling party rather than an ideal to seek. (…)

Now, the United States seems to have lost its way at home and abroad. Under the Trump administration, the country’s overall standing in the world has never been lower, and even close allies no longer view Washington as a reliable partner. Since well before the presidency of Donald Trump, U.S. foreign policy elites have been lamenting the decline of any consensus on foreign affairs, but they have proved incapable of restoring it. Now, the rest of the world questions the United States’ potential for leadership on issues great and small, issues on which American guidance would have been considered indispensable in the past. (…)

Attempting to disentangle the United States’ economy from China’s through political means, such as travel restrictions, technology bans, and trade barriers, will not work, unless a de facto state of war makes economic interaction impossible. In the short run, tariffs could create a more level playing field, but in the long run, they may end up advantaging China by making it more self-reliant, to say nothing of the damage they would inflict on American prestige. And so the rivalry with China will have to be managed within the context of continued economic interdependence. (…)

One of Kennan’s greatest insights, however, had nothing to do with foreign affairs; it had to do with American politics. He warned in his “X” article that “exhibitions of indecision, disunity and internal disintegration” within the United States were the biggest danger the country faced. Kennan also warned against complacency about funding for common purposes. Like 70 years ago, to compete today, the United States needs to spend more money, which necessarily means higher contributions from wealthy Americans and corporations, in order to provide top-quality skills training, world-class infrastructure, and cutting-edge research and development. Competing with China cannot be done on the cheap. Ultimately, Kennan argued, American power depended on the United States’ ability to “create among the peoples of the world generally the impression of a country which knows what it wants, which is coping successfully with the problems of its internal life and with the responsibilities of a world power, and which has a spiritual vitality capable of holding its own among the major ideological currents of the time.”

Although one might phrase it differently, the challenge is exactly the same today. Will the competition with China focus, to use one of Kennan’s favored phrases, “the American mind” to the point that the United States abandons domestic discord in favor of consensus? If some unifying factor does not intervene, the decline in the United States’ ability to act purposefully will, sooner than most people imagine, mean not just a multipolar world but an unruly world—one in which fear, hatred, and ambition hold everyone hostage to the basest instincts of the human imagination.

RECESSION WATCH

David Kotok, Cumberland Advisors: Does Trump-Navarro Equal Smoot-Hawley?

(…) The late Allan Meltzer noted in A History of the Federal Reserve Volume 1: 1913-1951 that “Research suggesting a small effect [i.e., from tariffs] ignores the pronounced effect on farm exports, distress, bankruptcies, and bank failures in farm states” (p. 564, note 299). Readers are invited to check the rising bankruptcy statistics in farm states in 2019. The Trump-Navarro trade policy is responsible; the correlation between the Trump trade war and rising distress is very high. (…)

Peter Navarro owns the advisory role and the argument in favor of the present US trade war policy. President Trump owns the decisions. Together they are digging a hole, and that hole is getting deeper. Market agents know it. Farm-state voters know it. Financial agents know it.  

No matter what Navarro says and whom Trump blames, the truth is that the responsibility for the economic slowdown and the financial volatility lands squarely on the Oval Office desk and in the lap of the president and his advisors. He does not have the courage to admit an error. He avoids any self-blame. He constantly bashes the Fed since it (and Jay Powell) is a convenient and distracting target.

There is a fitting adage attributed to Will Rogers: “If you find yourself in a hole, stop digging.” Mr. Navarro, Mr. Trump, read history. You are digging a deeper and deeper hole for the nation and the world. Stop digging

Lacy Hunt, Hoisington Investment Management:

Fundamental economic indicators suggest that recessionary forces may be advancing faster than is generally recognized inside and outside the Fed:

(1) Real gross domestic income (GDI) gained at a very meager 0.76% annual rate in Q4 2018 and Q1 2019, well below the 2.65% growth in real GDP. Over the past year, real GDP growth was 3.2%, versus 1.7% for GDI, hardly ebullient growth. Normally, GDI and GDP have moved together going into recessions but prior to the severe recession in 2008, GDI led GDP, just as presently, a clear warning sign.

(2) Net national saving as a percent of gross national income was just 2.4% in the first quarter of 2019, well down from the post 1929 average of 6.4%. Based on net national saving for this year’s first quarter, the economy is just as ill-prepared for recession as in 2007, the year before the Great Recession.

(3) Real disposable income in the latest month was below the level attained in December 2018, the potential cyclical peak.

(4) Manufacturing, which is the high value added sector, has also declined since the end of 2018 and shows the most definitive sign of already being in a recession.

(5) The transportation sector, rail, truck and air freight, have all declined this year.

(6) The Economic Cycle Research Institute’s weekly leading economic indicator in late June was more than 2% below the cyclical peak reached about two years ago. (…)

Accordingly, monetary restraint is continuing to weigh on economic growth. Inflation, which fell below the Fed’s targets and most Wall Street forecasts, will remain on a downward path. These cyclical forces suggest that inflationary expectations should continue to fall this year and next as the economic growth rate weakens further. This means that a mild recession would push the real rate into negative territory. Thus, both determinants of the nominal long risk-free rate (i.e. the real rate and inflationary expectations) are directionally favorable for further interest rate declines, although the path will continue to remain volatile.

U.S. New Home Sales Disappoint in July But Large Upward Revision to June

New home sales declined 12.8% m/m (+4.3% y/y) in July to 635,000 (SAAR) from 728,000 in June, a massive upward revision from the initially reported 646,000. Sales in May were revised down slightly to 602,000 from 604,000. (…) Despite the latest decline, new home sales remained 14.0% higher than the recent low in October. These sales transactions are recorded when sales contracts are signed or deposits are made. (…)

EARNINGS WATCH

Amid all the uncertainties on the economy and trade wars, earnings provide a fundamental underpinning for equities. The Q2 earnings season ends this week.

From Refinitiv:

Through Aug. 23, 482 companies in the S&P 500 Index have reported earnings for Q2 2019. Of these companies, 73.9% reported earnings above analyst expectations and 18.0% reported earnings below analyst expectations. In a typical quarter (since 1994), 65% of companies beat estimates and 20% miss estimates. Over the past four quarters, 76% of companies beat the estimates and 18% missed estimates.

In aggregate, companies are reporting earnings that are 5.6% above estimates, which compares to a long-term (since 1994) average surprise factor of 3.3% and the average surprise factor over the prior four quarters of 5.3%.

Of these companies, 57.1% reported revenues above analyst expectations and 42.9% reported revenues below analyst expectations. In a typical quarter (since 2002), 60% of companies beat estimates and 40% miss estimates. Over the past four quarters, 63% of companies beat the estimates and 37% missed estimates.

In aggregate, companies are reporting revenues that are 1.3% above estimates, which compares to a long-term (since 2002) average surprise factor of 1.5% and the average surprise factor over the prior four quarters of 1.0%.

The estimated earnings growth rate for the S&P 500 for 19Q2 is 3.2%. If the energy sector is excluded, the growth rate improves to 3.9%. The estimated revenue growth rate for the S&P 500 for 19Q2 is 4.7%. If the energy sector is excluded, the growth rate improves to 5.1%.

Earnings revisions remain lukewarm on large caps but still negative on smaller caps:

Preannouncements are not worsening two months into Q3. Last week, 5 were positive and 2 negative.

The estimated earnings growth rate for the S&P 500 for 19Q3 is -1.9% (-1.6% last week). If the energy sector is excluded, the growth rate improves to -0.3% (-0.1%).

1987?

Current geopolitical conditions remind me, to some extent, of the German/USA confrontation of September/October 1987 with the U.S. trade deficit at the center of the clash. There is still a debate on what really caused the crash but on the eve of Black Monday, financial markets realized that Germany and the USA were not “cooperating” anymore creating much uncertainty about what would happen without coordinated monetary policies.

• But in an appearance on Cable News Network the following day, Treasury Secretary Baker warned that the U.S. would not be pushed into further interest-rate hikes to defend the dollar. The German authorities “should not expect us to sit back here and accept” rate increases by the Bundesbank. “We will have to re-examine the scope and basis” of the Louvre Accord, which had been reaffirmed just the previous month by the Group of Seven. Bottom line: Given the choice between higher U.S. interest rates and a weaker dollar, the Baker Treasury would opt for the latter.
• “They should not expect us to simply . . . accept increased tightening on their part on the assumption that somehow we are going to follow them on a path of deflation,” Baker said in a television interview on Cable News Network. “That’s an assumption that’s not warranted.”
• Hermann Remsperger, chief economist at Deutsche Bank, said he did not find it ”very helpful that Mr. Baker used a lower dollar as a threat or a weapon against other nations.” ”I think there is a big necessity to cooperate in economic policy, and we should avoid such statements,” he said. ”It is not good for the overall climate to threaten.”

Uncertainty freezes corporate spending but also scares financial markets. Too many people uncertain and scared at the same time can find themselves without bids all of a sudden. At 9:30 on October 19, 1987, there were literally no bids above a 20% markdown from Friday’s close. The DJIA sank 22.6% that day!

The S&P 500, at 2847, is selling at 19.5 on the Rule of 20 P/E scale. Few would bet on rising P/Es in current circumstances. The December 2018 low was at 16.8 (that would be 2400, 15.7% lower).

FYI, the low in 1987 was 18.1 on the Rule of 20 scale (2620 today, 8% lower). On the conventional P/E: 14.4 on trailing EPS. Currently, 2400 on the S&P 500 would be a P/E of 14.6 and 2620 would be 15.9.

Note that in 1987, earnings were on a recovery path, rising at an accelerating rate while inflation was slowly edging higher. Today, inflation is creeping up and earnings are still rising, albeit slowly, but forward earnings are highly questionable.

Few would also bet on earnings rising meaningfully for a while. As to inflation, ask the Fed!

Careful out there!

Will the S&P500 crater under the weight of trade tensions?

NBF plots the 125 corporations with the largest foreign revenues (%) vs the 125 with the largest U.S. revenues (%)

We’ve argued several times that the U.S. corporations are not immunized against a trade war escalation as foreign sales account for no less than 43% of total revenues for the S&P 500 listed companies. As today’s Hot chart shows, stocks of firms with the largest foreign exposures are still outperforming by a significant margin the ones tilted towards the domestic economy. This advantage can wane fast if trade tensions do not abate in the coming weeks. Recent S&P500 drawdowns have indeed been felt more acutely for these corporations.

• RBC plots small caps (mainly domestic revenues) against large caps:

RBC points out the high debt levels in small caps and that some 33% of Russell 2000 companies are money losers (2% for S&P 500). Beware the relative P/Es.

TECHNICALS WATCH

Lowry’s Research commentary for the week ended Aug. 23 remained positive but I discovered that the Supply/Demand analysis omitted Friday’s data and thus that Selling Pressure actually regained the dominant position to Buying Power on Friday. The chart below includes Friday’s data: