Last Week Today (market-moving events): President Trump quadrupled-down on China, threatening tariffs on $200 billion more Chinese imports, on top of the $50 billion already announced; China announced they intend to reciprocate with tariffs on goods imported from the US; Trump threatened 20% tariffs on European automobiles. | OPEC’s members agreed to increase crude production by 600,000 barrels per day.
In a week dominated by trade concerns, global equity markets failed to gain traction and the MSCI ACWI declined by a modest -0.6%. The domestic benchmark S&P 500 fared slightly worse, falling -0.9%. In a rare win for value investors, the Russell 1000 Value Index outperformed its companion Growth Index -0.6% vs. -1.1%. One week is not a pattern, but a broad swath of active managers would welcome consistent outperformance of value over growth stocks. Meanwhile, emerging market and frontier market stocks took it on the chin, falling more than 2% for the week, led by China’s 3.7% decline (China’s Shenzhen 300 Index is now down nearly 10% YTD). Developing-nation stocks are suffering from both the threat of reduced trade and a stronger US dollar (+2.6% YTD). In fixed income investments, all eyes remain on the yield curve as it continues to flatten. The spread between the yield on 10-year and 2-year treasuries tightened again, such that investors in bonds maturing in 10 years earn only 0.35% more per year than those investing in 2-year bonds (2.89% vs. 2.54%). Within commodities, Dr. Copper (so called because it is an indicator of global economic growth) fell 3.7% and is now down 8.3% YTD. WTI Crude oil rose (5.4% to $68.58 per barrel) on news of the OPEC production increase, which was a) in line with expectations and b) an indication that the cartel is not splintering apart, as some had feared.
For detail on weekly, month-to-date and year-to-date asset class performance, please click here.
This Week Today: This week’s knowable potential market-moving events are mostly tied to economic data releases, including New Home Sales (May), Consumer Confidence (June), Durable Goods Orders (May), and Personal Consumption Expenditures (May). Of course, it is often the unexpected that moves markets, so we’ll see what this week brings along with everyone else.
Tariffs and Global Economic Growth
As noted above, headlines about actual and threatened tariffs continue to buffet financial markets. The consensus is tariffs are bad (unless you happen to work in an industry that “benefits” from the tariffs), but why? In this short piece, we review how tariffs affect economic growth, beginning with economic theory and ending with practical implications.
One cannot explore the economics of tariffs, without first considering the theory of comparative advantage. Introduced by eighteenth-century economist David Ricardo, the theory of comparative advantage posits that a country can experience its highest potential growth by focusing on the industry (or industries) in which it can produce goods or services with the lowest opportunity cost.
A comparative advantage differs from an absolute advantage, a concept with which most of us are familiar. As a refresher, absolute advantage is anything a country does more efficiently than other countries. An absolute advantage can be achieved in various ways, including cheaper labor, abundant resources, or superior technology. Whereas an absolute advantage considers only the relative competitiveness of a country’s ability to produce a product or a service, a comparative advantage considers the opportunity cost to a country of producing Product A vs. Product B. Indeed, a country can have an absolute advantage in producing multiple products, yet only have a comparative advantage in a subset of those products.
To demonstrate the difference between the concepts of comparative and absolute advantages, consider a hypothetical scenario including an attorney (Pam) and a secretary (Ann). Pam is an excellent attorney and a proficient typist (60 words per minute). Ann is not an attorney, but she can type well, averaging 50 words per minute. As such, Pam has an absolute advantage over Ann in both legal and typing skills. Let us further assume that Pam can charge $150 per hour for her legal services, but the market value of her typing skills is only $25. Pam can maximize the profitability of her practice (or GDP output if Pam were a country) by hiring Ann, even though Ann is a less-skilled typist. Pam’s profit maximization comes from focusing on the higher value legal work as her opportunity cost of typing is $125 per hour.
Source: Market Business News
This simple example provides a baseline for understanding how the theory of comparative advantage applies to global commerce. Technological advances have given rise to globalization, allowing companies to procure components (or services) from suppliers around the world. The suppliers of these products and services offer companies an alternative to using local suppliers if they provide products/services that are more efficient – either due to price, quality, or a tradeoff between the two. In other words, globalization allows companies to source products/services from countries with the greatest comparative advantage, whether it be from their own country or from another country.
Source: Our World in Data
As this chart illustrates, global trade was limited through the early 1800’s, never surpassing 10% of global GDP. Improved technology, primarily in the form of communications and transoceanic shipping, led to the first wave of globalization in the late 1800’s. However, the globalization trend reversed during the World War era (the blue lines in the chart) when enemy countries ceased trading, and international liberalism gave way to nationalism. Following World War II, countries reopened trading channels, international commerce accelerated (the orange line in the chart), and global economic growth along with it.
Today international commerce is once again threatened by nationalist tendencies. This statement is not intended to suggest that the currently proposed tariffs will reduce trade to World War-era levels. Yet, tariffs artificially inflate the cost of international commerce and, in so doing, reduce the efficiencies otherwise available from maximizing comparative advantages.
When companies are unable to source goods/services at price levels set by countries with the greatest comparative advantage, the global economy is less efficient and productivity declines in each affected country. For example, if President Trump’s threatened tariffs on $250 billion of Chinese imports were implemented, the domestic GDP growth rate would be “taxed” by approximately 0.2% (Source: Cornerstone Macro). While unlikely to plunge the economy into a recession, at that level tariffs would offset nearly half of the economic growth from the recently enacted tax cuts.
The expansion of global trade has created winners and losers both between countries and for different groups of citizens within countries. But, in the aggregate, expanding global trade has generated a higher standard of living through greater global economic growth. Moreover, global trade facilitates efficient production and resource utilization as there is a ready market for the products/services supplied by countries pursuing their comparative advantage(s). Global trade and comparative advantage are critical aspects of capitalism, which thrives on the efficient allocation of resources.
Capitalism is most effective when governments allow companies to make decisions unfettered by politically motivated taxes designed to curry favor with constituents – this applies internationally as much as it does domestically. In this respect, tariffs are the enemy of capitalism and global economic growth. Indeed, during the recent G7 summit President Trump (in direct contradiction to his actions) shocked our trading partners by suggesting that everyone agree to eliminate all tariffs, trade barriers, and subsidies to promote free trade. President Trump’s casual suggestion to level the playing field for international commerce is the optimal solution to maximize global growth and the benefits that come from it.
Last Week Today: The annual G-7 meeting concluded with fireworks as President Trump sharply criticized EU trade policies, and heard an earful himself from the other leaders criticizing U.S. tariffs. | President Trump and Supreme Leader Kim Jung-un’s historic meeting resulted in a suspension of US/South Korea joint military exercises, though sanctions on Korea will remain in place until there is further progress on a denuclearization agreement. | The US District Court approved AT&T’s acquisition of Time Warner over the antitrust-based objections of the DOJ. The next day, Comcast bid $65 billion for 21st Century Fox’s entertainment assets, topping Disney’s existing bid of $52.4 billion. Coincidence or not, the DOJ’s decision to allow the AT&T-Time Warner merger sets a precedent for how competition is viewed and is likely to lead to increased corporate M&A activity. | The Fed raised their target interest rate to 1.75% – 2.0% (a 0.25% increase). | The ECB announced it would begin tapering its QE program in September and halt the expansion of its balance sheet by the end of the year. At the same time, the ECB pledged to keep rates at current negative levels (-0.4%) until mid-2019 at a minimum. | The SEC ruled that cryptocurrencies are not financial securities (the SEC considers them a commodity), catalyzing a rise in prices for cryptos such as Bitcoin and Ethereum. However, the SEC underscored that most Initial Coin Offerings (ICO’s) are securities and subject to SEC regulation. |President Trump announced tariffs on $50B of Chinese imports, targeting China’s industrial advancement. China responded with tariffs on $34 billion of US imports, focusing on commodity producers in Trump’s support base in Middle America. The tit-for-tat tariff announcements resurfaced trade war concerns, briefly roiling financial markets on Friday before cooler heads prevailed and the markets recovered into the close.
Financial markets zigged and zagged, but ended the week pretty much where they started, at least domestically where the S&P 500 finished flat (technically, it rose 0.02%). European stocks gained 1%; however the Euro currency was smashed following the ECB’s announcement, plummeting 1.9% (vs. the US dollar) on Thursday. Emerging Market stocks continued their downward trend as a stronger dollar (up 6% in the last two months) is causing investors to reassess the ability of EM countries to service their US dollar-denominated debt. The Fed’s rate hike resulted in further yield curve flattening. The difference in yields between a 2-year Treasury and a 10-year Treasury is now less than 0.4%. Finally, it was a poor week for commodity prices (e.g., gold -1.15%, silver -1.3%, copper -4.7%, WTI crude -1.0%), which suffered as the US dollar rose 1.3% for the week.
For detail on weekly, month-to-date and year-to-date asset class performance, please click here.
This Week Today: The Organization of the Petroleum Exporting Countries (OPEC) will meet on June 22nd in what one energy-focused portfolio manager called “…the most important gathering of OPEC ministers since the November 2014 meeting in which OPEC agreed to engage U.S. shale producers in a battle for market share.” At the center of the discussion will be whether to adhere to the 2016 production cuts or to relax the standards allowing more crude oil into the market. | Economic data due for release this week includes May housing data and Markit Purchasing Manager Index updates for June (consensus estimates are for a slight decline from survey readings in May).
Interest rates bite: Credit card debt delinquencies are on the rise, and while not at disconcertingly high levels, maybe the first indicator that the Fed’s seven rate hikes are beginning to bite into the real economy. With the Fed forecasting six more hikes in the next 18 months, history suggests credit card delinquencies are likely to rise further. Note that in the chart below, the credit card debt average interest rate (the black line) is advanced 18 months, suggesting that delinquencies do not rise concurrently with higher rates, but rather with a delay.
Source: Capital Economics
Even as credit card delinquencies are on the rise, delinquency rates on other forms of borrowing remain flat or declining.
Sources: Capital Economics and Covenant Investment Research.
The shift higher in credit card delinquencies can be tied to the quick reaction function of credit card companies to changes in the Fed Funds rate as compared to other sources of credit. To illustrate this point, the table below compares the change in average interest rates for credit cards, mortgage rates, and auto loans since the Fed began hiking interest rates in December 2015.
Sources: Federal Reserve Bank of St. Louis, Freddie Mac, and Covenant Investment Research.
Since the Fed initiated this rate hiking cycle, average mortgage rates have increased 70% less than the Fed Funds rate and auto loan rates 45% less. Yet, the relative percentage change in credit card rates is 31% higher than that of the Federal Funds rate.
This interest rate data combined with the delinquency statistics illustrate a fundamental principle of economics. A higher cost of credit leads to lower credit demand as consumers and corporations either proactively decide they cannot safely service more debt, or through higher delinquency rates. The interest rate/credit demand relationship is precisely why central bankers use interest rates as their primary monetary policy tool to manage economic growth. Lower credit demand results in slower credit growth, which in turn leads to slower economic growth. Conversely, higher credit demand (resulting from lower interest rates) generally stimulates economic growth.
However, higher interest rates do not immediately reduce economic activity, just as lower rates do not engender faster growth instantaneously. Economies are too complex, and monetary policy too blunt a tool to fine-tune an economy to the optimal growth rate that promotes maximum employment and price stability (i.e., the Fed’s dual mandate). Hence, despite all the available economic data, large research staffs, powerful computers, and a dizzying array of economic formulae and theories, central bankers are essentially guessing at the appropriate interest rate and the ideal unemployment rate. Indeed, at the press conference following last week’s rate decision, Fed Chairman Jerome Powell stated, “We can’t be too attached to these unobservable variables. We have to be grounded by what we see in the data.”
Powell’s comment is a rare admission by a central banker, and it highlights the fine line that central banks must walk to maintain interest rates at the appropriate level to neither overstimulate an economy nor plunge it into recession. As the Fed continues to tighten from this level, credit will become more expensive, and the economy will slow. It won’t happen overnight, but eventually, the Fed will get what it wants, which is why one of the most repeated sayings on Wall Street is “Don’t fight the Fed.” With financial market valuations stretched by most historical measures, investors should keep in mind that history is not on the Fed’s side to “stick the landing” with regards to the correct path for interest rates. Since the Federal Reserve was created, ten of the thirteen rate hiking cycles have ended in recession….Food for thought, if nothing else.
Last Week Today: Former Fed Chair Ben Bernanke warned that the US economy will face a “Wile E. Coyote moment” in 2020 as the double-whammy of fading effects from the tax-cut stimulus are met with the impact of Fed interest rate hikes. | Mexico placed tariffs on $3 billion of U.S. goods (e.g., apples and potatoes) in retaliation for President Trump’s tariffs on aluminum and steel imports. | Data from the Bureau of Labor Statistics showed that there are more job openings than unemployed workers, a rare event and further evidence of a tight labor market. | The G-7 Summit kicked-off on Friday and it was reportedly a tense meeting with President Trump leaving early for his summit meeting with Kim Jung-un. Trade tariffs are the focal point of the G-7 this year, and little seems to have been resolved. Indeed, China’s President Xi Jinping stated during a speech “We reject selfish, shortsighted, closed, narrow policies, (we) uphold World Trade Organization rules, support a multilateral trade system, and building an open world economy,” in a thinly veiled swipe at the U.S.
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This Week Today: On Tuesday, President Trump and Kim Jung-un will meet in Singapore to discuss denuclearizing North Korea. | Also on Tuesday, a U.S. District Court is expected to announce whether it will allow AT&T to merge with Time Warner, setting a significant precedent for the administration’s regulatory policy. Given the President’s words and actions favoring deregulation, interfering with this merger seems counterintuitive. | Even so, the odds of approving the merger are lower than the odds of the Fed hiking the target Fed Funds rate on Wednesday for the seventh time in this cycle by 0.25%– the futures market this morning is pricing in an 86% probability of the Fed moving their target rate up to 2%. | On Thursday, the ECB is expected to announce whether they will continue their QE program beyond 2018. Having cut their purchases from €60 billion to €30 billion per month in January, the market expects the ECB to wind down the program by the end of this year removing another significant source of liquidity that has fueled the historic rally in financial asset prices. On that note, the Fed will increase the pace of its balance sheet reduction from $30 billion per month to $50 billion per month by October.
Mean Reversion – Financial markets are wonderful, fantastically confounding systems. Prices can move (both higher and lower) for long periods of time, sometimes bordering on lunacy which gave rise to John Maynard Keynes’s most relevant quote on risk management in investing “Markets can remain irrational longer than you can remain solvent.” However, even as financial asset prices move to extremes, they always, eventually, revert to the mean and often below the mean, be it Tulips in 1637, Dotcom stocks in 2001, the S&P 500 in March 2009, or Bitcoin in December 2017. The question facing investors is that of timing. Unfortunately, attempts to time the market have probably contributed more wealth destruction throughout history than any other non-economic human endeavor. It is for this reason that having an investment plan, remaining disciplined to the plan, and maintaining a diversified portfolio are vital facets of long-term wealth generation and preservation. This statement should not be interpreted as an endorsement of pure buy-and-hold investing. Indeed, your plan should include regular rebalancing and tilting your portfolio to take advantage of opportunities when they present themselves (e.g., stocks in March 2009). But, swinging your portfolio around wildly to what has worked recently or concentrating your portfolio in just a few holdings is unwise. Indeed, it is often better to shift modestly away from what has worked lately (sell high) in favor of what has not worked (buy low). With that in mind, below are two examples of extreme market conditions present today.
Source: Capital Economics
Technology stocks are not at their most extreme level relative to their proportion of market capitalization in history, but they are higher than at any point since the Dotcom Bubble. The rise in prices of IT stocks is also contributing to the performance divergence between Value and Growth stocks, which is at the widest level in over ten years.
On the topic of diversification, the math is straightforward. The chart below shows the total real (inflation-adjusted) return of the S&P 500 including reinvestment of dividends and highlights the time required to get back to break even following major market peaks.
Source: Real Investment Advice
This reality of investing in equities is that these investments will be underwater a significant portion of your investing life when inflation is considered. Yes, markets move higher over time, but they do not move in a straight line. Indeed, while pensions and endowments operate with an infinite investment horizon, most investors don’t enjoy that same luxury hampered by the inconvenient truth of actuarial tables in which we all have finite lives.
To this point, what the chart doesn’t contemplate is the effect that spending out of your portfolio has on the recovery time to new portfolio value highs. As you sell securities to fund your lifestyle or other life-events during a market drawdown, you reduce the amount of money available in your portfolio that will benefit from a market recovery following a crash. Hence market losses act as a “volatility tax,” in which progressively high downside volatility reduces your long-term net worth disproportionately to your spending rate. This “volatility tax” extends the timeframe to recover. In fact, if you only spent 5% of your portfolio each year since 1999, you would still be underwater today (more than 18 years after the Dotcom Bubble peak), despite the historic bull market we have experienced.
It is for this reason that significant losses in a portfolio are so devastating to accumulating wealth. Indeed, Warren Buffet’s two most important rules of investing are:
1. Don’t lose money.
2. Refer to Rule #1
While losses cannot be avoided entirely in financial markets, one can reduce the chances of experiencing substantial losses through thoughtful diversification. By spreading your portfolio exposures across a variety of investments with different return drivers (equities, fixed income, absolute return strategies, hard assets, etc.), you improve your probability of generating long-term wealth by reducing the size of portfolio drawdowns. The ride may not be as exciting, but in the end, it is the result that matters.
Last Week Today – Italian President Sergio Mattarella blocked anti-European Union coalition parties; the Trump administration caught the world (and investors) off-guard by imposing new tariffs on steel and aluminum imports from the EU, Canada, and Mexico; these same NAFTA partners retaliated with tariffs on US imports to their respective countries; nonfarm payrolls grew by 223,000 in May (vs. forecast of 190,000), and the official unemployment rate fell to 3.8%; the U.S. / North Korea Summit is back on and scheduled to take place on June 12th in Singapore.
Tracing prices of risky assets last week generated graphs that resembled erratic EKG charts as geopolitical events (mostly negative) and strong domestic economic data releases pushed markets back and forth. The S&P 500 moved a lot with 3 of 4 trading days showing gains or losses of more than 1%, but ultimately the benchmark index closed the week up 0.5%. International equities did not keep pace, with the MSCI EAFE Index recording losses of 1.3% (thank you Italy). US Treasury yields declined modestly, but, here to, the finish belies the day-to-day volatility which saw the 10-year yield close at 2.78% on Tuesday before rising to 2.9% to end the week (only two weeks ago this benchmark had a yield of 3.11%). For the week precious metals declined (gold -0.7%, silver -0.6%), industrial bellwether copper gained 0.4%, and WTI Crude fell 6.9% to $65.81 per barrel (on concerns that Russia and Saudi Arabia intend to boost production levels).
Having closed-out May last week, the table below shows the monthly and year-to-date performance of several broad market indices.
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GDP Update – First quarter annualized, real GDP growth was revised down by 0.1% to 2.2% – the revision was expected, and in fact was smaller than many economists forecast. Overall, the mix of growth improved as inventories were lower and final sales higher than anticipated. Similar to the last several years, it appears that the first quarter will once again represent the slowest pace of growth for the year. The Atlanta Fed’s GDPNow algorithm is forecasting Q2 2018 GDP growth of 4.7%. Keep in mind that this forecast is volatile early in the quarter as the algorithm extrapolates only the currently available reported data into its projections. Hence, the forecast becomes more accurate closer to the end of the quarter. Meanwhile, the NY Fed’s GDP forecast is for Q2 growth of 3.3%, which is likely closer to reality.
Puzzle Pieces – Labor market data has been strong for a long time now, pushing the unemployment rate down to 20-year lows. Despite steady job gains, real wage growth is subdued. The absence of accelerating wage inflation amid historically low unemployment calls into question the veracity of the Phillips Curve — an empirical model that implies declining unemployment generates higher wages — favored by the Fed. This model worked reasonably well from the mid-90’s until the Great Financial Crisis (GFC), but since then unemployment has fallen dramatically (the red line with the inverted y-axis shown on the right) without a commensurate rise in wages (the blue line).
Adherents of the Philips Curve remain faithful, citing that the curve is “kinked.” That is, wage inflation is more sensitive to moving from low levels of unemployment to ultra-low levels of unemployment. If they’re right, we should be seeing wage inflation any day now… Others have pointed out that retiring Baby Boomers, who generally earn higher pay, are being replaced with younger, less tenured workers. These less experienced workers command a lower salary, which on balance, reduces wage growth.
The wage growth picture is indeed a puzzle, so let’s spread the pieces out on the floor, and try to put this together to see the big picture.
- Over the last five years, monthly job gains have averaged 211,000, equating to 12.6mm new jobs created.
- The headline (U-3) Unemployment rate is 3.8% (matching the previous cyclical low in April 2000)
- A broader measure of unemployment (the U-6 rate), which include discouraged workers and employed part-time for economic reasons is 7.6% (the lowest level since May 2001)
- The May employment report showed that annual hourly earnings increased a muted 2.7% year-over-year.
- The St. Louis Fed reported in the latest Fed Beige Book that “Some firms have begun relaxing drug-testing standards and restrictions on hiring felons to alleviate labor shortages.”
That last point, though anecdotal, is an interesting one, and certainly supports the survey data that labor is in tight supply. However, if the labor market is tight, why aren’t wages rising?
To this question, economist Paul Krugman offered a potential explanation in a recent NY Times Opinion column. What if the answer is that wages already rose? Said differently, what if wages should have been cut more dramatically in the aftermath of the GFC, implying that employers have overpaid employees since the GFC. Research shows that employers are extremely reticent to reduce wages because of fears of the impact on worker morale. Hence, while employers would cut wages if they could do so without consequences, that option is largely off the table even in a depressed, low-inflation economy like that experienced during the slow recovery from the GFC.
This concept is known as “downside wage rigidity,” and data tracked by the San Francisco Fed’s wage rigidity meter shows this is more than a theory. Because employers did not reduce wages commensurate with reduced demand for products/services in the aftermath of the GFC, they created a backlog of pent-up wage-cuts which must be worked through before meaningful wage increases can gain traction. In other words, employers subsidized laborer salaries through a period of reduced demand (i.e., revenue), and while demand has increased in recent years, it has not yet caught up to the point where employers are comfortable offering raises. Another factor likely weighing on employers’ minds is the memory of the GFC. Even as the economy has largely emerged from that depressed state-of-affairs, employers may be reticent to lock-in higher wages that they know will be problematic to reduce in the next economic downturn.