Covenant Weekly Market Synopsis for May 31, 2019

June 3, 2019

Last Week Today. S&P 500 earnings season concluded with corporations reporting year-over-year profit growth of roughly 1.5% in Q1. A pretty thin margin of expansion, but impressive relative to analyst expectations of a 4%-5% decline heading into Q1. | President Trump broadsided Mexico (and the markets) late Thursday Tweeting that the U.S. will put 5% duties on all Mexican imports on June 10, incrementally rising to 25% in October, unless Mexico stops “illegal migrants” from entering the U.S. | China’s manufacturing Purchasing Manager Index (PMI) declined to 49.4 (a reading below 50 indicates negative growth), blamed by most observers on the trade war with the U.S. The employment index fell to 47.0, the lowest reading since 2009 (Source: FTN Financial). | Q1 GDP was revised down by 0.1% to an annualized real (inflation-adjusted) rate of 3.1%.  While still the fastest Q1 growth since 2015, keep in mind that Q1 growth was boosted by a large build in inventory levels, and we expect GDP growth to track back towards 2%. | The Fed’s favored measure of inflation, Personal Consumption Expenditures, rose only 1.6% year-over-year in April. Well below the Fed’s target of 2%, one is left to wonder when the Fed will recognize (or admit) that the “transitory” deflationary effects are in fact, structural and that monetary policy is too tight.

Global risk assets capped off a lousy month with another losing week. Equities are struggling to gain traction, slipping on a combination of slowing global growth and trade tensions. As of Friday, the losing streak included four consecutive negative weeks for the S&P 500 and Nasdaq indices, and six for the Dow Jones Industrial Average Index (first time since 2011). For a change, international equity indices outperformed domestic equities in May, though all recorded negative performance:

May*

YTD*

MSCI All Country World Index (ACWI)

-5.9%

+9.4%

MSCI Europe, Australasia, Far East Index (EAFE)

-4.7%

+8.1%

S&P 500 Index

-6.4%

+10.7%

Nasdaq Index

-7.8%

+12.9%

*Performance is inclusive of dividends. Source: Bloomberg.

It’s also worth noting the yield curve inverted further last week providing a market indicator (to go along with fundamental economic data showing slowing growth) that the Fed needs to cut interest rates. Currently, one can buy a U.S. Treasury bond maturing in three months and that yields 2.3% or they can purchase a bond matures in 20 years and earn the same interest rate.

Tariffs for All. Someday, we may learn there is a carefully conceived strategic plan behind the Administration’s decision to exacerbate longstanding U.S. supply chains via tariffs on Mexico. But for now, the surprise announcement was puzzling for at least two reasons:

  • At a time when the U.S. is competing with China for future global supremacy via a trade war, it would seem logical to build stronger trade alliances with our allies to isolate China further.
  • Mexico is the U.S.’s second largest trade partner by both imports ($353 Billion in 2018) and exports ($266 Billion), which equated to $1.18 million of trade every minute in 2018. According to the Wilson Center’s Mexico Institute, a nonpartisan policy think tank, there are 4.9 million U.S. jobs at risk if trade stopped with Mexico. Said differently, 1 out of every 29 workers in the U.S. has a job supported by trade between the U.S. and Mexico. The states most dependent on normalized trade relations with Mexico are California and Texas, as shown in the graphic below.

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Source: MarketWatch

What if a trade deal is not the objective for China or the U.S.? We first published this piece in October 2018. Since then, the prospects of a near-term trade deal for the U.S. and China shifted from likely to unlikely, at least on the surface. But what appeared like progress in the trade deal may have been China making nice on terms they never intended to honor. Since last October, the relationship between the two competing superpowers has deteriorated materially, and the trade war expanded to new fronts:

  • Corporations: the U.S. targeting Huawei and China announcing an investigation into FedEx this past weekend.
  • Key Production Inputs: China’s threat to cut off access to rare earth metals.

In light of these recent events, it seems worthwhile to revisit the longer-term strategic implications of how the U.S. and China regard one another.

Many celebrated the trade agreement with Mexico and Canada (the “USMCA”) as the first step in a broader strategy to further isolate China in global trade, thereby increasing pressure on Chinese President Xi Jinping to come to the negotiating table. [Editor’s note: As mentioned above, the USMCA is in jeopardy, but the agreement is salvageable, and its role in a broader trade battle remains relevant. ] However, what if the NAFTA revamp instead merely opens the door to a prolonged battle with China? This is the thesis of Arthur Kroeber, an analyst for the well-regarded macroeconomic research firm Gavekal. Kroeber posits that a fairer trade agreement for the U.S. with China is not what’s at stake. Instead, the stakes are much higher and focus on China’s existential threat to continued U.S. global dominance.

Politics were a primary source of motivation for President Trump to complete the USMCA deal because more than half of U.S. states count Mexico or Canada as their largest export market. Absent an agreement, the Republican party would have invited increased political vulnerability in the mid-term elections. Moreover, neither Mexico nor Canada presents a threat to U.S. geopolitical power. However, with China, the situation is decidedly different:

  • China is the top export market for only five states, reducing political fallout from a trade stalemate.
  • China presents a clear-and-present danger to U.S. influence in Asia (i.e., China’s “Belt and Road” project designed to secure trade links with Central Asia, Europe, and Africa).
  • China represents a strategic threat as they have openly stated their intent to surpass the U.S. to become a leading producer of cutting-edge technology, such as artificial intelligence.

Fundamental to the last two points, a subset of President Trump’s advisors consists of trade warriors and national security hawks who now see an opportunity to reverse China’s growing global influence. In sum, the political limitations are looser and the long-term implications far higher in the dispute with China as compared to Canada and Mexico.

If Kroeber is correct, the objective of U.S. policy is to break or, at least, severely reduce the reliance of U.S. companies to manufacture goods in China. Evidence of success would be U.S. companies moving manufacturing operations to other countries, removing a critical source of intellectual property and business investment from an obvious strategic rival. For example, last week Bloomberg reported that the Chinese military had embedded microchips in servers used by at least 30 U.S. companies (including Apple and Amazon), as well as the Department of Defense and Department of Justice, to gather intellectual property along with trade and government secrets. It’s notable, relative to Kroeber’s thesis, that this act of espionage was first discovered in 2015 but is just now being made public. This revelation alone is likely to reduce U.S. management team’s enthusiasm for investing in China and will assist the U.S. government in its efforts to break the China-US manufacturing supply chain.

On the other side of the world, and the geopolitical chess match, China may not be all that interested in rushing to strike a trade deal with the United States. If China’s long-term strategy is to compete with the U.S. for global leadership, it will need to consolidate regional power, de-link its currency from the U.S. Dollar, and take steps to be viewed as a safe harbor for countries to invest excess currency reserves, according to Gavekal’s Founding Partner, Charles Gave.

As it turns out, China has been moving in this direction for several years now. For example, the “Belt and Road” venture is a massive infrastructure project that will increase China’s financial and commercial cooperation with more than 70 neighboring countries across the Eurasian land mass and beyond.

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Concerning further de-linking the Chinese Renminbi (RMB) from the U.S. Dollar, earlier this year, China took a significant step forward by launching an RMB-denominated oil futures contract. Importantly, the launch of the futures contract strategically lines up with the near completion of hydrocarbon pipelines between Russia and China. The ability to hedge oil prices in the local currency via the RMB-oil futures contract makes RMB a more attractive medium of exchange and reduces the need for China to pay Russia in U.S. Dollars for imported Russian oil.

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Finally, to provide a repository for countries’ excess currency reserves, in early 2017 the Chinese government opened its bond market to foreign investors via the “bond connect” program to serve as the Asian equivalent of a risk-free asset. The government did so after several years of ensuring that Chinese bonds outperformed traditional safe-haven assets, like the German Bund and U.S. Treasuries, to attract investors. Indeed, since the beginning of 2013, Chinese bonds have outperformed both U.S. and German equivalents, and foreign holdings of Chinese bonds are now 1.5+ trillion RMB, an increase of more than 60% from a year ago (source: Bloomberg). If the bonds continue to perform and the RMB remains stable, at least relative to other Asian currencies, Chinese sovereign bonds will allow governments in the region to invest excess capital within Asia.

These articles illuminate the deeper strategic objectives of the two most powerful countries in the world. Most observers still believe the U.S. and China will eventually reach a trade deal as it seems to be in both countries best immediate interests. That may still be the case. However, if Gavekal’s theses prove accurate, trade is merely a pawn in each country’s longer-term strategy.

Early warning signals that Kroeber is correct include the U.S. levying higher tariffs, limits on visas for Chinese tech workers and students, and sanctions on Chinese companies with a record of cyber-espionage. If Gave’s thesis is accurate, China will delay substantive trade negotiations choosing instead to use this time to more firmly entrench itself as a regional hegemon. As the famous Chinese military strategist, Sun Tzu wrote: “He who knows when he needs to fight, and when he doesn’t, will be victorious.

Kroeber and Gave are fundamentally speaking about two sides of the same geopolitical coin. The reasons the U.S. may not be interested in a trade deal with China reflect the Chinese government’s actions to compete head-to-head with the U.S. for global supremacy.  What’s interesting about Krober and Gave’s theses, unlike most macroeconomic discourse, is that they are not mutually exclusive, and both may be correct.

Be well,

Justin