Government deficits as a source of corporate profits, US-China trade war impact on Germany, update on autos and Turkey

1 Big Idea: Trump’s deficits are driving corporate profits

I intend to delve into the macro modelling of this idea in more depth later. But I wanted to flag a concept for you regarding why this expansion has legs. It’s the fact that government deficits are key driver of corporate profitability. Some comments by Tim Duy spurred this thought. Here’s what Tim wrote yesterday:

The recent firming of economic growth, however, is a reminder that the shrinking difference between short- and long-term Treasury yields by itself does not indicate economic weakness ahead.

Quite the contrary. The economy tends to grow and stocks advance even as the curve shrinks toward zero. In fact, a yield curve holding at the current levels would suggest a bright outlook for the economy and equities.

The fretting over the yield curve stems from the reality that a flattening must precede inversion; hence the flattening is every bit an indicator of economic weakness as inversions. While this is arguably true, the fact that flattenings precede inversions is not a particularly useful relationship from a forecasting perspective, because of the long and variable lags between flattening and inversion and then inversion and recession.

Why this matters: In the past, I’ve been at pains to point out that the 1990s boom occurred with a flat yield curve. A flat yield curve says Treasury market participants expect the economy not to be strong enough to withstand much more tightening. It’s more a signal of market’s expectation of tightening or easing than a predictor of outcomes. So there is no imminent recession on hand.

Deeper dive: In fact, if you follow a macro approach called “the profits perspective” which looks at aggregate flow of funds data, you would be fairly bullish on the US economy right now.

The profits perspective is an approach that disregards the savings = investment thinking in getting at the sources of profits. It instead looks at sectoral balances in the government, business, non-business and foreign sectors to get a sense of how flows across these sectors are impacting the economy in aggregate. Tax flows to the government either increase business expenses or reduce business revenue. So, Trump’s deficits are a major source of profits that are keeping this cycle going.

If you go back to the December 2017 tax cut and the subsequent Congressional spending bill, you can see a lot of stimulus directed toward the private sector, much of it targetted toward businesses. And the deficits created by those tax cuts are a buffer between the US economy and recession as this business cycle ages.

In short, this cycle has legs.

2. Automakers sales drop

Having said that, I am still looking at signals of consumer exhaustion. We see that higher interest rates are having a negative impact on both new and existing home sales in the US. And the auto sector looks to be flagging as well. Data released yesterday show new US auto sales dropped in July, with the steepest declines in passenger cars as consumers switch to SUVs.

Why this matters: 2016 was better than 2017 in terms of auto sales. And likely it will also be better than 2018 as well. So automakers are rightfully concerned that the auto tariffs that Trump was proposing would lead to problems, even for domestic producers. The steel and aluminum tariffs are already certainly leading to higher costs in the sector.

3. Germany is getting hit by the trade war too

This comes from Reuters:

The [German Chambers of Industry and Commerce] DIHK said a survey among its members doing business in China showed that 41 percent were already affected by the higher tariffs when exporting to the United States while 46 percent reported higher costs when importing from the United States.

Among the German companies doing business in the United States, 57 percent said they already faced negative effects when exporting to China while 75 percent reported disadvantages such as higher costs when importing from China.

Why this matters: think of trade in a multilateral sense rather than in the bilateral sense that the Trump Administration does. The pain German companies are feeling in China tells you why doing so makes sense. And what it also tells you is that the trade war will reduce global growth overall, not just in China and the US.

Deeper analysis: JP Morgan’s global manufacturing PMI index  is already falling. The July figure came in at 52.7, down from June’s 53.0. And that was the weakest reading since a year earlier in July 2017. It is also down from the rolling 12-month average is 53.5, with the peak being December 2017

So the trade war is occurring at a time when the global economy seems to have slowed ever so slightly. The US is being bolstered by cash flows from the public sector to the private sector as a result of a huge increase in government deficits. But elsewhere, the picture is not as bright. A breakdown in international trade relationships, then, would come at the wrong time for the global economy.

4. More pain for Turkey

The country hurting the most is Turkey. After the Trump Administration applied sanctions on Turkey over the jailing of an American pastor, markets tanked. The pastor, Andrew Craig Brunson, led a church in Ízmir and was arrested in December 2016 after the failed coup d-etat attempt that summer. He’s been in jail for 600 days.

The US Treasury Department said it would specifically sanction interior minister Süleyman Soylu and justice minister Abdulhamit Gül, designating them as leaders of organizations that have perpetrated serious serious human rights violations. The sanctions are unprecedented because the US is imposing them on a NATO ally.

The Turks have vowed to retaliate. Turkish newspaper Hurriyet says that Turkey’s İYİ Party suggests the government will ‘seize Trump Towers’ in Istanbul as retaliation for the sanctions

The Turkish lira went through the 5 lira per US dollar level on the news, falling as much as 2% to record lows. That puts it down 25% against the dollar this year. Bond markets tanked as well. Benchmark 10-year Turkish government bond yields rose 89 basis points to a record 19.48%. And finally, Turkey’s benchmark share index also dropped, losing as much as 2.8%. That brings the loss this year to 18% in local currency terms, and even worse in US dollar terms. In fact, Turkey is the worst performing market in the world in local currency terms this year.

Why this matters: I continue to look at Turkey as a canary in the coalmine. Its problems are unique. But aren’t all countries’ problems unique? The question is whether Turkey goes into full-bore panic mode, and then, whether it creates a domino effect across emerging markets. Think Thailand in 1997, for example. I am bullish on the real economy. But it’s not inconceivable that we get a September of October financial crisis.