Wait until crisis for the dollar, expect 2019 curve inversion, plus other predictions
There are a number of market, economic and political threads I want to comment on as we end the week. In terms of my mood, having digested the recent economic and political news, I am actually hopeful. I think the prospect of recession and crisis hangs over us on a number of fronts – from the Trump White House to a US-China trade war to a decelerating global economy to Brexit. And I recognize the dangers in each of these threads, as I will outline below. Nevertheless, overall I continue to stress that the near-term economic outlook in the US is good. And to the degree there is any crisis or recession, I don’t think it would be for several months. That’s my mood as we end this week.
1 – The shambles that is Brexit
Having made a glass half-full statement, let me lead immediately into the biggest near-term risk: a hard Brexit.
The biggest issue here is the so-called Irish backstop. For those of you unfamiliar with what this is all about, I think this explainer from the British House of Commons website does a good job on the broad strokes.
The key here is that Ireland is an Island that contains territory from two separate countries that joined the EU together in 1973, the Republic of Ireland and the United Kingdom. And twenty years ago, to facilitate peace in Northern Ireland, the British part of the Island, the Good Friday agreement set out that there would be no patrolled ‘hard’ border between the Republic of Ireland and Northern Ireland, allowing people to pass freely between the two areas.
If the UK leaves the EU, this becomes a big problem because, suddenly, the Republic of Ireland and Northern Ireland would have wholly different trade relationships with EU countries beyond the Island. And, try as they have, negotiators have not come up with a solution to this problem that will mollify the worries of those who want the Good Friday Agreement to remain viable, those who worry about trade frictions forming between Northern Ireland and the rest of the UK, and those concerned about the UK remaining in a halfway house limbo of a customs union with the EU indefinitely.
I don’t believe anyone – not just Theresa May – could find a viable solution to these three competing worries within the limited time that remains before 29 March when the UK is slated to leave the EU. And so, any Brexit agreement will draw fierce opposition in the British Parliament from some faction irrespective of other issues that remain contentious.
What do you do about this? One option is to delay or cancel the Article 50 process. The other is to take a risk and leave the EU with the Theresa May deal or no deal at all. Theresa May seems set on the second riskier option and barely mentions the other possibility. This is the worry here. And it would affect the whole of Europe, not just the UK.
2 – China is ceding ground to Trump
In terms of the next ticking clock negotiation, China has until 1 Mar to agree with the US on trade or face tariffs. The Chinese have shown they are willing to give ground.
First of all, there is the fact that the Chinese economy is slowing.
China’s economy slowed again in November as retail sales and industrial production weakened, creating a challenging backdrop for policy makers who gather next week to set the tone for the year at their annual Economic Work Conference in Beijing.
Industrial production growth decelerated to 5.4 percent, below all 38 economists’ estimates. Retail sales — formerly a pillar of support for the economy — posted the weakest performance since May 2003, rising 8.1 percent from a year earlier. Chinese stocks fell along with the currency as data signaled a deepening slowdown.
So, the Chinese, fearful of further slowing, have backed away from their pivotal Made in China 2025 policy.
China is preparing to replace an industrial policy savaged by the Trump administration as protectionist with a new program promising greater access for foreign companies, people briefed on the matter said.
China’s top planning agency and senior policy advisers are drafting the replacement for Made in China 2025, President Xi Jinping’s blueprint to make the country a leader in high-tech industries including robotics, information and clean-energy cars. The revised plan—Beijing’s latest effort to resolve trade tensions with the U.S.—would play down China’s bid to dominate manufacturing and be more open to participation by foreign companies, these people said.
Current plans, they said, call for rolling out the new policy early next year, when the U.S. and China are expected to be accelerating negotiations for a deal to end their bruising trade battle. China has signaled other measures as well, including lowering tariffs on auto imports and increasing purchases of U.S. agricultural products.
Remember, all of the diplomatic wrangling around Huawei has been directed from China at Canada in order to avoid a direct confrontation with the US. So, it’s clear that Trump’s hard-line approach is getting movement out of the Chinese on this. Moreover, the US has found allies here too.
Pressure from Europe and Japan is amplifying the president’s vocal complaints about Chinese trade practices that he says discriminate against foreign companies and threaten U.S. economic growth — as fresh economic data Friday in Beijing showed the economy slowing more than expected…
“One thing the Chinese have had to acknowledge is that it wasn’t a Trump issue; it was a world issue,” said Jorge Guajardo, senior director at McLarty Associates and a former Mexican ambassador to China. “Everybody’s tired of the way China games the trading system and makes promises that never amount to anything.”
…Attacking Chinese protectionism now has bipartisan support in Washington; Germany and the United Kingdom joined the United States this year in tightening limits on Chinese investment.
At this point, I think the Chinese can avoid tariffs in March. Let’s see how this progresses.
3 – Trump is in trouble
As much success as Trump seems to be having regarding China, he is getting killed regarding his campaign finance and inauguration activities. I think that he faces the real possibility of becoming an unindicted co-conspirator for felonies associated with that time period, or at least prosecution once he leaves office. And so, Republicans have to be anxious regarding the liability Trump represents for the party with voters and who is going to lead them into the 2020 election. The election could be worse for them than 2018 was. This is what the ‘Never Trumpers’ warned about in 2016.
First, as Trump insider Kellyanne Conway’s husband George explains, Trump’s claim that he didn’t violate campaign finance law is weak — and dangerous. The payments to Stormy Daniels and Karen McDougal were almost certainly campaign contributions under existing US law. It’s not just Cohen who is saying that. So is National Enquirer publisher David Pecker, a close associate of Trump, who also has a lot of dirt on him and has been cooperating with Mueller.
Moreover, Trump can’t hide behind the excuse that he didn’t know, that it was Cohen’s responsibility to know that. On TV this morning, Cohen said “There’s a substantial amount of information that [Mueller’s people] possess that corroborates the fact that I am telling the truth.“ And that basically means that Mueller has proof beyond Cohen that Trump is lying right now about whether he knew what he was doing was illegal. And to the degree Trump told Mueller in written testimony that he didn’t know, he would have perjured himself, something that sets him up for a potential impeachment.
Personally, I believe there are many more shady and illegal acts not related to the election to uncover with Trump. And Cohen has created a beachhead into those activities which NY state prosecutors could look into. Trump’s legal troubles are just beginning in my view.
What does he do if he feels cornered? That’s an important question given the power he wields as President of the United States.
4- Wait until crisis on the dollar
When you think about the possibility of the Fed slowing its rate hike timetable and the US entering a lull in growth or even a dip toward recession, that’s bad for the US dollar. I think we are at pre-crisis highs about right now. And so, until we get a flight to safety associated with a financial crisis, the US dollar is likely to be relatively weak, as are US-dollar denominated assets. Since we are in a relatively good spot for risk assets from the emerging markets, now is the best time for EM debtors thinking of issuing US dollar debt to do so. They may not get a better opportunity for a long while
5 – The US Treasury yield curve will invert
What punters are saying is that 2019 is when a full inversion happens in the US.
The U.S. Treasury yield curve will invert next year, possibly within the next six months, much earlier than forecast just three months ago, with a recession to follow as soon as a year after that, a Reuters poll showed on Thursday.
Those expectations come on the heels of a deep sell-off in global stocks and the flattening of the U.S. yield curve, with the gap between longer-dated and shorter-dated yields narrowing to its smallest in more than a decade.
Some maturities on the curve, notably yields on 2- to 5-year notes have already flipped. An inversion between 2- and 10-year yields is a closely watched signal as that has preceded almost all the American recessions of the past half century.
Markets have caught up with my view. Now, I have been saying since early 2018 that the risk was inversion by the end of this year. And we came darn close to that, with the 10-year trading only 10 basis points wide of 2-year Treasuries at some points. And we still have over two weeks left, a time period that includes another Fed rate hike, policy statement and post-FOMC press conference. So, we could yet see inversion before this year is out.
I think long-dated Treasuries are overbought at this point. And I expect most of the US data to be good. So I am not anticipating inversion before the year is out. But I do think we are headed there in 2019.
6 – US stocks are the cheapest in 10-years
I don’t use forward earnings for P/E ratios. But if you did, you would find stocks in the US at their cheapest in five years.
The forward price to earnings ratio for global stocks is at five-year lows, having dropped to about 13.3 times. That’s down from more than 16 times in early 2018, according to FactSet’s World stock index, which includes tens of thousands of listed securities around the world.
The price to earnings ratio is a favorite among analysts and investors for valuing companies.
Valuations for some blue-chip stocks have plumbed multiyear lows: Japan’s Honda Motor Co. and U.S. computing giant International Business Machines Corp. , for example, have both seen their PE ratios fall to around 10-year lows this quarter.
On one alternative, price to free cash flow, which measures the money a company has generated after operating expenses and capital spending, the trend is even more clear. By that measure, stocks are the cheapest they have been since early 2012, when the eurozone sovereign debt crisis was still raging.
Now, I called the P/E ratio decline out recently, saying that “Ostensibly, that decline has been predicated on rising rates. But with the 10-year down 40 basis points in the last two months, it isn’t clear what the future path will be. That uncertainty is driving volatility.”
So for me, the key is not a directional call per se but a volatility call, because I believe we are going to see greater volatility. And this is due in large part to the data dependency of the Fed at the tail end of an economic cycle. Long vol.
That’s it for today. Have a great weekend.