The hardening trade war and the pause in IPO easy money

Like yesterday, I have a few thoughts on the economic headlines below. This one is behind the paywall though and I am going to focus mostly on two topics.

Yield curve inversion

At its worst yesterday, the risk-off play saw the 10-year falling to 2.40%, marginally below the 3-month yield. As I write this, the inversion is still from 6 months to 10-years, with the 10-year up to 2.416%.

I am not concerned about the recession signal of curve inversion right now. First of all, we need to see a persistent two- or three-month inversion. And I would need to see confirmation from the 2-10 year spread as well. And that is trading at +22 basis points, wider than at many points early in 2019, when it dipped to single digit spreads. I think economic momentum is too great to make recession in the US or globally a near-term consideration. Nevertheless, yesterday was a shot across the bow, signalling the dangers lurking ahead.

For me, the big danger is a US shooting war in Iran more than the trade war with China. Oil was up on the likelihood that Iran was behind an attack on Saudi tankers. And a shooting war there could see oil prices (and inflation) skyrocket, with unknown consequences on monetary and fiscal policy. Brent is well below 12-month highs of $86.34. So, we would absorb another $15 before we breach the highs. But a rapid up move toward $100 a barrel is the black swan event to be thinking about here.

The US – China Trade War

Having said all of that, the skirmish between the US and China is not trivial in economic terms. And the battle lines appear to be hardening. Trump thinks he has China on the ropes because he believes their economy is more vulnerable to a trade war than the US. And his calculation is that this will make them likely to compromise. I believe his reasoning is wrong.

Dave asked in yesterday’s post, “what do you think the chances the market pushes the US and China into a deal? How bad does it have to get? Or, alternatively, if both sides are dug in, do you think we could get a rate cut from the Fed?”

My response was that “I think there is little chance the markets push a deal. My sense is that the politics isn’t just posturing but identification of a gulf that won’t be bridged. The Chinese are just waiting for another President.”

But more than that. Politically, the hardliners are winning the battle within China, as anti-US sentiment skyrockets. Ambrose Evans-Pritchard put out a piece this morning that dovetails with my thinking here, commenting that “Chinese no-dealers say their country can weather the crisis since dependence on exports has fallen to 18 per cent of GDP from a peak of 36 per cent in 2006.”

There isn’t going to be a solution to this problem in the near-term. That’s my read. And markets are going to slowly come to grips with that reality. At the same time, it is not a death knell for the global economy. It is impactful only at the margin. And since we are no longer thinking of the economy as being at stall speed, its impact is not a decisive blow to the course of growth.

The market fall yesterday

One way to think of yesterday is as a reminder that volatility is still lurking in the background. The VIX has traded down to as low as 10, but that was broken in August as it traded up to 30 by November. And the recent selloff had us up to 20, after a period in the low teens. I think there are so many pockets of vulnerability that have built up that we should expect volatility not to go back to the previous lows, but remain at some plateau above until these issues are resolved one way or another.

That’s not a good environment in which to IPO. Uber was down 34% from its IPO price at the close yesterday. And it was also 28% below its last funding round as well, which hurts those private investors. The corrolary may well be what I said yesterday:

The private market is flush with cash. Why subject yourself to what Uber and Lyft are dealing with unless you need the money because of cash burn? To me, it points to the possibility that the only companies we will see IPO are the ones that are hemorrhaging cash and need the money. Those are the riskiest bets. And it’s far from clear investors will continue to have a FOMO-based mentality on these names.

WeWork is the biggest loser there. Recent events make it seem like the easy money window for gargantuan cashflow-negative companies is closing, if only temporarily. But Slack, which I like, is still slated for a direct listing on June 20, despite the selloff. That’s because a direct listing shows it doesn’t need to raise more capital. That’s just a vehicle to let insiders sell. Moreover, I think investors see it as less vulnerable given its concentration on selling to businesses and not consumers. Enterprise-focused IPOs have generally held up better in recent weeks.

Final Thoughts

So, as we head into the New York open, I continue to believe that the trade noise is not fundamental. And yesterday’s sell-off was just a shot across the bow of a market that was ripe for some selling. Fundamentally, we are still in a growth phase, limited to a degree by tough year-on-year comps and the vulnerability that a strong US dollar creates on non-US earnings.

I remain optimistic about both the economy and the ability for risk assets to grind higher for the foreseeable future.