Market Commentary: December 6, 2018

Paradigm Financial Advisors

Market Update

December 6, 2018

 

Wild Ride for Investors Continues into December:

The stock market rose almost 2% on Monday after it was announced that President Trump had reached an agreement with Chinese President Xi to suspend all tariffs and continue negotiating a trade agreement over the next 90 days.   However, the rally faded quickly and the market fell  3% on Tuesday due to concerns over the flattening bond yield curve.   On Tuesday the spread between the 2-year and 5-year Treasury notes became negative for the first time since 2007.    The spread between 2-year and 10-year Treasury Bonds flattened further to .13%.

Investors became very nervous on Tuesday as the noise level rose and many commentators declared dooms day is coming because in the past an inverted yield curve has historically been a leading indicator of an impending recession. However, as the chart below shows, an inverted yield curve does not always lead to a recession and there have been a number of time periods where the U.S. economy and stock market have continued to do very well with an inverted yield curve.

 

Programmed Trading Increased Selling Pressure on Tuesday:

After looking at the volume spikes on Tuesday, it appears that the selling was exacerbated by institutional trading programs that were triggered when the 2-year and 5-year yield curve became inverted for the first time since 2007.   Many hedge funds and wall street firms have built trading algorithms that are programmed to sell stocks when certain leading economic indicators hit certain levels.  These trading programs were triggered on Tuesday as the 2-year and 5-year yield curve became inverted and the programmed trading once again dramatically increased the volume of short term selling in the stock market.  As we have discussed, programmed trading by Wall Street firms, hedge funds, etc. is designed to create short-term chaos so that they can profit from “retail investor’s panic selling”.  The wild swings in the markets are frustrating but they do not impact disciplined investors that do not succumb to emotional selling because over the long-term stock prices have consistently been determined by earnings, cash flow and other fundamentals.

 

Disconnect between the Federal Reserve and the Bond Market:

The yield curve has been flattening for several years because of the disconnect between the Federal Reserve and the bond market’s divergent outlooks for future economic growth.

The Federal Reserve believes that the U.S. economy is going to continue to grow at a healthy pace in the next few years.  However,  bond market participants do not share this view because they think the following risks could derail the U.S. economy:

a)      The Federal Reserve could derail the U.S. economic recovery by raising short term rates too quickly.

b)      S. corporate earnings may have reached a peak in Q3 2018 and earnings could fall in 2019.

c)     President Trump’s tough trade negotiations with China could lead to a full-blown trade war which could have a negative impact on U.S. and global economic growth

d)      Geopolitical risks in the Middle East could rise if President Trump decides to  punish Saudi Arabia for the brutal murder of Jamal Khashoggi by cancelling the sale of U.S. military equipment and/or imposing harsh sanctions on Saudi Arabia.

e)     The European economy may continue to struggle due to the turmoil surrounding BREXIT and Italian debt negotiations.

Long term bond yields have fallen as the bond market continues to price in all of the risks that could have a negative impact on U.S. economic growth.

 

The Federal Reserve is moving more dovish on the likelihood and pace of future rate hikes:

Federal Reserve Chairman Powell made it clear last week that they recognize that there are a number of issues that could have a negative impact on economic growth and he indicated that the Fed is going to be more “data dependent” moving forward which should result in fewer rate hikes than they originally anticipated.   In the summer, the Federal Reserve indicated that they would likely raise rates on more time in December 2018 and three more times in 2019.   The data now suggests that they will probably do one hike in 2 weeks and possibly just one more in the summer of 2019.

 

Leading Economic Indicators remain positive:

Even though the yield curve has been flattening, nearly all of the other leading economic indicators are still positive which indicates that the U.S. economy is not at risk of entering into a recession any time soon.

 

Job Growth remains strong:

  • The November ADP payroll Report came out this morning which showed 179K new private sector jobs were created last month.
  • The November Non-Farm Payroll Report will be released tomorrow and the consensus estimate has come down slightly from 200K jobs to 198K jobs.
  • Initial Jobless Claims fell by 4,000 to 231K last week from an upwardly revised 235K the previous week, which is still near a 50-year low.
  • Continuing Jobless Claims fell from 1.705 million last week to 1.631 million, which is also near a 50-year low.

 

2018 Christmas Shopping Spending stronger than expected:

  • Black Friday sales grew 23.6% year over year to $6.2 billion.
  • Thanksgiving Day was also a big up-day for retailers, bringing in $3.7 billion, up 28% from a year ago.
  • Small-Business Saturday, also part of the holiday shopping pantheon, rose 24% this year to $3 billion overall.
  • Other big retail winners over the weekend: Walmart (WMT) grew sales 23% year over year between Thanksgiving and Black Friday, boosted notably by its Click & Collect feature, which cranked up 73% from the year-ago quarter.  Target (TGT) sales over the weekend grew at 47% from a year ago.
  • Cyber Monday sales were over $8 Billion which was the largest shopping day in U.S. history.  Total sales on Cyber Monday grew at over 20% from 2017.
  • Christmas spending from Thanksgiving through Cyber Monday was reported at over $60 Billion, which is an increase of over 20% from 2017.

 

The Conference Board’s Leading Economic Indicators Index for October rose 0.1 percent in October to 112.1 (2016 = 100), following a 0.6 percent increase in September, and a 0.5 percent increase in August.  The index still points to robust economic growth and should continue in 2019.

The chart below shows that the Leading Economic Indicator Index has historically dropped below its six-month moving average before a recession. The latest index reading shows no near-term recession risk.

 

President Trump and Chinese leader Xi agree to suspend Tariffs:

Over the weekend President Donald Trump and President Xi Jinping agreed to a “truce” during their meeting at the G20 summit.  President Trump agreed to leave tariffs on $200 billion worth of Chinese goods at 10%, rather than increase them to 25% on January 1, 2019, as originally planned. In turn, President Xi pledged to immediately resume purchases of U.S. agricultural goods, including corn and soybeans, which were hit particularly hard by China’s retaliatory tariffs. China also agreed to buy an unspecified amount of energy, industrial and other products from the U.S.

The two sides agreed to continue talks to resolve contentious policies at the heart of the trade conflict. Such policies include intellectual property protection, state-sanctioned cyber intrusion and forced technology transfer.  President Trump said he is confident that they can reach an agreement within 90 days.  Trump also cautioned that if China does not follow through on their promises made at their meeting then he will increase tariffs on China to 25%.

While considerable uncertainty remains around resolution of these trade conflicts, the fact that the U.S. and China reached a tentative agreement could benefit recently troubled emerging markets stocks (EM). We believe EM stocks offer a very good opportunity for investors because many EM companies are selling at deep discounts.  Many Chinese stocks have sold off by 30% to 40% this year due to concerns over a trade war with the U.S.   The sell-off in China presents an historic opportunity for investors because many Chinese companies have strong cash flow and are forecast to grow earnings by over 20% in 2019.  If a final agreement is reached between the U.S. and China in the next 90 days it will provide a much needed catalyst that could spark a strong rally in Chinese and EM stocks in 2019.

 

President Trump’s goals:

President Trump and his team of negotiators are going to try to convince the Chinese leaders to agree to a new trade agreement that will achieve the following goals:

  1. Prevent the Chinese from stealing technology, intellectual property and trade secrets from U.S. companies.
  2. Stop the Chinese government from forcing U.S. companies to turn over their trade secrets and technology as a prerequisite for doing business in China.
  3. Get China to agree to designate Fentanyl (an addictive opioid) as a controlled substance which would subject any Chinese sellers of the drug to criminal penalties.
  4. Get China to take affirmative action to help the U.S. in its efforts to convince North Korea to end nuclear weapons development.
  5. President Trump also wants to make sure that China’s new long-term development plan, “Made in China 2025,” does not create an unlevel playing field to help China gain a lead in artificial intelligence, automation, robotics and electric vehicles by unfairly subsidizing Chinese companies while discriminating against U.S. businesses operating in China.  Currently, China has two sets of rules for conducting business in China – one that favors Chinese companies and another set of laws that make it incredibly difficult for U.S. companies to succeed in China.

 

President Xi’s Goals:

Negotiating with the Chinese leaders will be the most difficult “deal” that President Trump has ever tried to make.  China has a Communist Ruling Party but it also has a quasi-free market system and their views and goals are very different than other countries the U.S. has negotiated trade deals with.

When Xi became President in 2010, he started creating a new vision for China – he announced a new national plan to create what he called a “great modern socialist country that is going to be prosperous” and “a global leader in terms of composite national power”.  Xi’s goal is to double China’s GDP per capita to $10,000  by 2021, which is the year that China will celebrate the 100th anniversary of the founding of the Chinese Communist Party.

Xi recently announced an expanded long-term national plan for China called “Made in China 2025”.  This new plan creates a vision for China to become the global leader in key technologies including computing, robotics, artificial intelligence and self-driving cars.   Xi’s vision for China is not just about economic growth and increasing the wealth of the Chinese people, Xi’s vision is to make China powerful and make the Chinese people proud again.  China’s goal is to become the global leader in finance, automation, defense, science, technology and the arts & culture.

President Xi’s wants the U.S. to allow China to pursue its “One-China policy” which they have used to assert that Taiwan is a part of China.  The negotiations will be complicated by the fact that the Chinese leaders believe that the U.S. wants to prevent China from achieving their goal of becoming one of the world’s economic and military super powers.  The Chinese think that America’s strategy is to isolate and contain China.  The Chinese also believe that the U.S. does not want to recognize and accept the political legitimacy of the Chinese Communist Party because it is not a democratic based party.

President Trump and his team have their work cut out for them to convince their Chinese counterparts that the U.S. is not going to try to sabotage the Chinese government or try to derail China’s economic growth plans.  The U.S. negotiators will have to remind their Chinese counterparts that the U.S. led the world back to stability after the second World War.  The U.S. has also played a major role in helping China and other Asian countries prosper.  The Chinese recognize the role the U.S. has played but China does not want to be dependent on the U.S. in the future. President Xi made this clear in a speech he gave in 2014 when he said, “In the final analysis, it is for the people of Asia to run the affairs of Asia, solve the problems of Asia and uphold the security of Asia.”

 

Investors remain concerned about uncertainty of a trade deal with China:

The initial excitement wore off quickly after Monday’s announcement of the truce agreed to by  President Trump and President Xi due to the fact that there does not appear to be any formal written agreement between the U.S. and China and many skeptics have expressed doubts over the trustworthiness of China.  However, we believe that Trump and Xi will be able to reach a formal agreement because both countries have too much at risk if they allow this to turn into a full-blown trade war.  The final deal may end up being criticized by media pundits but it would still be a monumental success if China agrees to make a genuine commitment to stop stealing U.S. technology and other intellectual property, to buy more U.S. agricultural and other products and agree to label Fentanyl as a controlled substance and to prosecute Chinese illegal sellers.  President Xi has an historic opportunity to improve China’s tarnished reputation in the World Trade Organization.

 

Huawei CFO Arrest threatens to derail U.S. and China trade negotiations:

After being closed on Wednesday for President Bush’s funeral, the market opened down over 400 points today after news broke that the CFO of Chinese technology giant Hauwei, Wanzhau Meng, was arrested in Canada and she is going to be extradited to the U.S. to face charges by the U.S. Department of Justice. It is unclear at this time if President Trump and President Xi knew about the arrest at the time of their meeting on Saturday.

It is being reported that the Justice Department is investigating Hauwei based on the following potential charges:

1) they violated U.S. sanctions on Iran by selling them telecommunications-equipment

2) they violated U.S. sanctions by selling U.S. technology to Syria and North Korea

3) they violated a variety of laws by installing secret chips that provided them with a “back door” into the equipment sold in the U.S. that allows them to monitor user activity and helped them steal technology from U.S. companies and possibly top-secret information from the U.S. government.

Chinese officials immediately condemned the arrest of Meng saying it is a violation of its citizens’ rights and demanding that the U.S. and Canada release her immediately.  Meng’s arrest will certainly increase tensions between President Trump and China’s President Xi.  The arrest was made on the same day Trump and Xi had dinner and agreed on a truce on tariffs.  Neither Trump or Xi has made any comments yet to address concerns that China may suspend negotiations on a new trade agreement.  The arrest is an unprecedented move by the U.S. Department of Justice and it remains to be seen if Trump knew about the impending arrest or if the Justice Department kept him in the dark as they arrested Meng.

Meng is the daughter of Ren Zhengfei, the founder of Hauwei.  Zhenfei is well connected with Xi and China’s ruling party.  He is a former army engineer and he has led Hauwei to become one of the world’s largest sellers of smartphones and networking gear. He’s regularly named among China’s top executives and he has a similar status in China as Bill Gates has in the U.S.

Huawei has been trying to acquire U.S. technology on artificial intelligence, chipmaking and 5G wireless technology and U.S. companies have complained to the Department of Justice that they have tried to hack their networks, etc. to try to steal U.S. technology.   By arresting the CFO of Huawei, the U.S. is threatening one of China’s most successful companies.

In August, Trump signed a bill banning the government’s use of Huawei technology based on the security concerns and many U.S. allies are either imposing or considering similar moves. That same month, Australia barred the use of Huawei’s equipment for 5G networks in the country and New Zealand last week did the same, citing national security concerns. The U.K. and European Union are also considering banning Hauwei products. In November, Huawei said that banning Hauwei products will hinder the development of 5G and raise prices for consumers.

 

Impact of the arrest on trade negotiations with China:

There is no question that the arrest of Hauwei’s CFO makes it clear that the U.S. is prepared to play “hard ball” with China on the trade negotiations.  The arrest does increase the risk of a break-down in negotiations leading to a trade war with China and more punitive tariffs from both sides.  It appears that China wants to get a deal done because they have more to lose because their economy is still dependent on exporting goods to the U.S.  A protracted trade war with the U.S. will lead to rising unemployment in China which could lead to Xi’s worst fear – civil unrest that could jeopardize the future of China’s communist ruling party.  The arrest of the CFO of Hauwei should make it clear to China that the U.S. is not going to allow them to continue to steal our technology and that China is going to have to abide by international law in the future.

We will update clients on any new developments on the tensions between China and the U.S. as we get new information.

 

PFA Investment Committee

Jim Reding      Ryan Powers

 

Brad Combs    Matt Schaller

 

Bob Spindel     Matt Kellermann