Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.
 

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Neutral
• Trading model: Neutral

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.
 

An FOMC meeting preview

As we look ahead to the FOMC meeting next week, the market has priced in three quarter-point rate cuts for 2019, with the first cut occurring at the July meeting.
 

A rate cut is not unexpected, as the bond market has pushed the Treasury yield curve down so far that only the 30-year Treasury bond is trading above the current Fed Funds target. It is likely too early for the Fed to cut rates at its June meeting next week, but if the market is discounting a July cut, the Fed is likely to signal either it is either in agreement with that expectation, or correct the market.

Rather than debate whether the Fed should cut rates, I consider the scenario of what might happen if it were to proceed with a July rate cut. What are the consequences for economic growth, and the stock market? After all, the track record of Fed Funds futures in forecasting the actual trajectory of interest rates has been less than stellar.
 

I conclude that while the Fed could decide to cut rates at its July FOMC meeting, the future path of interest rates and stock prices depends on the reasoning behind the rate cut. If the cut is in response to the eruption of a full-blown trade and economic cold war with China, then it is likely to be the start of a protracted rate cut cycle, with bearish implications for equity prices. On the other hand, if the rate cut is an “insurance” cut designed to head off further economic weakness in the face of a stalemated trade dispute, I expect the cut to be reversed relatively quickly because the global growth backdrop remains constructive. Equity prices would rise under such a scenario as the bullish implications of higher growth would overwhelm the bearish implications of higher interest rates.
 

1995 all over again?

Fed watcher Tim Duy believes that the soft May Jobs Report is clearing the way for a rate cut. He believes that the Fed may be trying to engineer a 1995-style soft landing.

The current setup feels a lot like 1995.Then, like now, the Fed spent the first part of the year struggling with the magnitude of the economic slowdown underway. By the time of the July 1995 meeting, however, the Fed had enough evidence in hand to justify a rate cut, the first of three 25 basis point cuts. Interestingly, the employment picture shifted in the first half of 1995 as it has so far in the first half of 2019. If the Fed can engineer a repeat, 1995 would be a good model to follow as it is arguably the only instance of a soft landing for monetary policy.

As a reminder, here is how interest rates, stock prices, and the yield curves behaved since 1990. The yield curve, as measured by the 2s10s and 10s30s, were on the verge of inverting when the Fed stepped in and began to ease policy. Stock prices consequently took off, and the run did not end until the NASDAQ Bubble burst in 2000. By contrast, the vertical lines depict the instances when the 2s10s and 10s30s both inverted, and the stock prices topped out soon afterwards. The key difference today is while the 3-month yield is above the 10-year, the 2s10s and 10s30s are nowhere near inversion.
 

The subsequent rise in equity prices was not surprising, but it cannot be said that the rally was purely valuation driven. Data from Yardeni Research Inc. shows that US forward P/E ratios were lower than they are today, but both short and long rates were considerably higher in 1995 than they are today. By contrast, global forward P/E ratios are roughly the same level they were in 1995.
 

Gavyn Davies, writing in the Financial Times, agrees with the 1995 analogy. In particular, Davies pointed to the CNBC interview with Fed vice chair Richard Clarida as evidence for a precautionary rate cut:

Fed vice-chair Richard Clarida explained in a must-read CNBC interview that he “as one member of the committee” would tend to look through the initial effects of higher tariffs on the price level, while seeking to ensure that the economy continued to grow at or near trend.

This clearly suggests that any slowdown in the growth rate, which is already slightly below trend, will trigger a policy easing, even if tariffs are pushing 12-month consumer price increases upwards at the time.

Mr Clarida went further when he pointed out that policy had been eased in the past (he specifically mentioned 1988 and, significantly, 1995) in order to provide an insurance against downside risks to activity. He added that the need for a pre-emptive easing this year would be assessed as new evidence presents itself.

It is interesting that the vice-chair, an accomplished economist who is increasingly vocal as a policy spokesman, seems ready to ignore the possible inflationary effects of the president’s programme of tariff increases. These effects were initially expected to be small and manageable, but recently estimates have increased substantially.

Davies concluded:

There is little doubt that the doves on the FOMC, including Mr Clarida and Charles Evans, are moving towards a 1995-style “insurance” cut in policy rates. Then, the Greenspan Fed cut rates by 75bp over an eight-month period, arguing that these cuts were justified by success in bringing inflation under control, at a time when downside risks to economic activity appeared to be on the increase. An economic soft landing followed.

Mr Powell is likely to reflect this thinking in his press conference after the next policy meeting on June 19. The committee will probably not implement a rate cut on that date, because of its earlier promise to be “patient”. But it might use the interest rate “dot” plot to foreshadow one or more rate cuts before year end.

In addition, rate cuts can further be justified in the face of tame inflationary expectations (via the Cleveland Fed).
 

Scenarios for a July rate cut

Supposing that the Fed were to signal that it is open to a July rate cut next week. What does that mean? While current economic conditions are a little soft, the case for rate cuts is a little unclear. The wildcard that presents downside tail-risk is a trade war.

For some perspective on the near and longer term outlooks, I refer you to the work of New Deal democrat, who monitors high frequency economic indicators and helpfully categorizes them into coincident, short-leading and long-leading indicators. He is sounding nervous about the short-term outlook, which has turned negative, in light of trade war uncertainties.

Between lower interest rates and improving real money supply, the overall long-term forecast has turned even more positive. The short-term forecast, however, remains negative, and the nowcast has declined from weakly positive to neutral.

As I have pointed out before, these metrics are good at forecasting the economy “if left to its own devices.” At present, however, it’s far from being left to its own devices, in particular because of chaotic trade and tariff policies. Even if one agrees with the trade objectives and the use of tariffs toward those objectives, however, the chaotic nature of their deployment is asymmetrically negative, as no one can be sure that even a fully agreed to trade deal can survive beyond the next tweet. Thus the near-term forecast is not better than, and may well be worse than, indicated by these indicators.

There are many obstacles to a deal. The current state of the US-China trade dispute cannot be resolved by low-level negotiators, and the big issues have to be resolved by the respective presidents. The American side has announced that Trump and Xi will meet to discuss trade at the G20 meeting in Japan in late June. However, the Chinese side has not confirmed the meeting. Bloomberg reported that Trump’s threats of imposing tariffs if there is no trade meeting at the G20 have painted Xi into a corner:

Trump on Monday said he could impose tariffs “much higher than 25%” on $300 billion in Chinese goods if Xi doesn’t meet him at the upcoming Group of 20 summit in Japan. China’s foreign ministry — which usually refuses to provide details of meetings until the very last minute — declined Tuesday to say whether the meeting would take place.

The brinkmanship puts Xi — China’s strongest leader in decades — in perhaps the toughest spot of his six-year presidency. If Xi caves to Trump’s threats, he risks looking weak at home. If he declines the meeting, he must accept the economic costs that come with Trump possibly extending the trade conflict through the 2020 presidential elections.

Whether they meet or not, none of the possible scenarios are good for President Xi or the economy in the long run,” said Zhang Jian, an associate professor at Peking University. “You don’t have a good choice which can meet the needs of the Chinese economy or Mr. Xi’s political calculations.”

Prodded by hawks in Washington to take a “whole of government” approach toward China, Trump may make it harder for Xi to compromise at the negotiating table. The U.S. administration’s efforts to sell arms to Taiwan and criticize China’s mass-detention of ethnic Uighurs in the remote far west of the country are fueling nationalist fears in Beijing that the U.S. wants to weaken and contain its biggest rival.

A separate Bloomberg article revealed that, in addition to the trade frictions, China believes American provocations with respect to Taiwan, and its troubles in Hong Kong, amount to a direct political challenge the Chinese Communist Party`s legitimacy:

Chinese officials have been frank about the seriousness of Trump’s attacks. One senior Chinese diplomat recently told a foreign counterpart that Beijing sees the U.S. actions as a challenge to the Communist Party’s right to govern China, according to a person familiar with the exchange.

Former Australian prime minister Kevin Rudd wrote a commentary in the Sydney Morning Herald and stated that he was seeing a marked change in tone from China towards the US.  It was a level of belligerence that he hadn’t seen in 30 years, and compromise may not be possible under these conditions [emphasis added]:

Beijing then proceeded to unleash an avalanche of nationalist rhetoric against the US
of a type I hadn’t seen in 30 years. America was now routinely described as a swaggering bully. The People’s Daily reminded its readers that the People’s Republic, less than 12 months after its founding, had fought the US to a stalemate in Korea.

Xi Jinping then went south to Jiangxi, from where the Communist Party had set out on the Long March in 1934 and lost 90 per cent of its forces, before finally winning the war against the Nationalists 15 years later. Xi also happened to visit a rare-earths facility in Jiangxi, while not being so crass as to state publicly that America is ultimately dependent on Chinese rare earths for America’s own needs across multiple industry sectors.

The message to the domestic body politic was clear: the world has thrown a lot at China over the last 5000 years, but we Chinese have a long, long history of enduring pain, and we always prevail. Meanwhile, on the policy front, China has calculated that a full-blown trade war, if it comes to that, will cost its economy 1.4 per cent in growth per year. A full range of fiscal, monetary and infrastructure investment measures are already under way as part of a stimulus strategy to keep growth above 6 per cent. Other measures are in the pipeline.

The mere act of meeting Trump in Japan will make Xi appear weak. This time, Trump may have overplayed his hand with his endless threats and the Chinese have begun to view him as an unreliable negotiating partner. Bloomberg reporter Shawn Donnan recently toured China and found that the Chinese are preparing for a protracted trade war:

President Donald Trump is eager to crow about the economic weapon he wielded against Mexico to win concessions on immigration: “Tariffs are a great negotiating tool,” he declared Tuesday.

Now, Trump says, it’s China’s turn to cower. Yet to visit China these days is to encounter the limits of his punch-them-in-the-nose strategy. Even as Trump threatens to raise import duties to painful levels, 10 days of meetings with Chinese officials, academics, entrepreneurs and venture capitalists revealed a nation rewriting its relationship with the U.S. and preparing to ride out a trade war.

Trump is seeking to increase pressure on Xi Jinping, his Chinese counterpart, before this month’s G-20 summit, but Trump may already have pushed too far. Last month, Xi exhorted his countrymen to a second Long March, an echo of Mao’s seminal strategy to preserve the communist revolution. What Xi didn’t say was that the new march — this time in the service of China’s own model of capitalism — is already underway.

“This is definitely an inflection point,’’ said Tom Liu, chief executive officer of Shanghai-based data company ChinaScope Financial Ltd. ”People are seeing an indefinite trade shock.’’ And they are planning for it.

Donnan cited examples such as Huawei’s preparations for an American embargo, Chinese tactics “aimed at spurring innovation and shoring up its economy”, the compilation of “an ‘unreliable entities’ list that would ban U.S. companies that cut off Chinese firms for political reasons”, Chinese companies creating “sanction proof” corporate structures to avoid getting caught up in a trade war, and so on.

From a tactical perspective, reports from official state media China Daily is talking up the possibility of further PBOC stimulus, which could be interpreted as a preparation for a trade war:

Moderate inflation and the global dovish monetary environment may provide more room for the Chinese authorities to adjust money and credit supplies as a tool to counter downside risks if trade tension escalates, said economists.

Stronger counter-cyclical measures are expected in the coming weeks, including possible adjustments of interest rates or the reserve requirement ratio, to maintain ample liquidity in the financial market and support infrastructure investment, according to some economists after they viewed the new financing data released on Wednesday.

It is therefore possible that a trade war erupts because Trump’s threats make it impossible for Xi to meet him without losing face, and China is preparing itself for the consequences. The Chinese has not confirmed a Trump-Xi meeting, and my best case scenario at this point is a backroom deal where no official side meeting is scheduled, but there is an agreement that Trump and Xi could “accidentally” brush by each other in a corridor and decide to retire to a side room to discuss trade issues. Such a compromise could save face for Xi inasmuch as he did not acquiesce to American pressure.

Even if the two presidents were to meet, it will be difficult to see how a complete agreement could emerge from a single discussion. The best the market could hope for is an announcement that the talks were constructive, both sides agree to keep talking, and the US suspends the imposition of further tariffs.

In short, the range of results from the G20 is neutral at best, and catastrophic at worst. While the Fed might choose to cut rates if negotiations collapsed and the US imposed further tariffs, how will the Fed react to a stalemated outcome?

The path of the Fed Funds rate therefore depends on the degree of progress at the G20 meeting. Greg Ip of the WSJ believes that the Fed needs to become the adult in the room:

This is eerily similar to what the Fed faced in early 2003, when growth was tepid and U.S. forces were poised to invade Iraq. “Our degree of uncertainty has gone up dramatically, largely because of…Iraqi oil uncertainty and the other geopolitical risks,” then-Chairman Alan Greenspan told his colleagues on March 18. While leaning towards a rate cut, he advised against moving then since “we are going to learn a great deal about the economy over the next several weeks.” The war began the next day. In June, the Fed cut rates.

Mr. Powell similarly can better judge at the Fed’s July 30-31 meeting whether a full-blown trade war with China is likely and will hammer the U.S. Cutting rates before the Fed can make a clear case with the evidence on hand doesn’t exactly project stability and calm. And the world needs a calm, stable Fed.

If trade risk is grave enough for Mr. Powell to cut rates, either in July or sooner, he will be accused of acquiescing to Mr. Trump’s demands that the Fed support him in his fight with China. He should brush off the accusations. It’s not Mr. Powell’s job to shape trade policy any more than it was Mr. Greenspan’s to prescribe military doctrine. The Fed chairman has to accept such policies as given, then act to protect the economy from the fallout. The biggest risk to the Fed’s independence isn’t Mr. Trump but failing at its job.

How weak is the economy?

The Fed would be fully justified to embark on a rate cut cycle if a full-blown trade war were to break out, but it is difficult to estimate the effects of a trade war. Morgan Stanley recently warned that a recession could begin in nine months if Trump were to impose a 25% tariff of the remaining $300 billion of Chinese imports, and if China were to retaliate with tariff measures of its own.

David Kostin at Goldman Sachs estimated the first-order effects of the 25% tariff on $300 billion of Chinese imports to be up to 6% of 2019 earnings, but he was silent on the second-order effects such as the loss of business and consumer confidence, which are very hard to model.
 

For equity investors, the bearish effects of falling earnings expectations would be offset by the bullish effects of an easy monetary policy. My hunch is the bears will win out in that scenario, as earnings matter more than interest rates.

What if the G20 meeting ended with a neutral result, namely both sides continue to talk and further new tariffs are suspended? How would the Fed react then?

That depends on how weak the economy is. The latest Atlanta Fed nowcast of Q2 GDP growth is 2.1%, and the New York Fed’s nowcast is 1.5%. These figures, combined with the soft May Jobs Report and tame CPI, provide justification for a preventive rate hike.

The risk for Fed policy makers is the economy recovers on its on in H2 2019. Callum Thomas pointed out that OECD leading indicators are pointing to a H2 rebound in the global economy. A July rate cut now would be pro-cyclical, which may not be the effect that the Fed wants to convey.
 

Separate analysis from Richardson GMP of global leading indicators came to a similar conclusion.
 

Another set of indicators that I like to monitor come from the NFIB monthly survey, which is useful because small businesses have minimal bargaining power and they are therefore sensitive barometers of the economy. The latest May 2019 NFIB survey shows small business confidence to be on fire. Confidence rose to 105.0 after a late 2018 decline “thanks to strong hiring, investment, and sales,” Unlike the Beige Book or other surveys, there are zero mentions of tariffs.
 

Expansion plans has rebounded strongly and readings are higher than they have ever been compared to past expansion cycles.
 

Hiring plans are strong.
 

Real retail sales per capita, which is one of my long leading Recession Watch indicators, made a new high for this expansion cycle.
 

The Fed may be premature in embarking on a rate hike cycle in the absence of downside risk from a full-blown trade war. Past recessions have been marked by a combination of a positive and rising real Fed Funds rate and an inverted yield curve. Neither condition is arguably in place today. The real Fed Funds rate rose into positive territory, but real rates have backed off their highs. The yield curve is only currently showing minor inverted properties, and neither the 2s10s nor the 10s30s are inverted. In fact, the 10s30s spread is above 0.50% and steepening.
 

Is this the picture of an economy in desperate need of a rate cut cycle?

I believe that if the Fed were to engage in a July “insurance” rate cut under a trade stalemate scenario, the risk is it will have to reverse course later in the year. Potential triggers are a possible natural recovery of global growth, or a trade agreement that resolves much of the downside tail-risk of a full-blown trade war.

While the resumption of a rate hike cycle may first appear to have bearish overtones for stock prices, the reverse may be true. That’s because the bearish effects of higher rates are likely to be offset by the bullish effects of higher growth expectations. The market currently trades at a forward P/E ratio of 16.5, which is equal its 5-year average and above its 10-year average of 14.8. Stocks are not very expensive and can have room to run if earnings estimates were to resume their upward trajectory, especially when rates are this low.
 

Strategist Tom Lee pointed out that the equity markets perform well in the wake of a first rate cut, as long as the economy is not in recession. Since 1970, stocks rise an average of 16% nine months after the first rate cut, and P/E ratio expands by 1.7.
 

In conclusion, while the Fed could decide to cut rates at its July FOMC meeting, the future path of interest rates and stock prices depends on the reasoning behind the rate cut. If the cut is in response to the eruption of a full-blown trade and economic cold war with China, then it is likely to be the start of a protracted rate cut cycle, with bearish implications for equity prices. On the other hand, if the rate cut is an “insurance” cut designed to head off further economic weakness in the face of a stalemated trade dispute, I expect the cut to be reversed relatively quickly because the global growth backdrop remains constructive. Equity prices would rise under such a scenario as the bullish implications of higher growth would overwhelm the bearish implications of higher interest rates.
 

The week ahead

Looking to the week ahead, it is difficult to make a strong call on short-term direction based on technical analysis in light of the wildcard risks posed by the FOMC meeting next week and the G20 meeting the week after.

As I expected, the SPX started to consolidate and trade sideways after a strong rebound off an oversold condition and panicky sentiment. Short-term readings are overbought, but overbought markets can become more overbought, or they can resolve by either going sideways or correcting.
 

The weekly chart is equally puzzling and presents a case of fun with technical analysis. If the engulfing reversal the previous week was bullish, why was it followed by a bearish graveyard doji the next week?
 

Sentiment models offer little or no directional trading edge as readings have begun to normalize after a crowded short condition. The AAII Bull-Bear spread is just one of many examples. Arguably, sentiment remains bearish, which shows that the market has room to move up before the consensus reaches excessively greedy levels. However, the presence of the twin event risks makes a bullish bet the equivalent of trying to win two coin flips.
 

Seasonal patterns offer no directional insights either. Next week is option expiry week, and Rob Hanna at Quantifiable Edges found that June OpEx has a slight bearish bias that offers little or no statistical edge.
 

A more detailed historical analysis of June OpEx from Jeff Hirsch at Almanac Trader does inspires neither bullish nor bearish confidence.
 

Market expectations are leaning towards equity bullish outcomes. While the fixed income markets do not expect the Fed to announce a rate cut next week, it does expect hints of a July cut. We can see the effects in the USD Index, which has been trending downwards and it is now testing a key support level. Any hint of hawkishness will send the greenback screaming upwards, but a dovish hold is likely to result in further weakness.
 

My own naive trade war factor, which is measured by the relative performance of Russell 1000 companies with only domestic exposure, has been tilting towards a “trade peace” in the last week. While Trump and Xi are expected to meet on the sidelines at the Osaka G20 at the end of June, there has been no official confirmation from the Chinese side that a meeting has been scheduled. While this may be just an example of negotiating brinksmanship, benign market expectations is setting up the possibility of disappointment.
 

Looking out over the valley of the twin event risks, intermediate-term technical conditions are bullish. Both the NYSE and SPX Advance-Decline Lines set fresh all-time highs, which are signals that we are still in a bull market. Tom McClellan agrees with that assessment, and he characterized A-D Line highs as a sign of “plentiful liquidity”, which is intermediate-term bullish.
 

The combination of an intermediate-term bullish outlook with short-term event risk argues for a neutral investment position. My inner investor is positioned at about the equity weights set out by investment policy. He has selectively sold covered call options against long positions to take advantage of the above average option premiums.

My inner trader has stepped aside and moved to a 100% cash position. There is no point in trading if you don’t have an edge.

Preface: Explaining our market timing models
We maintain several market timing models, each with differing time horizons. The “Ultimate Market Timing Model” is a long-term market timing model based on the research outlined in our post, Building the ultimate market timing model. This model tends to generate only a handful of signals each decade.

The Trend Model is an asset allocation model which applies trend following principles based on the inputs of global stock and commodity price. This model has a shorter time horizon and tends to turn over about 4-6 times a year. In essence, it seeks to answer the question, “Is the trend in the global economy expansion (bullish) or contraction (bearish)?”

My inner trader uses a trading model, which is a blend of price momentum (is the Trend Model becoming more bullish, or bearish?) and overbought/oversold extremes (don’t buy if the trend is overbought, and vice versa). Subscribers receive real-time alerts of model changes, and a hypothetical trading record of the those email alerts are updated weekly here. The hypothetical trading record of the trading model of the real-time alerts that began in March 2016 is shown below.

The latest signals of each model are as follows:

• Ultimate market timing model: Buy equities
• Trend Model signal: Neutral
• Trading model: Bullish

Update schedule: I generally update model readings on my site on weekends and tweet mid-week observations at @humblestudent. Subscribers receive real-time alerts of trading model changes, and a hypothetical trading record of the those email alerts is shown here.

Tariff Man and Dow Man gang up on the Fed

David Rosenberg advanced an intriguing theory last week. Could Trump be weakening the economy sufficiently for the Fed to cut rates, and then call off the trade war so that the stock market could soar ahead of the 2020 election?

Viewed in the context of Jerome Powell’s remarks at a Fed policy conference last week which acknowledged trade tension risks, that scenario is a possibility.

I’d like first to say a word about recent developments involving trade negotiations and other matters. We do not know how or when these issues will be resolved. We are closely monitoring the implications of these developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion, with a strong labor market and inflation near our symmetric 2 percent objective. My comments today, like this conference, will focus on longer-run issues that will remain even as the issues of the moment evolve.

Will the Fed play ball? The market is now discounting three rate cuts by year-end, with the first one at the July FOMC meeting. This matters to equity investors. A historical study from Barclays showed that the stock market tends to have a strong positive reaction a month after the first rate cut, and returns were even stronger after six months.

I leave the conclusion to Fed watcher Tim Duy, who puts it much better than I could ever do:

Although the stage is set for the Fed to cut rates, policy makers won’t have sufficient data to act until the end of the summer. A move at the September meeting is a reasonable baseline at this point. If the data deteriorate more quickly, or if markets seize up, pull that cut forward into July. If trade tensions ease and growth stays strong, push it back.

Will the on again, off again trade tensions drag on until Q3 or Q4? If so, expect a choppy range-bound and headline-driven market until the end of the summer and into the fall.

A softening economy

Here are some reasons why the Fed might cut rates. First, the economy is starting to soften. The latest miss on the May Non-Farm Payroll report was a negative surprise. The downward revisions to employment in March and April were also disappointing.

The latest ISM Manufacturing PMI fell and missed expectations, though ISM Services did rise and beat.

However, both IHS Markit’s US Manufacturing and Services PMI weakened, and missed expectations. The Composite PMI is now consistent with GDP growth decelerating to about 1%.

The Atlanta Fed’s nowcast of Q2 GDP growth is 1.5%, which is consistent the New York Fed’s nowcast at 1.48%. If Q2 GDP does come in at about 1.5%, this would represent a severe deceleration from the Q1 GDP growth rate of 3.2%,

Trade war jitters

The market reaction to the trade war has followed the script of past unexpected macro shocks. At first, investors only know the direction of the shock, but cannot accurately estimate the magnitude. Consequently, the only investment factors to matter are the technical analysis factors, because price reacts quickly to news. Strategists then begin to either revise their estimates, or build a range of scenarios with differing estimates. This is followed by earnings estimate revisions by company analysts, once they can quantify the magnitude of the disruption. This template has been followed by positive shocks, such as the last round of Republican tax cuts, and the numerous negative shocks that have hit EM economies over the years.

We are now at the second stage, and strategists are beginning to issue top-down revisions to earnings and GDP growth. Bloomberg reported that both BAML and Citi have reduced their top-down earnings estimates:

Bank of America and Citigroup have lowered their U.S. corporate profit forecasts while pointing out the risk of a recession as trade tensions escalate.

Savita Subramanian, who heads the U.S. equity strategy team at BofA, cut her 2019 estimate for S&P 500 companies by $2 a share to $166, saying import tariffs are set to increase costs, hurting profits for American firms. Tobias Levkovich, chief U.S. equity strategist at Citi, trimmed his projection by the same amount, to $170 a share.

In a separate article, Bloomberg reported that Morgan Stanley is calling for a recession if the trade war isn’t resolved:

A recession could begin in as soon as nine months if President Donald Trump pushes to impose 25% tariffs on additional $300 billion of Chinese imports and China retaliates with its own countermeasures, according to Chetan Ahya, chief economist and global head of economics at Morgan Stanley.

The rift between the Trump administration and China has escalated as each side blames the other for the breakdown in talks. Over the weekend, Trump celebrated his trade policies and the recent move to impose tariffs on Mexican goods in response to illegal immigration.

While stocks have declined, investors are still overlooking the impact the trade war will have on the global macroeconomic outlook, Ahya wrote in a note on Sunday. Growth will suffer as costs increase, customer demand slows and companies reduce capital spending, he said.

As the negative effects of the tariffs become more apparent, it may be too late for political action, according to Ahya. Policies to ease the impact are likely to be too reactive and slow to take effect.

David Kostin at Goldman Sachs laid out several scenarios and estimated the impact of China tariffs to be as much as a 6% cut to 2019 earnings estimates.

While analysts can estimate the direct first-order effects of tariffs and a trade war, it is far more difficult to estimate the second-order effects. How will these measures affect business and consumer confidence? A survey by Oscar Sloterbeck at Evercore revealed how a full-blown trade war might affect business confidence. 32% of US companies said that they would cut their capex plans if the US-China trade talks broke down.

Deutsche Bank correlated the level of uncertainty with investment spending. The results are not pretty.

You can see why Powell said that the Fed is “monitoring the implications of these developments”. The Fed is clearly worried. The combination of a soft patch in growth and the rising tail-risk from trade wars has opened the door to rate cuts.

Market pressures

In addition, Powell has stated that the last two recessions have been caused by financial instability, and this is an important unspoken third mandate for the Fed. Consequently, I believe the Powell Fed is far more attuned to the market than either the Bernanke or Yellen Fed.

So how does the Fed interpret the message from the bond market? Not only is there a partial inversion, but most of the yield curve is under the Fed Funds target rate of 2.25% to 2.50%?

To be sure, there are limits to the Fed’s reaction function. Reuters reported that vice chair Richard Clarida said that the Fed can’t be handcuffed to the market.

The U.S. Federal Reserve will consider investors’ expectations when they weigh what to do with interest rates, but they will not be “handcuffed” to market prices, a central bank policymaker said on Tuesday.

“We’ll look at market pricing,” along with a range of data on how the economy is doing, Fed Board of Governors Vice Chair Richard Clarida told CNBC. “Market pricing can go up and down so we can’t be handcuffed to that.”

What’s the Fed’s reaction function?

How will the Fed react to these pressures? Will it cut rates?

For some perspective, policy makers do not use a seat-of-the pants decision process. They need a policy and decision making framework, or a model. The Fed may learn from the Bank of Canada. BNN-Bloomberg pointed out that the process to change a monetary policy framework can be excruciatingly slow:

Don’t bet on Federal Reserve officials to overhaul how they target inflation if the experience of counterparts at the Bank of Canada is anything to go by.

As Fed policy makers meet in Chicago to debate whether to change their inflation target, they have been sharing notes with counterparts north of the border where mandate reviews have been regularly undertaken over the past two decades.

The lesson they’ll learn is that the bar to change is high.

Every five years, the Bank of Canada reassesses its monetary policy guidelines, not unlike what the Fed is currently doing, including a conference this week on alternatives. While the research surrounding Canada’s reviews has been serious, the end result each time has only been minor changes.

The biggest tweak, made in 2011, gave the Bank of Canada more time to reach its target. The underlying objective — to focus exclusively on price stability and use 2 per cent inflation as an operational guide — has been largely untouched.

While the market has seized upon the changed tone of the latest Fedspeak, expectations for rate cuts may be premature. The party line has changed from “the economy is in a good place”, and “we will be patient”, to “the economy is in a good place”, but we are monitoring the situation. The term “patient” has been interpreted by the market as “we will neither raise nor lower rates”, while “monitoring the situation” is viewed as “we are open to rate cuts”.

That said, the current state of the economy does not warrant a rate cut. While there is some softness from ISM and PMI readings, they remain above 50, or expansion mode. The latest Beige Book Report showed modest growth and “improvement” from the previous month:

Economic activity expanded at a modest pace overall from April through mid-May, a slight improvement over the previous period. Almost all Districts reported some growth, and a few saw moderate gains in activity.

In fact, Renaissance Macro found that the word count of “slow” or “weak” in the Beige Book has improved over last month.

While the headline Non-Farm Payroll print was disappointing, a number of internals indicating decelerating growth, but not a cratering economy. In particular, temporary jobs have historically led NFP, and so has the quits to layoffs ratio, which comes from the JOLTS report. Temporary employment continued to rise in May, albeit at a reduced pace, indicating deceleration but no contraction.

In the absence of negative shocks, these conditions do not scream for a rate cut. In the end, it may have been left to former New York Fed president Bill Dudley, who can speak more freely, to outline the Fed’s process in a Bloomberg opinion piece. Dudley laid out three scenarios:

I see three potential paths forward. First, both sides concede that a trade war is not winnable and eventually reach a deal of modest consequence. The U.S. unwinds tariffs, reversing the fiscal tightening, reducing the damaging uncertainty and restoring confidence in the economic outlook. If I were in the president’s shoes, this is the outcome I’d want because it offers the best chance of reelection.

Second, the sides stay in a holding pattern. Trade negotiations don’t resume, but nobody escalates. President Trump’s threat of a 25% tariff on the remainder of Chinese imports remains no more than a threat — as has happened with tariffs on European car imports. It’s still out there, but keeps getting pushed into the future. In this case, the economy and markets remain somewhat stressed. But over time, uncertainty subsides as people increasingly assume that this is how matters will remain.

Third, the trade war escalates further and the U.S. carries through on its threat of more tariffs. In this case, the impact on the U.S. economy becomes significant. Higher import prices boost inflation, and added fiscal tightening markedly increases the risk of a recession. Worse, China retaliates, with more negative consequences for the U.S. economy and stock market.

However, the Fed cannot act until it see the actual results [emphasis added]:

There’s not much the Federal Reserve can do before it knows which of the three scenarios will prevail. This reinforces its inclination to keep interest rates on hold. Officials would likely view the increase in prices as a one-time event, unless it somehow triggered more persistent wage inflation. That said, I suspect that Fed economists see the potential impact of uncertainty on activity as the more significant risk at this point. So if Trump goes further down the escalation path, it’s certainly possible that the Fed will cut its short-term interest-rate target by 0.5 percentage point over the next 12 months — as futures markets currently expect.

Beware of lurking negative shocks

The markets are adopted a risk-on tone this week. Negative sentiment became overly stretched. The alleviation of some trade related tail-risk sparked a rally. However, investors should be aware of lurking negative shocks from a number of different sources.

Hu Xijin, editor-in-chief of China’s official media Global Times, tweeted an ominous warning last week.

In addition, former American diplomat turned consultant Kurt Campbell revealed last week that China has begun a low-level harassment campaign against American companies.

“I work with Americans, largely American businesses, that are engaged deeply in China,” Kurt Campbell, chairman and CEO of The Asia Group, said in a speech at The Atlantic Council. “Without revealing details, I would say over the course of the last week, of 50 or so interlocutors in Asia, more than half have called and said ‘We suddenly have a problem’.”

Most of the difficulties have not yet been reported by the media. But companies have called to say that “suddenly their warehouse has been raided,” Campbell said. “Or maybe a movie company, the movie they wanted to be able to show, suddenly the airplane has not manifested for the movies, or the bank records need to be reviewed again.”

Campbell interpreted this campaign as a hint to the US:

“What we’re seeing now is phase two in the Chinese approach,” said Campbell, who served as the assistant secretary of State for East Asian and Pacific Affairs in the Obama administration.

“Now, it’s going to be a subtle message that if you proceed down this path, we’re going to retaliate against American firms,” Campbell said.

Trump scored a goal for the Chinese side when he visited the UK last week, and said publicly that while he would welcome a free-trade agreement with the UK, everything, including Britain’s National Health Service, was on the table. While I have not always been a fan of China’s mercantile trade practices, Trump’s deep intrusion into a trade partner’s longstanding institutions like Britain’s NHS will win him few friends among his allies.

Then there is always the possibility of unexpected surprises from the Tweeter-in-Chief. Arbor Research compiled the history of Trump tweets and found that negative sentiment began to increase steadily about a year ago, and spiked to all-time highs in early May.

The Atlantic offered this framework for analyzing Trump’s policy surprises [emphasis added]:

According to current and former aides, who requested anonymity to speak freely, when Trump feels he has lost control of the narrative, he grasps at two issues: border security and trade. Those aides said he sees these topics as reset buttons, ways to rile both Democratic and Republican lawmakers and draw attention away from whatever dumpster fire is blazing in a given week. “Whenever a negative story comes around, his instinct is to pivot to immigration or trade,” a senior campaign adviser told me. “It’s kind of like his safety blanket. He knows that Fox and conservative media will immediately coalesce and change what the base is talking about.”

Specifically, the Mexican tariffs was just a reaction to the Mueller report:

That Trump reverted to tariffs on Thursday offers a clue as to just how distressing the past week has been for him. Trump is no stranger to bad weeks, of course. But according to the senior campaign adviser, he was particularly unnerved by the media attention Mueller’s statement received. “Mueller controlled the news cycle,” this person said. “It was 24/7 the last couple of days. And that’s what bothers him.” Added to that was the increasing number of 2020 candidates calling to begin impeachment proceedings against the president, a topic most have been loath to touch on the campaign trail. For any public bluster from the White House welcoming an impeachment fight, Trump has zero private desire to take one on, according to a second senior campaign official. “To be impeached?!? No one wants that,” the source told me in a text message.

One way to prepare for such surprises is to watch the sources of political irritants for Trump. Here are two stories that I am keeping an eye on.

The White House has directed former Trump aides Hope Hicks and Annie Donaldson not to provide the House Judiciary Committee with documents relating to the committee’s inquiry. The instances of resistance to congressional subpoenas by former and current Trump officials have been piling up. How will that battle play out?

In addition, Tucker Carlson at Fox recently gushed over Elizabeth Warren’s plan for economic patriotism and characterized Warren sounding as “Trump at his best” (link to video). Ouch! That’s got to hurt. Does this story have legs? How will Trump react?

Rate cut timing

After a long-winded analysis, we return to the original question. Will the Fed cut rates? I leave the last word to Fed watcher Tim Duy:

Fed officials have resisted sending signals about the direction rates, assigning equal possibilities of either an increase or a cut. The shifting balance of risks, however, make that an increasingly difficult story to sell. The escalation of trade wars from China to Mexico create substantial uncertainty for the outlook, and none of it good.

Some complain that the Fed would only be bailing out President Donald Trump in his ill-advised use of tariffs by cutting rates. Such charges will fall on deaf ears at the Fed. Policy makers may not like responding to Trump’s escapades with easier policy, but they ultimately have little choice but to do so. The Fed responds to shocks in a systematic fashion, even those created by the government. The Fed will respond to this shock with easier policy as they seek to sustain the expansion and meet their employment and inflation objectives.

Duy concluded that the likely timing of the first rate cut will be in September:

Although the stage is set for the Fed to cut rates, policy makers won’t have sufficient data to act until the end of the summer. A move at the September meeting is a reasonable baseline at this point. If the data deteriorate more quickly, or if markets seize up, pull that cut forward into July. If trade tensions ease and growth stays strong, push it back.

Will the on again, off again trade tensions drag on until Q3 or Q4? If so, expect a choppy range-bound and headline-driven market until the end of the summer and into the fall.

The week ahead

It is stunning how sentiment has taken a complete U-turn in one week. A week ago, my inbox and social media feed were filled with “the world ending” missives. By the end of this week, sentiment had changed to “we are going to fresh all-time highs” as a result of the relief rally.

The reflex rally was no surprise, as the market had become extremely oversold and sentiment had become excessively bearish. However, my base case scenario was the 2011 template, when the combination of the Greek Crisis and a possible budget impasse in Washington spooked the market. Prices chopped around in a trading range (shaded zone) until the ECB resolved the crisis with its LTRO program. The range-bound period was characterized by an initial fear spike, followed by a series of lower sentiment tops indicating fading fear.

Fast forward to 2019. We are seeing some evidence of fading fear. What is different this time is the spike in S&P 500 new highs in the latest rally. New highs rose above 70 on Wednesday, which was a new 52-week high level indicating strong momentum. New highs continued to expand as the rally proceeded, and ended the week at 126. The same behavior was not evident during the choppy range-bound period in 2011, which suggests that the reflex rally may have further legs, and could continue higher in a V-shaped pattern, rather than the W that I originally envisaged.

SentimenTrader observed that the historical experience of fresh highs on NYSE new highs has generally been bullish.

To be sure, short-term sentiment had deteriorated to a crowded short, which accounts for the reflex relief rally. The AAII Bull – Bear spread was -20. In the last 10 years, the market had only one failure (red line) when the spread reached this level. In all other instances, the downside was limited and risk/reward was skewed upwards.

Troy Bombardia studied the historical record of what happened when the 4-week bull-bear spread fell below -14%, and he came to a similar conclusion.

While the bulls may have temporarily seized control, the bears are still lurking in the woods, ready to pounce. FactSet reported that forward 12-month EPS estimates have started to fall, which may indicate that analysts are becoming increasingly jittery about the earnings outlook due to trade war risks. Keep an eye on this in the coming weeks to see this is a data blip.

The analysis of the relative performance of the top five sectors that comprise just under 70% of the index shows a mixed bag at best. Technology and Healthcare stocks have rebounded, but Financials and Communications Services are neutral, and Consumer Discretionary stocks are underperforming. It is difficult to see how the market can make significant headway until a majority of these top sectors show strong leadership qualities.

The daily S&P 500 chart also shows a mixed bag. The stochastic indicator recycled early last week and flashed a buy signal, but reading are close to overbought levels where the advance could stall. On the other hand, both the VIX Index and the VIX term structure showed increasing fear on Friday when the index advanced 1.05%, which anomalous and may be a sign that the market is climbing a wall of worry.

The weekly chart is flashing some potentially bullish signals. The stochastic indicator stabilized, indicating a loss of bearish momentum. Moreover, the S&P 500 exhibited an engulfing candle reversal, also known as an outside week, indicating that a possible price reversal is at hand.

Short-term breadth has become highly overbought and a pullback or consolidation could happen at any time.

Event risk will overhang the markets for the remainder of the month. We have the FOMC meeting in the third week of June, where the market has more or less priced in a Powell Put. In addition, Trump and Xi are expected to meet on the sidelines at the G20 meeting in the last week of June. These two events will represent high sources of uncertainty, and investors and traders are advised not to be sensitive to potential volatility.

I am inclined to think that the strong momentum exhibited by the market in last week’s relief rally is a bull trap. At a minimum, prudent risk management practices call for scaling trading positions to potential volatility. My base case remains a range-bound market, which calls for a trading strategy of fading strength and buying weakness.

My inner investor is neutrally positioned at the asset allocation specified by investment policy. My inner trader is bullish, but he lightened up some positions at the end of last week as the market rallied. He is preparing to sell the rips, and buy the dips.

Disclosure: Long SPXL