Global-Macro Review

July 24, 2018

"If you mix politics with your investment decisions, you're making a big mistake."
-Warren Buffett, 2017
. . . . .
Today's headlines contain more compelling stories than an Appalachian family reunion. Forcing us to sit back and scan the horizon. As we attempt to identify the risks and opportunities extant in today's global marketplace.
So, grab a coffee, water or cocktail. And join us as we spitball through a multitude of issues and scenarios burdening the psyches of global investors...

Equities have spent 2018 meandering across the landscape like a herd of Walkers from The Walking Dead. But why so aimless? Tax cuts were passed. Earnings have been excellent. And GDP growth continues to rise.
Which can only bring us to glance over at the 900-lbs gorilla sitting in the corner. The Fed. Most investors have little to no idea as to how much the Fed drives the business cycle. And so the economy. And thus stock and bond markets.
Like a rising tide will lift all boats, so increasing amounts of global liquidity can elevate asset prices. All of them. And which institution, more than any other, is responsible for driving global liquidity? The Fed.
After years of Zero-Interest-Rate Policy (ZIRP), followed by years of Near-Zero-Interest-Rate Policy (NIRP), the Fed has reversed course. Moving from Quantitative Easing (QE) to Quantitative Tightening (QT). Removing liquidity from the marketplace by selling its vast trove of Treasury Bonds back to the marketplace. And leaving us to crave a warm bowl of Chef Boyardee Alphabet Pasta with Meatballs.
Given its growth since the end of the Credit Crisis, the Fed's balance sheet will likely continue to contract in the near-term. Just as it did following the Dot-Com Bubble Bust in 2000. And as in 2000, that contraction eventually impacted stocks. As it appears to be doing today. In fact, Q4 2017 and Q1 2018 S&P 500 price action looks eerily similar to late 1999-Q1, 2000. But on a smaller scale.
As the Fed removes dollars from global markets, dollars become increasingly scarce. Causing their value to rise. Unfortunately, a rising Dollar does not help American multi-nationals to export goods and services. As such goods become ever-more expensive to overseas consumers.
Yet, so long as global Dollar liquidity (availability) continues to shrink, upside pressure on the Dollar will continue. Exerting additional pressure on American companies doing business abroad. Just when tax reform was supposed to be pushing their share prices higher.
If the Fed continues with Quantitative Tightening (QT - which soaks up the dollars sloshing around the global economy as the Treasury sells bonds for cash), the Dollar will move higher in value against rival currencies. Which is near-term bearish for the U.S. economy. Especially the export sector and multi-national corporate earnings.
Tossing fuel upon the flames, credit spreads have moved in the wrong direction. With 10-year U.S. Treasury yields cresting above three percent in May. Providing investors with 61 percent more yield than the dividend on the S&P 500. And giving global investors pause before simply shoveling fresh capital into equity markets. As they ponder the additional risk that accompanies an allocation into stocks.
Fixed-income guru Jeffrey Gundlach recently explained that every indicator he follows was flashing positive to begin the year. Halfway through 2018, the outlook's not so rosy. And investors need to be cautious.
"There's a narrative out there that says the flattening yield curve isn't sending any message about a recession, and that couldn't be more wrong," he said. "In fact, with rates so low, the yield curve signal is even stronger than usual."
Gundlach warns that this closely watched signal is flashing yellow and needs to be respected as we edge ever closer to a recession. Nor is the increasing tendency towards quantitative tightening helping.
"It's like a death wish," Gundlach explains. "The U.S. is taking on hundreds of billions of dollars of debt while raising rates, which means our debt-service payments are going to be under serious pressure to the upside."
When you combine, 1) The Fed hiking interest rates, 2) QT, and 3) The U.S. refinancing short-term Treasury debt, you realize that all of this will eventually affect lending in commercial markets. The lifeblood of any economy. Leaving less money to find its way to corporate and residential borrowers. Both of which will respond by spending less. Leaving the economy to scratch its head and ask where all the liquidity (and good times) went.
But at least the U.S. economy continues to grow. Which is more than can be said for others.
Across the pond, European economies appear to be slowing. A result of political discord, Brexit, high indebtedness and delayed corporate spending/hiring due to U.S. tariff perceptions. Moreover, the European Central Bank plans to begin tapering in a few months. Which will squeeze Europe's manufacturing base. Already we've seen the price of copper heading lower. Which often portends future economic headwinds.
For two years, we've slated European equities as a potential hotspot for fresh capital. We saw equity valuations that were a bargain compared to the S&P 500. We saw a eurozone that had been an economic basket case. And saw plenty of upside potential. Yet, for the second year in a row, we've been off on our assumptions. Failing to understand the scope of Europe's political and economic problems. And so we continue to be underweight European equities.
In Asia, Japan's central bank balance sheet has also begun to shrink. And China's economy has slowed. Leaving the U.S. as the only major economy still accelerating. Though some of our more respected analysts have forecast a meaningful economic slowdown in three to four quarters as decreasing global liquidity begins to have an impact closer to home.
Last year, Goldman Sachs released a report which found that "the most frequent contributor to modern recessions have been monetary policy tightening and oil price shocks, with the former in response to inflation that often-gained momentum from the latter."
Suffice it to say that global central banks have enacted (or soon will enact) monetary tightening policies. Intent as they are on rolling back the last decade's monetary easing. Simultaneously, Crude Oil prices have spiked 45 percent this past year. Leaving bullish economists on thin ice from a historical perspective.
"Although stocks have been ebullient heading into Q2 earnings, Treasury bonds and copper futures have been flashing red and warning of trouble."
Still, the bottom line for U.S. investors remains positive until proven otherwise. As domestic investors have managed to shrug off concerns over equity and economic headwinds. Allowing U.S. stocks to hold onto gains and continue to chart an upward trajectory. Even as foreign indices have given back earlier gains. Or settled into full-out retreats.
The S&P 500 and Dow Jones Industrial Average have risen since July 6, when the U.S. and China imposed tariffs on each other. The S&P 500 has risen 4.3 percent for the year. While international markets have fallen. China's Shanghai Composite has dropped 14 percent. South Korea's Kospi Composite Index has shed 6.3 percent. Germany's DAX has lost 2.9 percent. And Japan's Nikkei Stock Average has declined 0.7 percent.
Bespoke Investment Group reports that 83 percent of U.S. industry groups remain above their rising 50-day and 200-day moving averages. Another bullish sign.
Yet, although stocks have been ebullient heading into Q2 earnings, Treasury bonds and copper futures have been flashing red and warning of trouble. The 30-year Treasury yield has drifted below its March and May lows. Falling further below the 3 percent threshold as the yield curve flattens -- an oft-cited and critical pre-recession signal.
Moreover, copper prices have trended lower. A bad omen, given that copper is said to have a PhD in economics because of its sensitivity to the business cycle. Copper prices have collapsed to levels not seen since last summer. Falling nearly 16 percent over the past two months.
Ed Yardeni at Yardeni Research notes that China alone accounts for 40 percent of global copper demand. Providing a sign that growth in the Middle Kingdom is slowing. In fact, it's possible when we look back at this period that the tariff brouhaha marked the start of a slide in China's hegemony.
The world's second-largest economy grew 6.7 percent last quarter from a year earlier. Above the annualized target of 6.5 percent. But down from Q1's 6.8 percent rate. Q2 was slowed by the government's effort to clean up its unruly debt situation. Before growth takes an expected hit from the trade spat with the U.S.
China's real estate and small business sectors have slowed. Portending further weakness. And establishing a difficult path for China's economic leadership in the second half of the year.
And remember, this occurs despite the One-Belt, One-Road initiative (OBOR), China's modern-day repprisal of the Silk Road trade route established 2000 years ago. That project established China as the center of global commerce. OBOR is meant to do the same. And there are many nations throughout Southeast Asia, Eastern Europe and Africa that are counting on China's investment expenditures in naval ports, railways, airports and all other logistical nodes of global commerce. Should China's economy slow further, so might its ability to fund that massive undertaking. Providing a ripple effect throughout the global economy.
Were there a scorecard to track which side is winning the China-U.S. trade spat, one might find the opposing trend lines of the U.S. Dollar vs. the Chinese Yuan, as well as the S&P 500 vs. the Shanghai Composite. With both revealing that the clear winner, thus far, has been the U.S.
Since the trade spat began, the S&P 500 has risen 5.5 percent. While the Shanghai Composite has fallen 20 percent.
Concurrently, Chinese Yuan has fallen seven percent against the Dollar. Amid increasing signs that something is wrong with the Chinese economy. With efforts to attract foreign capital finding limited success. Chinese GDP data softening. And the Communist Party leadership unable to prevent collapses in equity and real estate markets.
Which brings us to limit our current exposure to the Middle Kingdom. Despite our longer-term optimism.
Geopolitically, things are no less entertaining. Assuming you can differentiate between that which is material to our wealth creation efforts, and that which is simply kabuki theater.
Recently, President Trump visied the United Kingdom. Where he attended a black-tie dinner with U.K. business leaders. Held meetings with embattled Prime Minister May. Had tea with the Queen. And then had meetings with officials from the NATO alliance. Culminating in a brief trip to Helsinki to meet Vladimir Putin.
But Trump wasn't the only U.S. show in town.
U.S. Ambassador to Germany, Richard Grenell, held a meeting at the Berlin embassy where he met the chiefs of BMW, VW and Daimler-Benz. At that meeting, Grenell offered a U.S. trade option. Not to the German government. But to German industry. Which would basically strike down tariffs on German car exports to the U.S., if Germany were willing to do the same.
The offer was interesting. Nor likely to be the last. German auto chiefs cannot make a trade deal on their own. As such a deal must go through the EU. However, they do have an outsized influence on German government policies and if the response of German auto stocks on the day of that meeting was any guide (they rose 5 percent), they liked the idea and so did the market.
Soon after, Chancellor Merkel made the point that EU partners would have to be involved in a tariff-free deal. And under WTO rules, tariffs would also have to be dropped for other auto manufacturers such as Japanese and South Korean firms.
Consider what a broad tariff-free U.S.-EU deal would do to Europe's economy and to Germany's 8 percent net trade surplus. The trade surplus would shrink. Resulting in downward price pressure on a range of goods which might be imported on more advantageous terms.
Any American who travels in Europe has noticed how high prices are. With property prices often beyond the reach of ordinary citizens. Conversely, Europeans who travel to the U.S. often remark on how inexpensive things are. Food, housing, clothing, etc. And once they're outside of New York and California, they often comment on how spacious the U.S. remains. As America has significant underdeveloped physical space while Western Europe has been in the process of development for thousands of years. Which impacts real estate prices when the only way to build is up, rather an out.
For decades, America has strictly operated within the WTO's rules-based trading system. In fact, restraint from operating outside of that system is what enables it to work. And what ensures the system's legitimacy. Yet, such restraints are coming off. Especially in Europe. And we will not be surprised to see a tariff-free deal soon proposed between the U.S. and U.K. As well as a similar deal between the U.K. and the EU.
The U.K. represents the world's fifth-largest economy. It would be a real coup if the U.S. had a truly special relationship with the U.K. One based upon mutual economic interests. And existing beyond the realms of the EU's convoluted political and economic machinations.
Moreover, we believe such changes are in the offing. Like it or not. As the current tapestry making up the eurozone represents too many competing interests. Which has given rise to populist movements in the region's southern and eastern areas. With Italy now openly discussing its own version of Brexit. And eastern member states in open revolt against immigration policies being forced upon them by the EU's unelected bureaucratic overlords.
Inevitably, Europe will be forced to change. Or face the union's likely disintegration. As its newer and/or poorer member states continue to question the sense and efficacy of remaining within a commercial/cultural union in which so many important matters reside outside of their control, and seem to benefit the wealthiest member states. And those wealthy member states are well aware of what they're facing. As last fall, a leaked German defense document revealed that even Germany was creating contingency plans should the EU collapse.
"Of the 28 NATO members, only four have been meeting
NATO budget requirements established by the alliance decades ago."
Which brings us to NATO... where the truth may be more interesting than what the media is reporting.
Much of what we read and hear regarding boots-on-the-ground intelligence has it that -- despite the controversy surrounding Trump's recent NATO meetings -- the NATO staff was pleased by what occurred. Because, by their assessment, NATO needs a shake-up. It needs to better explain its mission, and then focus on and properly fund that mission. What is not acceptable is to accept that Germany's air force has 128 jets, of which only seven are operational. Nor the amount of required but unattainable training equipment for NATO personnel.
The media got the NATO summit only half right. Some of the EU politicians in attendance were offended by what Trump said. Yet many of the professionals who work there were emboldened by it. And excited about prospective changes. Especially if it brings another $150 billion in defense spending across Europe.
Consider that, of the 28 NATO members, only four have been meeting NATO budget requirements established by the alliance decades ago.
And that helps us. As Europe's defense industry cannot absorb the additional defense spending. Leaving large allocations to be fast tracked to U.S. defense companies. Which continue to rank among our favored sectors.
Trump did not threaten to leave NATO. Nor break up the alliance. But he did stress the need to modernize. Bring the alliance's potential up to the challenges it faces. And a good start would be to have all 28 members meeting their agreed-upon financial responsibilities.
As for Trump's comment on Germany's energy deal with Russia?
It wasn't popular with many on both left and right. But it received silent plaudits from many in the NATO establishment. Who have viewed it as absurd that NATO's biggest European member continues to purchase 40 percent of its energy supply from the very nation against which NATO was created to protect Europe.
Which leads to Trump's meeting with Putin in Helsinki. At which Trump appeared to let his guard down. Which might be expected of a 70-year old man who has kept a high-school track star's schedule the previous few weeks.
What did Trump and Putin have to talk about? Lots, starting with Syria and how to end that conflict. Then there's the Iranian problem. Oil pricing was also likely high on the agenda as the President leans on OPEC (which Russia is basically a part of now), to increase production and so lower U.S. gas prices ahead of the mid-term U.S. election. Yet, many pundits acted as if the idea of the nation's chief executive meeting with Russia's leader was anathema to American interests. Even though Russia holds the world's second-largest nuclear arsenal. Is among the largest energy producers outside of OPEC. Has the world's fifth-largest standing army.
Much of that opposition stems from the increasing partisanship (is that even possible?) emanating from the nation's capital. Trump's constant blunderbuss continues to draw the ire of the global diplomatic set. Those who appreciate the decorum and subtlety by which politics (in Europe and the U.S.) have long been conducted.
Regardless of whether you support the man or not, one fact is certain. The nation's political class, and many of the relationships which they have long stewarded, had gone stale. Even broken. With the political class (the left and right) involved in intractable internecine warfare. And the only casualties being the nation's middle class.
"Hyper partisans (on the left and right) left pragmatism behind. And became a cancer in the nation's capital. Right when the middle class required real leadership."
While D.C. overtook Silicon Valley as the nation's most affluent metropolitan statistical area, the middle class garnered zero real wage growth. No increase in per capita wealth. Amid a decrease in the nation's confidence concerning its political and institutional leadership.
Hyper partisans (on the left and right) left pragmatism behind. And became a cancer in the nation's capital. Right when the middle class required real leadership. Then along came Trump. With his big mouth. And his foot often in it. Who is prone to hyperbole. And has made many mistakes. Yet, who has had many successes.
As uncomfortable as it can sometimes be to watch, Trump has oft served as chemotherapy to D.C.'s cancer. Because chemo can be brutal. Ugly. Even intolerable. But it is often the only option when it comes to killing the patient's cancer.
And because of that, polls show that the nation's pragmatists, those existing outside the boundaries of staunch political paradigms, who do not wear party pins on their lapels, have been willing to lend Trump a long leash so long as he continues to disrupt the stale status quo. As disconcerting as it may sometimes be. So long as his attacks on the entrenched and ineffective status quo brings some benefit. Some forward progression for the middle class. Their employers. Their loved ones.
Clinton. Bush. Obama. Trump. Each was duly elected. Though we may oppose their intentions, and rail against their efforts, shouldn't we refrain from assassinating the very being of those chosen by the nation's electoral constituency to hold that most challenging of offices? Perhaps such thinking is too old fashioned for these progressive times. But we were raised to hate the sin, not the sinner. And so it is difficult to watch the political discourse when there is so little to offer but hate.
We hope and believe that pragmatism will win the day. That those who dislike Trump will attempt to vote him from office. And that those who appreciate his efforts can do the opposite. While those on both sides can toast their mutual good fortunes. And get along.
Now back to our regularly scheduled programming...
Finally, from whence might the next financial crisis originate?
To properly tackle that subject, we must first look at how most global bull markets die. Which historically occurs in stages. Beginning with bond markets. Where we've seen bond yields cease to rise. Even as bond values have moved sideways and lower. Next, emerging equity markets become roiled. Which has transpired in China, South East Asia and Latin America. Then migrating to developed equity markets. Having already occurred to some extent in Eastern and Southern Europe. With even Western Europe and the U.S. not having achieved a new market high since January 26.
Then we usually see copper head south. Serving as a global economic barometer. Followed by a rise in oil markets, which tends to be inflationary (further hurting consumers) and catalyzes a drop in demand amid elevated supplies.
Similar patterns transpired in 2000 and 2008. And we're beginning to see "reflections" of those patterns today. Of course, we deal in probabilities. Not certainties. And nobody can call a market top with certainty. Yet, the probability of equity markets sitting at the cycle top appears more likely today than at any time over the last nine years.
Gazing further into the realm of probabilities, we would ask: where, specifically, might a financial crisis begin and emanate from?
One candidate is Turkey. Which recently granted enhanced authoritarian powers to President Recep Erdogan. Even though he has lost control of Turkey's economy, currency, stock and bond markets.
The Turkish Lira, going back to 1994, has traded from 32 to 0.21, losing 99 percent of its value. Turkish consumer product inflation runs at 15 percent. And looks like it could reach 27 to 30 percent. Even as Turkish unemployment rises, and economic growth slows. A toxic combination.
Philosophically, we do not understand how NATO can allow Turkey (a NATO member) to buy Russian missile systems while purchasing U.S. made F-35s. Fundamentally, we can't explain how a government works when it jails 18,000 people claiming they belong to terror organizations. Though, prior to last month's national election, they were freely roaming the streets.
Erdogan's Turkey appears to be a prime candidate for a financial and/or political meltdown. Which can only worsen as Turkey continues to cozy up to fellow indigent desperados like Russia and Iran. Were Turkey to implode, it would not require much imagination to see such contagion spreading to other emerging market countries. Which represents further evidence as to why emerging equity markets have become increasingly anathema to our wealth creation efforts. And will remain so for the foreseeable future.
"But that opportunity exists in the future. And effective
capital management decisions should never be made on the come."
Eventually, emerging markets will roar back to life. Taking willing investors along for the ride. But that opportunity exists in the future. And effective capital management decisions should never be made on the come.
We believe the second half of 2018 will be no less interesting than the first. Especially as we get past Labor Day. And the political caterwauling descends to new nadirs in lieu of November's elections. While the year's second half contains some upside possibilities, it will not provide what investors enjoyed in 2017. In this environment, active stock pickers will be rewarded. Passive investors shall be left wanting.
Though investors might wish they could focus on that which is truly material to their wealth creation and preservation efforts without the never-ending political circus, we take the opposite tact. As D.C.'s goat rodeo provides so much fodder and distraction from the more important issues. Assisting in the efforts of those who have learned to separate pragmatism from politics. Reality from theater. Leafy greens from intellectual trans fats.
As Louis Carroll's White Rabbit exclaimed in Alice in Wonderland, "When I used to read fairy tales, I fancied that kind of thing never happened, and now here I am in the middle of one!"
It seems we've all gone down the rabbit hole. Though opportunities still exist for those who know where to look.

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