Valuentum Exclusive Analysis for the Discerning Investor

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Last week, China issued retaliatory tariffs on US goods, and Trump responded in kind, escalating trade tensions. Caught in the middle of this US-China trade war is the Fed, however.

Let’s sit down with the Valuentum team and kick things off with our thoughts on Fed Chairman Powell’s speech, Challenges for Monetary Policy issued August 23 in Jackson Hole, WY. Our latest Economic Roundtable can be accessed here.

Matthew Warren: Powell is certainly leaving the door open for cuts if needed. To me, it’s largely pushing on a string. I don’t think cost of capital is the problem. Capital is already cheap. Mortgages aren’t even following the 10-year (TLT, TBT) down fully. Banks (XLF) won’t take credit card rates down much. 

The escalating trade war, on the other hand, looks ominous to me. China (FXI, MCHI) is already not the low-cost producer for many things and losing out to alternative countries. The country does benefit from integrated supply chains for things like chips and phones. If companies increasingly move their supply chains out of China, the country could go bust. If China goes bust, they will be a massive source of global deflation.

Spreading deflation would topple the weaker banks around the world. The only way to beat deflation is for monetary and fiscal authorities to cooperate in printing money and actually putting it in the hands of those with the propensity to turn around and spend it. Would politics even allow this to happen? Better to retreat from the trade war and come to some kind of agreement.

Callum Turcan: In regards to the proposed payroll tax cut idea being floated in the US (albeit not too seriously), while that would give more spending power to low and middle income households, that would bolster a part of the domestic economy that is already strong, consumer spending. A resolution on the US-China trade war is needed to improve the outlook for industrial economic activity, something only a reduction in tariffs and uncertainty would achieve.

We are past the point where strong consumer spending (in the US, Germany, and elsewhere) alone can turn around the dour outlook for industrial activity worldwide. Now we patiently wait for how monetary and fiscal policy reacts. In regards to Powell's remarks, it seems the Fed is doing more than just leaving the door open to additional rate cuts. The Fed chairman also noted policy tools outside of what would conventionally be used are being considered. Maybe that includes QE4, the fourth rollout of quantitative easing since the Great Recession, should a worst-case scenario arise?

Matthew: The comments about new tools were interesting. Even if the Fed embarks on QE4, what is the goal? NIRP (negative interest rate policy)? I think that would actually be counterproductive as it hurts the banks, pension funds, insurance companies (IAK), etc. It could mean something like buying stocks. The Japanese (EWJ) do it. How would that be for price agnostic buying?! My goodness.

Callum: If the Fed starts buying stocks, imagine the value "created" out of thin air simply by being part of a major index, Dow Jones (DIA), S&P 500 (SPY), NASDAQ 100 (QQQ), Russell 2000 (IWM), etc., assuming the Fed only buys equities included in key indexes as those would be considered "qualified stocks" or something similar.

Brian Nelson: The threat of price-agnostic trading is a key theme in Valuentum’s new book, Value Trap: Theory of Universal Valuation. If the Fed jumps in to buying stocks indiscriminately, this would only add fuel to the fire, a blaze that is already being fanned by the quant and indexing craze. Indexers are already “buying anything at any price,” and large quant fund managers are speaking out against some of the practices in quant, Rob Arnott as one prominent figure. As of September 2018, the firm Rob founded, Research Affiliates, advises on over $195 billion in investment assets.

I felt following the tone of Trump’s tweets Friday, August 23, that his staff may have talked him down from something very, very aggressive in response to the retaliatory tariffs from China. The adjustment to 30% from 25% on $250 billion of Chinese goods on October 1, and to 15% from 10% on another $300 billion worth of Chinese imports on September 1, was very, very mild compared to what I was expecting, especially in the context of his tweets.

This may signal that the White House may have almost fully played its hand without causing severe damage to the global economy, meaning that any next steps may cause that scenario the markets are hoping to desperately avoid: the one that inches China toward deflationary bust. I don’t think Trump was expecting the trade war to be this prolonged, and the quest for reelection in 2020 may cause him to desperately try to win, and in doing so, create a scenario that punishes the stock markets severely. The President is now even pointing to the Emergency Economic Powers Act of 1977 as a tool.

As might be expected in any political office, I think the President is largely working to try to win the 2020 election, but he might have bit off more than he can chew with this China trade war. Even now North Korea continues to test short-range ballistic missiles, and it’s anyone’s guess as to the status of their nuclear program. President Trump may "lose" the trade war, "lose" any goodwill he might have gained with peace talks with North Korea, and in trying to win the trade war with China for talking points during the 2020 campaign, he may hurt the equity markets, depleting the domestic economic strength.

The scenario that looks to be potentially playing out in the coming 12-18 months is not a good one, and if the President doesn’t win the 2020 election, progressive Democratic candidates may push to roll back the corporate tax cuts, which may further cause a drawdown in equity prices as market participants start to factor in lower corporate earnings and a more prohibitive tax environment. President Trump’s tweets have been all over the place for years, but more recently, I think he’s starting to feel the pinch as the 2020 election approaches, particularly as farmers express significant disappointment with his trade policies.

In other news, I found Nobel Prize laureate Robert Shiller’s comments about the yield-curve inversion predicting recessions interesting: ”he chalks it up to analysts’ “data mining” to find any indicator that holds up…a fairly small data set to be really conclusive.” Shiller believes the yield-curve inversion to be more behavioral or a “self-fulfilling” prophecy in predicting a recession, and I think that’s a big concern on the Fed’s mind, perhaps the biggest.

It’s not so much that the yield curve has inverted as it is in what people believe are the implications of the yield curve inverting, and in response to that, investors and businesses may reduce investment and actually cause the recession that the yield curve supposedly predicts. The markets are highly psychological and behavioral in this respect.

That said, we think the Fed understands this risk very well, and we would not be surprised by an aggressive rate-cutting regime, in line with St. Louis Fed President James Bullard views pointing to low expected inflation (1%-1.1%, below the Fed’s 2% target), an inverted yield curve, and that the federal funds rate is one of the highest on the yield curve (the 30-year bond recently breached below 2%) as reasons for aggressive rate cuts.

Callum: The next phase of the US-China trade war could be quite scary for equity markets. There has been talk of forcing companies that have federal government contracts with the US government to not do business China under the 1977 International Emergency Economic Powers Act, which many believe the Trump Administration could accomplish unilaterally in a fairly easy manner.

How such a move could impact Boeing (BA) and others remains to be seen, as reportedly the aerospace giant could receive a waiver of sorts or the sanctions (via the 1977 IEEPA) could be constructed in a way to give some companies, namely major US exporters with large US government contracts, more leeway. But that isn't certain. Also, how would such a move impact Amazon (AMZN) and Microsoft (MSFT) bid to win the multi-billion JEDI contract with the US DoD worth ~$10 billion over ten years? A lot of known unknowns popping up, it's the unknown unknowns that has the market spooked.

Matthew: Former Treasury Secretary Larry Summers spoke recently about rate cuts being potentially counterproductive. I agree as the transmission mechanism (banks and mortgage bond holders) don’t necessarily pass through all the benefits of lower rates to the end borrower. And we know negative rates are bad for banks and other financial institutions.

That leaves fiscal policy, but of course we are already running a large deficit after the Trump corporate tax cuts (the deficit could widen to $1 trillion in fiscal 2020). The only way to goose the economy effectively would be to put money in the hands of the lower and middle class, but political realities may make this difficult. Democratic candidate hopeful Andrew Yang wants to give everyone $1,000 each month in free cash, but then he is polling close to zero.

On the trade war, Trump is playing a game of chicken and he slammed on the accelerator on Friday, in my opinion. This better work and bring both sides to the table for a deal where both sides can claim victory. If not, and if it keeps escalating, it will simply put more pressure on the global economy. It’s clearly bad for business confidence, and I’ll bet it’s bad for consumer confidence when the tariffs flow through to prices at Walmart (WMT) and Amazon and the like.

Callum: In some ways, the interest rate cut and Fed communication strategy in July 2019 created a moral hazard when Fed Chairman Powell noted that increased trade tensions could lead to additional rate cuts within the coming months. The Trump Administration must have felt some comfort in this to ramp up US tariffs on Chinese imports knowing there's some room to artificially juice the economy via lower interest rates when the negative effects of trade wars set in, thus mitigating the exogenous shock to US economy activity to some degree. By adapting to President Trump's behavior, the US Fed may indirectly be encouraging it (arguably).

Regarding fiscal policy, the US desperately needs to invest more in infrastructure, for example, and only a major federal-level spending package would change that. However, that's the type of legislation that would likely only pass the current Congress if the US economy were growing at a significantly slower rate or in a recession. The Fed, in propping up economic activity in the short term, may actually be reducing the need to adapt.

Unless US growth moves materially lower, large fiscal spending likely won't happen, and when growth does move lower, monetary policy will be a completely “spent-force” to reverse economic weakness.

Brian: Interesting Callum. What was once thought of “insurance” years ago in the form of Fed hikes to add monetary policy flexibility under any downturn has now become “insurance” rate cuts to ward off even the potential of any US economic slowdown. The risks are certainly mounting for some stock-market “event,” and it’s very hard to get comfortable with the language coming out of the White House regarding China wanting to make a deal.

For example, in January 2019, President Trump said that China “very much wants to make a deal.” That was seven months ago and before the recent trade war escalation. At the G-7 summit August 26, the President reiterated that Beijing wants to make a deal ‘very badly.’ I’m not at the negotiating table, but it seems like China is not looking to fold in the face of American pressure, and talk from the White House seems to be closer to unfound optimism. China simply would not have issued retaliatory tariffs last week if the US and China were anywhere close to a deal.

If this issue comes to threaten President Trump’s chances at reelection, I believe he might take significant action to make it seem like the US has “won” this trade war, and in doing so, potentially sacrifice equity market returns for this talking point. After all, the market is near all-time highs, and making structural changes with China could be a long-term positive, he may argue. Regardless, his tweets calling for companies to look for alternatives to China runs counter to the idea of actually bolstering trade relations with the nation.

There are many things that can go wrong with this US-China trade war, and quite possibly the worst scenario might be if the US “wins” big, pushing China and the globe into deflationary bust. We maintain our view that the risk-reward of the equity markets today is imbalanced, with heightened risk to the downside after this roughly decade-long economic recovery/expansion and bull market run.

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