As summer’s light market volumes return to more normal measures, the market’s sangfroid attitude toward US-China trade tensions to date is slated to change. The market’s aloofness to the growing threat posed by the world’s two largest economies' tit-for-tat about-face from free trade could only go so far. December’s tax cuts delivered earnings growth of about 25% for the two quarters. That milestone is projected to be shaved to about 20% in the 3rd quarter and shaved yet again to about 17% in the 4th quarter under current consensus estimates. Still, US GDP is coming off of a 4.2% post, the largest single quarter output since the 3rd quarter 2014. GDP for the year projects out at just over 3% which, if realized, would be the first-time annual growth has exceeded that level since 2005.
Figure 1: Philadelphia Housing Index, S&P Case-Shiller Home Price Index, Fed Funds Rate, University of Michigan Consumer Confidence and the Producers Price Index
Leaving corporate and governmental spending aside, consumer spending alone on goods and services amounts to about 70% of total US output. Total personal consumption expenditures posted 3.8% QOQ increase from the anemic 1st quarter output of just 0.5% through August’s second estimate of 2nd quarter output. Durable goods were up 8.6% QOQ, a considerable improvement from the 1st quarter’s decline of 2% but down sharply from the 4th quarter 2017 blowout post of 12.7%. Final sales to private domestic purchasers rose 6.4% QOQ as spending by consumers, flush with tax savings and improving wage growth, appears comfortable with assuming increasing levels of revolving debt. Consumer spending on housing, negative on a QOQ basis for the year, stands in stark contrast to the 11.1% QOQ surge in the 4th quarter just before new state and local tax (SALT) went into effect. The Philadelphia Housing Index (green bars) has fallen dramatically in January’s market correction - and has never really recovered from the market shock. And for good reason: The S&P Case-Shiller Home Price Index (blue line) continues its upward trajectory, posting annualized monthly increases above 5% since August 2016. Meanwhile, existing home sales have declined in five of the first six months of the year across the country as the lack of inventory in many markets continues to depress sales. The median selling price through the end of July came to $269,600, with the average selling price posting higher at $307,800 as market activity skews to the upper end of the market. And as home prices and short-term interest rates (red dotted line) move to the upside, the amount of income required to purchase the average national existing home rises in sync. In July, that required income hit $54,528 nationally, an increase of over 12% YOY.
Total final demand goods (orange line) peaked in May at a MOM growth rate of 0.5%, and have slowly declined in each month thereafter, falling negative in August at -0.1%. The decline was driven by falling food prices as protein originally slated for export now swells refrigerated storage facilities across the country, putting downward pressure on domestic protein prices. Mexico placed a 20% punitive tariff on pork while Chinese tariffs on US pork now tops 60%. Final demand services have fallen negative for the past two months, with the changes in margins received by wholesale and retail levels falling by 0.9% for the period. Warehousing services and transportation fell 0.6% for the month as regulatory changes and rising wages in other economic sectors continue to create labor shortages for the long-haul trucking industry. The category has also been hit hard by the cessation of US grain sales to China due to punitive tariff duties.
Through all of this, lagging consumer sentiment (purple line) peaked in the latter days of February, only to head sharply to the downside in the wake of the market correction in the closing days of January. Consumer confidence bounced to the downside before etching out a trough in the latter days of July, spiking yet again in the closing days of August in the afterglow of the lowest unemployment rate outside of May since April 2000. Given increasing trade tensions and the escalating market value of the tariffs being proposed, a plethora of goods imported by US retailers will soon be included in US-Chinese tariff regimes, sending prices to the upside across the economy. The Trump administration’s proposed targeting of $200 billion of Chinese goods will now be over half of the $505.5 billion in goods traded by the two countries through the end of 2017 (see Figure 1, above).
Figure 2: Baltic Dry Index, Nordic American Tanker Shipping, Star Bulk Carriers against the S&P 500
US net exports of goods and services as a category has subtracted from total output in 13 of the past 17 years, and 2018 results to date appear poised at the moment at least to continue this long-term trend. Exports through the first seven months of the year totaled $146.7 billion, up just under 9% through the end of July YOY. Imports totaled $180.5 billion, up just over 8% over the same period, as a strong dollar (black dotted line) and US consumers’ fondness for imported goods continues unabated. The growing dollar value of tariffs since the beginning of August offers now up a downside harbinger for the balance of the year as a growing protectionist mood pressures global economic growth - particularly in export-oriented countries like Japan, China and the EU. The Baltic Dry Goods Index (green line), which lists dry bulk goods shippers worldwide, has dropped about 24% since early July. For the year, the Index is still up almost 37% YTD, but trending decidedly to the downside in the wake of the US move to tariff another $200 billion in Chinese goods that is likely to go online during the month. Nordic American Tankers (NAT) (red line), which operates Suezmax super tankers, has fallen 33% since July. Star Bulk Carriers (SBLK) (blue line), which ships industrial raw materials like iron ore, coal, bauxite and steel products as well as agricultural commodities such as sorghum, corn, soybeans, wheat and fertilizers, is down just over 14% since early July (see Figure 2, above).
Figure 3: 10-year Bund, Gilts, Japan, US and Italy
The yields on 10-year treasuries about the developed world are revealing. In the US, the 10-year yield (green area) started the year at 2.43%, increasing 56 basis points to a yield of 2.99% through Friday’s market close (14 September), up 23% YTD. The yield on the 10-year note briefly edged above the 3% mark for the first time since August in early trading before settling back at 2.992% at Friday’s market close. Yields have climbed 10 basis points in September as summer moves to fall, but also in response to myriad factors applying downward pressure on yields. Of late, these factors include hopeful hints on possible US-Chinese trade talks at the end of the month. Further respite came as the razor-edge of emerging market concerns dulled markedly by Thursday’s Central Bank of the Republic of Turkey's (CBRT) 600 basis point increase in the country’s lending rate and progress being made on an International Monetary Fund rescue for Argentina. Of course, the steady increase in US debt issues, higher inflation and recent increases in wage growth have all contributed to higher Treasury yields. It was only in the closing days of January that a 2.9% YOY wage growth spike in the January jobs report triggering fears of inflation that sent US markets plummeting into correction territory. All the while, offsetting pressure on the price side from arbitrage, economic uncertainty and international capital flight to safe harbor US assets have temporarily tilted the yield equation ever so slightly to the upside.
Still, the gaping spread between the yield of the 10-year Japanese (orange line), the 10-year German Bund (green line) and the 10-year Gilt (purple line) remains a telling expose of just how divergent monetary policy in the developed world continues to be. Consider the 10-year Japanese note which started the year at a yield of 0.056%, increasing to a yield of 0.11% for a gain of just over 96% for the period. Or the 10-year Gilt (purple line) which started the year at yield of 1.228%, increasing to a yield of 1.532% for a YTD move of 25%. And then there is the 10-year Bund (green line) which started the year at a yield of just 0.468% but settled at a yield of 0.447% for a loss of 4.48% on the year.
The Bank of Japan will increase its sovereign holdings by about ¥30 trillion this year — the slowest pace since 2014. The BOJ will still manage to buy a staggering ¥7 trillion through the end of the month. The central bank’s mandate for direct equity purchases on the Nikkei and Topix exchanges will net about ¥5.4 trillion for the year.
Thursday’s governing council meeting of the European Central Bank (ECB) confirmed the halving of its asset purchase program to €15 billion starting in October. The intent remains to close down the APP program by the end of the year, depending on incoming data. To date, that data has been far from favorable. After outperforming growth expectations last year in a historically low inflation environment, euro-zone growth has slowed measurably as German output weakens in the face of the Trump administration’s threat of levying a 25% tariff on EU — read German — cars coming into the US market. Turkey’s economic travails have already demonstrated the vulnerability of the EU’s weakest sector, with Spain’s Banco Bilbao (BBVA), Italy’s UniCredit (OTCPK:UNCFF) (OTCPK:UNCFY) and France’s BNP Paribas (OTCQX:BNPQF) (OTCQX:BNPQY) all feeling downward market pressure due to the banks’ significant Turkish sovereign and corporate debt exposure. Further erosion of the lira could erode banks’ reserves in a rather quick fashion. That the CBRT increased its prime lending rate 600 b/p, double consensus estimates, cools the inflation cauldron at least for the interim. How sustainable the move proves to be is simply unknown.
Another troubling unknown is rising Italian borrowing costs (red line). Of particular interest is whether Rome’s new populist duumvirate’s spending directives will stay within EU debt and deficit guidelines. Italy’s borrowing cost hit a four-year high through the end of August, with the difference between German and Italian yields hitting 105 b/p (yellow box) through Friday’s market close — the biggest spread between the two issues since May (see Figure 3, above).
The ECB’s €4.5 trillion balance sheet remains hefty by most measures. The reinvestment of maturing securities on its balance sheet will continue, providing about €20 billion/month. Reinvestment alone provides ample liquidity to keep monetary policy historically loose for the foreseeable future. Whether the ECB will find the necessary legal underpinning to offer up its remaining stimulus to countries according to need rather than by the strictures of national contributions to the EU budget remains unresolved. Calls for differentiating monetary stimulus have always been ignored since the ECB’s treaty appointed mandate is euro-wide, rather than nation-centric. There is little in the way of policy initiatives emanating from Brussels to change that basic equation in the foreseeable future.
Meanwhile, the Federal Reserve has raised short-term interest rates seven times since December 2015 and is slated to increase rates two more times at September’s and again at December’s FOMC meetings. September’s rate hike carries a 97.4% probability while December’s hike carries a 77% probability through Friday’s market close. Since the 4th quarter 2017, the Fed will have reduced its balance sheet by $450 billion by year-end. Another $600 billion is scheduled to be offloaded by the end of 2019, with similar amounts in subsequent years until the proper balance of Treasuries (and likely no MBS) reaches a level deemed appropriate to carry out Fed monetary operations moving forward. The appropriate post-crisis level is now a hot topic of debate and is yet to be determined.
Figure 4: Cheniere Energy, Brent, Western Texas Intermediate Crude against the S&P 500
Perhaps the most curious application of the Trump administration’s international trade policy comes to the fore in the energy field. Homegrown fossil fuels are a top priority of the Trump administration. From the EPA to the Department of Energy to the ongoing protective barriers erected by the USTR, the administration has done its utmost to loosen rules for drillers and coal miners, eviscerated CAFÉ rules for cars and trucks, blissfully ignoring the environmental consequences of their actions. The administration has erected stiff trade barriers to protect steel and aluminum workers, invoking national security for a sector of the economy that constitutes 0.003% of the US labor force through the end of August.
The reining in of China’s heretofore unbridled industrialization drive and resulting environmental woes now mandates production quotas on car and truck manufacturers that include an ever increasing EV offerings component in car lineups through model year 2025. China has set up a carbon tax credit system that will monitor and enforce the EV mandate. China has rigorously embraced the import of cleaner natural gas, and is now one of the world’s fastest growing markets for liquefied natural gas. Since the opening up of the Cheniere (LNG) (green line) LNG loading terminal in the Sabine Pass of Louisiana in 2016, coupled with the most recent opening of a Maryland facility in March, the US has become a net exporter of LNG. In August, China warned of a 25% tariff on US LNG in response to the Trump administration’s tariffing another $200 billion in Chinese export goods. In the first half of the year, an average of 300,000 tons per month of LNG. That total has halved in July and August. US exports already under contract will likely not be impacted by future tariff regimes that may materialize, likely sparing Cheniere’s February contract with PetroChina (PTR) to deliver 1.2 million tons of LNG annually over the 25-year duration of the agreement. Since then, liquefaction terminals have been build or proposed in Australia, Canada, Mozambique and Russia. PetroChina also agreed to a 22-year deal to buy about 3.4 million tons per year from Qatar, the world’s biggest LNG exporter. China has choice in its LNG purchases moving forward, choices that will likely not include the US under current US trade policy.
US crude inventories fell to 396 million barrels through the week ending 7 September, the lowest level since February 2015. Active oil rigs in the US through the week ending 14 September came to 940, down by one on the week. The Permian Basin had 232 active rigs over the same period. It is in the Permian Basin where pipeline shortages are impeding the delivery of crude to markets and/or export terminals. That infrastructural impediment shows up in the price differential between the Brent (red line) and West Texas Crude (blue line) indices, which hit $9.12 through Friday’s market close (yellow box). The export of light US crude should be heavily in demand in petroleum importing countries in Asia, Latin America and Europe.
The Trump administration’s international trade policies will likely dictate otherwise. US exports peaked at 3 million b/d through the week ending 22 June. That total has been reduced by over 60% to 1.2 million b/d through the week ending 17 August. Brent is likely on the uptick as global supplies contemplate the reestablishment of US sanctions on Iranian crude exports and production set to come online in November. Two more upticks in the federal funds rate will further strengthen the dollar (black dotted line), currently nursing a six-week low. A stronger dollar will push Brent prices higher in local currency terms, while higher energy costs offer up headwinds to further global economic growth through the end of the year and beyond (see Figure 4, above).
Saudi Arabia and Russia have increased production to offset the loss of Iranian crude in world markets. OPEC increased production by 420,000 b/d in August, according to news reports attributed to the Paris-based International Energy Agency. Meanwhile, Iranian production fell by 150,000 during the month, according to IEA data. Last week, South Korea announced the cancellation of future Iranian crude deliveries while traders in India and China have also reduced Iranian future crude contracts.
On Thursday, President Trump appeared to squelch the possibility of an agreement in upcoming talks scheduled for the latter part of the month, tweeting “…we are under no pressure to make a deal with China, they are under pressure to make a deal with us.” The comment sent the dollar (black dotted line) to the upside (yellow box) as markets closed for the week. US-China trade tensions are likely to increase with no respite on the immediate horizon. Markets will likely take notice.
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