The bear will be back
US economic data is not as encouraging as it may seem, and a trade deal with China is far from certain
Friday’s unexpectedly large US employment number and Fed Chairman Jerome Powell’s calming remarks sparked a monster rally in the US stock market, with NASDAQ up 4.26% and the broad S&P 500 index up 3.43%. A stronger-than-expected China services PMI also helped to dispel the fear that the world’s two largest economies were at risk of recession.
The market’s violent response isn’t surprising. After the NAPM Purchasing Managers’ Index Thursday showed the worst drop in industrial orders since 2008, hedge funds and other investors were short the market. Short-covering rallies in bear markets always are the biggest.
But is the bear gone? We don’t think so. The number of very large market moves in the past month is greater than at any time in the past six years and heavily skewed to the downside. One day’s market move up doesn’t convince us that the danger has passed.
Let’s start by translating Fed Chair Jerome Powell’s remarks into English: “During the past six years we shoved an unprecedented amount of liquidity into the market, ballooning the Fed’s balance sheet from $700 to $4.1 trillion in securities, and kept real short-term interest rates negative. The moment we propose to remove even a little bit of this liquidity, the air starts whooshing out of the stock market bubble. So we’ll ‘listen to financial markets’ for that great sucking sound and try to keep the bubble intact.”
That should not exactly be confidence inspiring. The Fed alluded to a tightening of financial conditions during the past several months, and we can see it in such basic measures of liquidity as the spread between federal funds and the interbank rate that big banks charge each other. As I reported in this space Jan. 3 (“The Specter of Deflation is Haunting Financial Markets”), oil and stocks both have traded directly with key market liquidity measures in recent weeks. The oil price collapse, in short, is not merely the result of excess supply, but the result of forced liquidation of inventories. Another ominous sign was the underperformance of real estate investment trusts, which usually trade like bonds. The market apparently fears rent deflation.
The Fed barely tapped the brakes and the car veered off the road.
The US economy isn’t crashing, but the employment report is not quite as encouraging as the headline number suggests. Forward-looking indicators like the purchasing managers’ index are showing a steep drop. The vast majority of jobs, moreover, were created in low-wage, low productivity sectors. The household survey, oddly, shows an increase of 306,000 in female employment and a decline of 132,000 in male employment. In the more commonly cited establishments survey, the composition of employment is consistent with a shift towards female employment. Education and health services account for the biggest increase (82,000) followed closely by Health care and social assistance (57,900), and Leisure and Hospitality (55,000). These three categories account for 195,000 new jobs. Add retail trade (23,800) and professional and business services (43,000), and we are at 262,000 jobs.
I also note that the female labor force participation rate is rising because more employment opportunities are available for women, and because more women wish to work (presumably because household income has stagnated for decades). It’s good that more Americans are working, but not too impressive that they are working at low-wage jobs.
We also note that the best performing stock in the S&P 100 (except for acquisition target Celgene) was Netflix, up 16.4% in the past week after an earlier nosedive. Netflix is the poster-boy for hot air valuations in tech. It presently trades at 95 times trailing earnings and 65 times expected earnings, at a time when everyone from Amazon to AT&T offers competing content-streaming services. Netflix is now a movie studio whose competitive advantage depends on a few blockbusters. It’s more like Disney (which also offers streaming content) than a tech company. But Disney trades at 15 times earnings.
Amazon, up 8% in the past week, was another top contributor to index gains. I still think (as I wrote Oct. 27) that any price above $1,200 assumes that the internet retailer will take over the US economy in the next ten years, and that isn’t going to happen.
There are plenty of good reasons to buy equity indices, but I can’t find many stocks that I want to buy – least of all the apparent comeback kids of last week.
A sharp slowdown in world trade remains the main problem in the background. I continue to believe that this is due to a sharp decline in CapEx in response to uncertainty about China-centered global supply chains – in other words, the result of an exogenous shock. In both the US and China, the domestic services economy is showing far better readings than the industrial economy.
The market is looking for an early resolution of the US-China trade war. Sadly, there is less reason to be optimistic about an early resolution of the US-China trade dispute than there was before the Dec. 1 summit meeting between Presidents Trump and Xi in Buenos Aires. Now that the dust has settled on the US attempt to persuade the world to blacklist Huawei, China is far more cautious. The erratic behavior of the US administration on this issue has left China less willing to make concessions demanded by the US. In large measure this is due to confusion about what Trump has in mind; the impression is that the Administration lacks direction.
China’s response to the lack of clarity is to go slow and act more cautiously. The US attempt to persuade its allies to blacklist Huawei convinced the Chinese that the object of US policy is not to reduce the trade deficit but to suppress China’s economic progress. The evident failure of the initiative against Huawei, moreover, has given the Chinese more confidence that the US is not in a position to box it in, even if the impact of US tariffs has hurt China’s industrial sector. The slowdown in world trade is painful, but China does not feel vulnerable in the medium term.
China is prepared to make substantial concessions on purchases of American products, but that has been its position from the beginning. But our sources anticipate a very hard and slow negotiation on other issues. China is NOT prepared to make concessions on WTO surveillance of its industrial policy, as the US has demanded in the past.
There is also a problem of timing; Trump and Xi had something of an agreement in principle at Buenos Aires Dec. 1 but the Huawei arrest and subsequent actions put that on hold. Now time is running short.
A low-level US delegation is en route to China headed by Deputy Trade Negotiator Jeff Gerrish and Treasury Undersecretary David Malpass. China will shut down for two weeks starting Jan. 31 for the Lunar New Year holiday and it seems unlikely that anything substantive will be achieved before then. That eliminates the first half of February. That leaves only two weeks before the National People’s Congress on March 1, and Xi will not go before that Congress appearing that he has been intimidated by the US. Our sources emphasize that the People’s Congress is not a rubber stamp exercise: It is the key annual event at which the leadership mobilizes its troops.
That takes us perilously close to Trump’s March 31 deadline, and it seems likely that Trump will go into “Art of the Deal” mode and threaten to impose the 25% level of tariffs.