The equity markets have gyrated around tariff and trade news (and Presidential tweets), falling when, at the last minute, the expected trade deal with China fell apart, and then fluctuating around various trade announcements, going up when they looked hopeful, and falling when they did not, including additional tariffs put on by both sides, suspension of European auto tariffs, and a deal to lift steel and aluminum tariffs on our neighboring countries.
Q1’s Underlying Growth Rate
No doubt, these trade issues will be blamed for any economic slowdown that appears, maybe even as early as June’s data. But, that blame will have been misplaced. As discussed later, Q2’s GDP growth is going to be significantly more anemic than Q1’s (+3.2%) which was hyped by inventory accumulation (now starting to unwind), an unusual increase in net exports, and unsustainable government spending. Without these anomalies, underlying growth was just over +1.0%. The Atlanta Fed’s GDP NOW tracker, which normally starts the quarter on the high side and then falls back toward reality as the quarter progresses, is now tracking 1.1% for Q2 with barely more than a third of the quarter’s data available.
Trade: Not that Big A Deal
First Trust’s economist, Brian Wesbury, argues that the equity markets are making too big a deal of the China trade issue. His data is pretty convincing. He points out that, even if China puts tariffs on all $180 billion of goods they import from the U.S. (so far, the retaliatory tariffs are on $60 billion), those tariffs are minuscule compared to $14 trillion of U.S. consumer spending and represents 0.9% of U.S. GDP. On the other hand, China exports $559 billion to the U.S., which represents 4.6% of their GDP. In addition, a long trade battle may very well cause U.S. companies to shift their supply chains to places like Singapore, southeast Asia, Mexico, or even back to the U.S., and China’s economy will suffer for years to come. The Chinese clearly misread President Trump’s “poker face.” Now, while they must “save face,” their economic interest dictates that they return to the negotiating table, the sooner the better.
Bonds Tell a Different Story
The point here is that the equity market is making a much bigger deal about the impact of the trade issues on the economy than is warranted. And, it is ignoring what the bond market is worried about, as long-term yields continue to fall. The 10-year T-Note is trading near 2.4%, down significantly from its cycle high of 3.25% in Q4, and more than 2.6% last month. And, yes, yields have continued down even despite China’s reduction of Treasury holdings. The bond market sees slowing domestic and international growth which has resulted in a definite deflationary bias.
The Consumer Price Index (CPI) rose +0.3% in April (consensus was +0.4%). Fully 50% of “core” CPI (ex food and energy) showed outright deflation. For the third month in a row, core goods prices fell (-0.3%) and are now negative vs. a year ago (-0.2%). The only reason CPI increased as much as it did was a rise in the price of services (+0.3%), with much of this rise due to “imputed” shelter costs (jargon for “algorithmically determined,” as they are not directly measured). Those “imputed” costs rose +0.4% in both March and April. This appears high for a housing market now with demand issues, where rents in places like Manhattan and San Francisco are now flat to falling. Likely, the algo hasn’t yet realized the change in market dynamics. Looking at the cyclical components of the CPI, those most likely influenced by current economic conditions, there were outright price declines in furniture, clothing, electronics, building materials, autos and auto parts, and even food.
Prices fall for one of two reasons: oversupply, or falling demand. Supply doesn’t seem to fit here, as Industrial Production, worldwide, has clearly peaked. So, falling prices must be due to weakening demand. Here are some indicators of that weak demand:
- A very large fall in Chinese exports to Japan, the EU, Russia, and the U.S. in April, and falling exports from Japan and So. Korea to China;
- Continued softness in EU data, now apparent not only in Italy, Germany, and France, but now also showing up in Spain;
- From official institutions, a reduction in the growth forecasts for 2019 and 2020 for the EU, Australia, and New Zealand.
Let’s not forget that 43.6% of S&P 500 company revenues are derived outside the U.S. Within the U.S., as already mentioned, Q1’s much ballyhooed GDP growth was due to non-recurring events. There is evidence (see, for example, the latest Philly Fed survey) that Q1’s inventory build-up is beginning to dissipate. And, with the world’s economic slowdown, exports from the U.S. won’t be as buoyant as they were in Q1. Net Exports also displayed the unusual phenomenon of falling imports, a sign of slowing U.S. consumer demand. Finally, data from the U.S. are anything but buoyant:
- Industrial Production fell -0.5% in April;
- Capacity Utilization also fell, and at 77.9% (peak was 79.6% last November) is the lowest it has been since early 2018;
- Retail sales were off -0.2% in April (vs. March). Consensus was +0.2%; the price at the pump has crimped other discretionary spending;
- On a more positive note, new housing data indicates a stabilizing housing sector, but stabilization is a far cry from significant growth;
- And, consumer sentiment (university of Michigan May data) hit a 15-year high, but that was before the “imminent” trade deal fell apart.
Q2’s underlying economic growth will continue to be weak. Real retail sales have been trending down since Q3/18, and they peaked last November. Since then, they have fallen at a 1.2% annualized rate. Industrial Production and Capacity Utilization have also peaked. Ditto for household employment as the Household Survey indicates a potential peak in February. Furthermore, weak foreign economies will have a negative impact on S&P 500 corporate revenues. Falling rates in the bond market reflect these realities. The trade issue, on which equities appear to be trading, has little real economic impact compared with the issues discussed above.