Written by Jim Welsh
Macro Tides Weekly Technical Review 01 Jul 2019
Trade Talks Will Resume
As expected (see video below) President Trump and President Xi agreed to restart trade negotiations during their meeting at the G20 summit in Japan. In the short term this is a positive compared to a complete breakdown and escalation in tariffs and tension that could have occurred. However, the disagreements that led to the cessation of talks in early May still need to be resolved.
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The consensus believes that President Trump will behave as politicians all around do when their reelection is on the table: Trump will make a deal since he needs a trade success to show he knows how to make a deal. A deal would provide a lift to the U.S. economy as he begins his campaign, allowing him to run on a strong economy theme. On the surface this view is easy to agree with since politicians the world over are more motivated by their reelection than anything else.
The flaw in this logic is that President Trump is not like any other politician. Unlike most politicians, he has followed through on his campaign promises after he was elected. While many people may be unhappy about this, one has to acknowledge that Trump didn’t zag after becoming president. Trump’s advisors understand that whichever country controls technology will likely be the global power in coming decades and President Trump agrees.
China has used the theft of intellectual property as an integral part of its growth strategy to catch up to the US faster than it otherwise would have been able to on its own. Since China joined the World Trade Organization in 2001, U.S. administrations and companies tolerated the theft of intellectual property as the cost of doing business and having access to the huge Chinese market. This is why this issue has garnered support from many U.S. and European companies that have direct experience with their intellectual property being stolen.
In this era of divisive politics it is amazing that some prominent democrats support the effort to challenge China on this issue. I think President Trump will not compromise on this issue which could easily be a deal breaker. The hardliners in China are unlikely to agree to make intellectual property theft illegal in China, so this could be a deal breaker for them as well.
No time frame was put on the trade negotiations, but I would be surprised if President Trump shows a great deal of patience. If no progress has been made by early August, there is a good chance that President Trump will hint strongly about the threat of new tariffs, or actually set a deadline to trigger new tariffs on the $300 billion of Chinese imports not currently subject to tariffs. The mere threat of additional tariffs is likely to cause the stock market to sell off, rather than the actual implementation of new tariffs.
If there is another breakdown in trade talks, it will be seen as a signal that the gloves are off and a full blown Trade War will follow quickly. I don’t think there will be a trade deal, and it may come down to when the trade talks collapse, not if.
Almost everyone assumes that President Trump will run for reelection after launching his reelection campaign on June 18. By announcing he is running again, President Trump will maintain his power, which would evaporate if he indicated he wasn’t running. Many point out that if President Trump decides in 2020 that he wasn’t running it would be a big problem for the Republican Party.
In 2016 there was a strong effort within the Republican Party to support any candidate accept Trump, which was known as “Anyone But Trump”. You can be sure that President Trump 
hasn’t forgotten and probably doesn’t feel an overpowering allegiance to the Republican Party. Trump would likely relish seeing the Republican Party flounder without him. On election night in November 2020, if the Republicans fared poorly, would anyone be surprised if President Trump Tweeted that the Republican Party was just a bunch of losers. Donald Trump didn’t expect to win in 2016 and I think President Trump may not run in 2020. If President Trump is considering not running, he would be more likely to hold the line in trade negotiations with China and not be willing to compromise his position on intellectual property. One caveat that would lead to President Trump running again is the prospect of criminal charges being filed against him since a sitting president can’t be charged.
Jobs and the FOMC’s Rate Decision
The June employment report will be released on July 5 and investors will be on edge to learn whether job growth improved after May’s surprise and disappointing increase of just 75,000. Economists are estimating that 165,000 new jobs will be reported for June, but other details will matter. Job growth was revised lower by 75,000 for April and March when the May number was announced, so additional downward revisions could indicate the slowing in job growth has become a real trend.
Average Hourly Earnings (AHE) slipped to 3.1% in June from 3.2%, but may be set up to rise to 3.2% since AHE only rose by $.06 in June 2018 compared to $.09 in May 2018. This lower bar will make it easier for a surprise increase in AHE. Hours worked was unchanged in May which was overlooked due to the weak gain of 75,000 jobs. Most companies reduce hours if sales are slowing well before they consider laying works off. If hours 3 worked in June continue to hold up that would be a sign that the labor market is still healthy.
Now that the trade issue has not escalated, the FOMC is truly data dependent which is why the jobs report, Retail Sales, and data on the service sector will guide the FOMC decision. At this point the majority of FOMC members are likely undecided. The probability of a cut at the July 31 is 100% so markets would be disappointed if economic data comes in strong enough to knock the probability lower. Conversely, another weak employment report might fan concerns that earnings will be weaker.
Strategists are invoking the mid-cycle rate cuts the FOMC enacted in 1995 and 1998 as further justification for the FOMC to lower the fed funds rate three times before the end of 2019. In 1995 and 1998 the ISM Manufacturing Survey was down to near 45 and well below the equilibrium level of 50. In June 2019 the ISM manufacturing number was 51.7 and still in expansion territory. Despite the concentrated weakness in manufacturing from the imposition of tariffs, this is hardly a level that normally would require a move for more monetary accommodation.
The FOMC increased the fed funds rate from 3.0% in May 1994 to 6.0% in March 1995, a doubling in 10 months. After such an aggressive move and the weakness in the ISM manufacturing sector, a move to lower the fed funds rate was appropriate. In 1998 the FOMC lowered the fed funds rate after Long Term Capital Management blew up in August. Long Term Capital Management was run by three Nobel Prize winners who thought they were smart enough to use 100% leverage. They weren’t and for a few fragile days the FOMC was concerned it might be facing a systemic problem. To make matters worse, Russia devalued the Ruble and defaulted on its bonds in mid August, which sent equity markets around the world into a tailspin. To compare 1998 to the current environment can only be done, if someone doesn’t know the history.
The ISM Non Manufacturing Index for June will be released on July 3.In May the Index was 56.9 and will likely dip a bit for June. The spread between the ISM Manufacturing Index and the Non Manufacturing Index is quite wide.
This illustrates that the weakness from tariffs and the Trade War to date has been concentrated in the manufacturing sector, which comprises 15% of GDP compared to 85% for the service sector (non-manufacturing). In 2007 and 2008 the Manufacturing and Non Manufacturing Indexes moved lower together. When oil prices collapsed in late 2015 and early 2016, the plunge in oil drilling hit manufacturing hard but services held up. The same pattern seems to repeating which further complicates the FOMC decision regarding rates. Based on the economy alone, the FOMC doesn’t have a compelling reason to lower rates especially if incoming data is good.
In early 2016 financial conditions tightened measurably as oil prices plunged, spreads between Treasury bonds and corporate bonds widened significantly, and the stock market fell by almost 15% in January and February. The FOMC decided to hold off on additional rate hikes, but it didn’t lower rates. Financial conditions tightened in the fourth quarter of last year, which was one of the reasons why the FOMC hit the pause button last January.
The primary reasons for pausing were allowing time for the FOMC to access the impact from the 7 prior rate increases from the beginning of 2016, and knowing that the federal funds rate was up to a level near the neutral rate. Since spiking higher in the fourth quarter, financial conditions have loosened considerably and are around the levels of 2012, 2013, and 2014. Based on the level of financial conditions, there is no demonstrable reason for the FOMC to lower the funds rate in July.
Since peaking last November, the 10-year Treasury yield has plunged from 3.25% to under 2.0% last week. This has enabled the 30-year mortgage rate to drop by more than 1.1%, which is creating an opportunity for current home owners to refinance and increasing affordability for prospective home buyers.
The drop in mortgage rates has already provided housing and the economy most of whatever benefit that could be expected, should the FOMC decide to lower the federal funds rate. With the federal funds rate at 2.4%, the FOMC only has 10 cuts to work with. The FOMC will want to maximize the bang from each cut, and taking out an insurance cut may not meet that threshold.
Many economists trumpet the need for the FOMC to cut rates since inflation is not at the Fed’s 2.0% target. At a minimum they say the FOMC has the cover to cut rates and can point to low inflation as justification. The FOMC isn’t that far under its target and is hitting the 2.0% target if one looks at the Dallas Fed Trimmed Mean PCE.
There is a good chance that those expecting the FOMC to cut rates three times before the end of 2019 are expecting too much. I think the FOMC wants to be aggressive if additional tariffs are enacted and would cut the funds rate by 0.50% and possibly between meetings to maximize its impact. But until then, the FOMC is data dependent and my guess is the data isn’t going to be so weak as to force the FOMC to cut rates aggressively.
Markets
Last week I wrote:
“If trade talks are restarted, the stock market would be expected to rally, while Treasury bonds and Gold and Gold stocks sell off.”
The trade talks will be restarted and the stock market rallied, while Treasury bonds declined, and Gold and Gold stocks fell hard.
Stocks
One of the reasons I thought President Trump and President Xi would agree to restart trade negotiations was the chart pattern of the DJ Industrials and S&P 500 indicated they were poised to rally to a new all time high. The S&P 500 did reach a new high on July 1, but the DJIA fell short by 62 points. The expectation is the DJIA will push to a new high before the market becomes vulnerable to a larger correction.
The market may experience a quick sharp drop if the employment report on July 5 comes in better than expected, dimming the certainty of a rate cut on July 31. Although less likely, a far weaker jobs report could cause some analysts to lower earnings estimates for Q4. My guess is that more companies are likely to guide estimates lower when they report second quarter earnings in coming weeks.
Click on anyt chart below for klarge image.
As discussed previously, the pattern in the S&P 500 since the January 2018 top has formed a Classic ‘Megaphone’. The high in January 2018 would be labeled wave (3) from the March 2009 low. (See chart above) The decline to the low in February 2018 is wave (A), the rally to the September 2018 high is (B), and the plunge into December 2018 is (C). The same pattern is clearly evident in the DJ Industrial average which is why that average is expected to reach a new high above the October high of 27,953 to complete Wave (D), while most of the other major market averages fail to do so.
As noted the last two weeks:
“Should the S&P 500 rally above 2954 in coming weeks, it would provide conservative investors the opportunity to become more defensive and a shorting opportunity for aggressive investors.”
I’m not ready to go short until the DJIA makes a new high, or more evidence that the topping process is complete.
When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open. I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1. The Tactical U.S. Sector Rotation Model Portfolio is now 100% in the money market.
Treasury Bonds
Since spiking down to 1.975% on June 20, Treasury bond yields have been chopping sideways and may have formed a small triangle in the process. This suggests that the 10-year Treasury yield will spike below 1.975% before reversing higher. The initial increase in yields is likely to be slow since the expectations for FOMC easing are so entrenched. If the FOMC doesn’t lower the funds rate at the July 31 meeting you can be sure it will take less than 1 minute for the focus to shift to the September 18 meeting.
The Treasury bond ETF is expected to rally above $133.50 as it potentially completes Wave 5 of Wave (C) and the rally from the low of $111.90 in November.
Investors are so certain that Treasury bond yields will continue to fall they are willing to accept a negative Term Premium. In the early 1980’s as Treasury bond yields were peaking, investors demanded a term premium of almost 5% for holding the 10- year Treasury bond. The Term Premium has dropped to a record low of -.0.82% which means investors are effectively paying 0.8% for the risk of owning 10-year Treasury bonds, rather than receiving some additional yield.
Almost $13 trillion of sovereign bonds yield less than 0%. To compensate, investors in Europe and in the U.S. have been extending their duration just to capture a decent yield. The Macaulay duration on the Bloomberg Barclays sovereign-debt index is near a record high of 8.32 years. If sovereign bond yields rise by just 1.0%, global bond holders would absorb a $2.4 trillion loss.
Given these facts one must be on the lookout for a sharp increase in bond yields in coming months. The most crowded trade on the planet is in bonds, whether it be European sovereign bonds, U.S. Treasury bonds, or high yield and junk corporate bonds which offer a skimpy premium to Treasury yields.
In recent months there has been a marked increase in the downgrades of High-Yield bonds as a percent of high yield bonds. Last month it reached the second highest percent since the financial crisis. However, the increase in downgrades has not resulted in an increase in the premium over Treasury bonds. This means that investors are not being compensated for the heightened risk and could be surprised when investors become less yield-hungry and more observant of what they own. More than 50% of investment grade corporate bonds carry a Baa or BBB rating, the lowest investment grade rating possible.
During the next recession, a wave of downgrades to less than investment grade could prove problematic for the corporate bond market. Many pension funds have limits on how much high yield or junk bonds they can own. A wave of downgrades could trigger a wave of liquidations that could swamp investors who own the high yield ETF (HYG) or the junk bond ETF (JNK).
A close below $106.00 would indicate trouble was coming. When JNK closed below $106 in November it quickly dropped to under $98.00. In the oil price collapse in 2016, JNK plunged to under $94.00 after it closed below $106.00.
Gold
I thought Gold could be vulnerable to a sharp decline if the trade talks were resumed since it was so over bought and sentiment had quickly become excessively bullish:
“Gold rallied $187 from a low of $1160 to $1347 in February. An equal rally from $1266 would target $1453. Although Gold may reach this target, it’s extremely overbought and getting a lot of media attention, which suggests a near term high is likely. If trade talks are resumed Gold could be vulnerable to a quick shakeout.”
Gold peaked last week on June 25 at $1438, and closed at $1384 on July 1, a quick fall of -3.75% in less than 4 trading days.
Last week I made this recommendation:
“Sell GLD if it trades up to $135.25 and IAU at $13.72.”
On Tuesday June 25 GLD traded up to $135.55 and IAU reached $13.75 before reversing lower. I think Gold is likely to chop around for a bit and may bounce to $1400, but is not likely to mount a sustained rally until more of the bullish sentiment wears off. If the employment report comes in better than expected, Gold could suffer another dip as expectations for a July 31 rate cut are lowered.
Gold Stocks
Last week I noted that I was long the Gold stock ETF (GDX) for managed accounts from $20.52, and the American Century Global Gold fund (AGGNX) for advisory accounts from $8.08. The American Century Global Gold fund (AGGNX) was sold at $9.95 on June 24. I noted that I would be selling GDX above $26.00 on June 25, as a sharp pullback to under $24.00 seemed likely in the next two months. On June 25 GDX opened at $26.22, and closed at $24.58 on July 1.
Dollar
The resumption of trade talks gave the Dollar a nice lift as a breakdown would have hurt the U.S. economy and led the FOMC to lower rates sooner and more aggressively. The Dollar could get another lift if the employment report is stronger than expected dimming the odds of a rate cut at the July 31 FOMC meeting. As noted last week, the Dollar is still expected to drop to 95.03 in coming months.
Tactical U.S. Sector Rotation Model Portfolio: Relative Strength Ranking
The MTI generated a Bear Market Rally (BMR) buy signal on January 16, 2019 (green arrow) and climbed above the green horizontal trend line on February 26 confirming the uptrend. The progressive weakening in the technical structure of the market since late April led me to reduce exposure. When the S&P 500 was trading at 2877 at 7am on May 16 I lowered the exposure in the Tactical U.S. Sector Rotation Model Portfolio from 100% to 50%. I lowered exposure to 25% in the Tactical U.S. Sector Rotation program on June 11 after the S&P 500 gapped up to 2903 at the open.
I lowered exposure to 5% from 25% at the close on Wednesday when the S&P 500 was 2913. I sold the 5% position in Technology ETF (XLK) shortly after the opening on July 1. The Tactical U.S. Sector Rotation Model Portfolio is now 100% in the money market.
The Megaphone pattern allows for the S&P 500 to trade up 3000 and modestly above that big round number. Although it may take a few more weeks for the stock market to complete its topping process, the next big move is likely to be down not up. Should the S&P 500 close above 3020 and hold above that level, the Megaphone pattern would probably be negated, and I would have to reassess the outlook.
Disclosure
The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell 3000 Index. The Nasdaq 100 is composed of the 100 largest, most actively traded U.S. companies listed on the Nasdaq stock exchange. All indices, S&P 500, Russell 2000, and Nasdaq 100, are unmanaged and investors cannot invest directly into an index.
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