Written by Jim Welsh
Macro Tides Weekly Technical Review 05 August 2019
FOMC, New Tariffs, and Yuan Depreciation
After the G20 meeting in Japan on June 28 most investors thought that a trade deal would be concluded in coming months. A week ago most investors expected the FOMC to lower the funds rate after the July 31 meeting but were also expecting the FOMC to signal that more rate cuts were in the offing. A week ago, with the U.S. trade negotiating team traveling to Beijing, most investors thought progress was being made and would continue in coming months.
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In last week’s WTR I warned that the FOMC would telegraph that future rate cuts were not on automatic pilot. In recent months I’ve discussed why I did not think a trade deal was likely. In recent weeks I’ve shown charts showing that investors had become quite bullish and that the technical structure of the market was weakening. This combination has usually preceded corrections.
The expectation was that the S&P 500 was likely to decline if the FOMC indicated that future rate cuts were data dependent. For weeks I’ve presented a chart of the S&P 500, which had formed a Megaphone pattern since January 2018 that suggested a larger correction that might carry the S&P 500 down to the December low of 2350 was possible. The key was whether a meaningful reason to sell materialized. As I noted last week:
“A decline of this magnitude will not materialize just because the S&P 500 has formed a Megaphone, sentiment is too bullish in the short term, or the softening technical landscape. There will have to be a reason to sell since most investors are optimistic and believe the Fereral Reserve will ride to the rescue. The most likely culprit remains an escalation of the Trade War.”
In the July 1 Weekly Technical Review (WTR) I provided the following expectation regarding the trade negotiations:
“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.”
It was not a coincidence that new tariffs were announced just after the S&P 500 and DJIA recorded a new high as has been the case since January 2018.
In the July 22 WTR I reiterated my view that a resolution in the trade dispute was unlikely:
“While it is certainly possible that another round of negotiations is announced, I am doubtful they will lead to a resolution. The question then becomes how patient will President Trump be if there is no real progress? I have no idea but he hasn’t given the impression that he is a patient man.”
President Trump proved less patient than expected which shouldn’t be a surprise.
After the trade talks ended on August 1 the U.S. team described the talks as “constructive“. The perspective from China was different. China’s Ministry of Foreign Affairs spokeswoman Hua Chunying made a number of telling comments:
“China doesn’t want a trade war, but will fight one if necessary. The Chinese side will not give in to any extreme pressure, intimidation or blackmail and we will never concede an inch on major issues of principle. I believe it doesn’t make any sense for the U.S. to exercise its campaign of maximum pressure at this time. It’s pointless to tell others to take medication when you’re the one who is sick.”
In recent months commentators on Chinese social media have called on Chinese consumers to stop buying U.S. products and to replace Nike with Germany’s Adidas, Converse with China’s Feiyue and Warrior, and Apple with Chinese smart phones like Huawei. A June survey by public relations firm Brunswick Group of some 1,000 Chinese consumers found they had avoided purchasing an American product to show support for Beijing in the ongoing dispute. With this escalation more Chinese consumers will boycott U.S. products in coming months.
Anyone who thinks we are merely a Tweet away from a resumption of productive trade talks (as I heard on CNBC numerous times on August 5) hasn’t been paying attention and may be surprised at how far the S&P 500 falls as earnings estimates are slashed.
Most investors were shocked when China devalued its currency on August 5 but I had warned of this potential in May and its significance. In the May 20 WTR I noted the importance of the 6.95 level and that financial markets would respond negatively if China allowed the Yuan to trade above 6.95:
“While negotiations were moving forward between last September and April, China allowed its currency to appreciate against the Dollar from 6.95 to 6.73. That literally changed overnight and now the Yuan is approaching levels only seen in December 2016 and September 2018 at 6.95. Should the Chinese allow the Yuan to rise above 6.95 (depreciate), it would signal that China had decided to use the depreciation of the Yuan as part of the Trade War and reflect a toughening in their trade position. If the Yuan does trade above 6.95 for a few days, global financial markets are going to respond negatively.”
China is dealing with a U.S. President who routinely Tweets about the level of the DJIA, so if you want to hurt him, hit him where he Tweets. After seeing how much the DJIA fell in August 2015, after China devalued its currency (DJIA lost 2,000 points), I expected China to take this action after more tariffs were levied last week.
The first punch that surprised investors and knocked the S&P 500 down last week was thrown by the FOMC when Chair Jay Powell strongly hinted that additional rate cuts were data dependent. The reason this outcome was expected was discussed in last week’s WTR:
“Markets are expecting the Federal Reserve to lower the federal funds rate by .25% on Wednesday and the FOMC will give markets what is expected. After the announcement the focus will shift to whether the FOMC’s statement or Chair Powell’s comments reaffirm the expectations for 2 more cuts before the end of 2019. The key question is whether Rosengren, and those who agree with him, strongly suggest that the FOMC should lower expectations for the 2 cuts that market participants are expecting before year end. This may be communicated in the FOMC statement but more likely during Powell’s post meeting press conference. Powell will do his best to soft peddle any shift away from the expected additional cuts”.
“The FOMC has already decided to stop the shrinking of its balance sheet on September 30. If the FOMC does desire to lower the market’s expectations for additional rate cuts, the financial markets will likely be disappointed with stocks, bonds, and gold selling off, while the Dollar strengthens. To mute this reaction, the FOMC may decide to announce it will end shrinking its balance sooner than September 30.”
Given the shift in the trade winds, investors are expecting the FOMC to lower the funds rate at the September meeting. I don’t think the FOMC will wait until the September meeting to act. The FOMC will want to act strongly and get the biggest bang as possible from another rate cut, since they only have 8 bullets left in their rate gun. One of the reasons I didn’t think it was wise for the FOMC to lower the funds rate at the July 31 meeting was to be able to respond quickly with a 0.50% cut once additional tariffs were announced. My guess is the FOMC will still move with a 0.50% cut when it determines that financial conditions have tightened enough to warrant it.
A tightening in financial conditions in late December, along with a number of other reasons discussed previously, prompted the FOMC to suspend additional rate increases in early January. The FOMC is not above looking at a chart of the S&P 500 to identify support, and time the announcement of a rate reduction as the S&P 500 approaches support or immediately after a penetration. Key support for the S&P 500 is near 2650 (red horizontal line).
Click on any chart below for large image.
Last week I discussed why the economic outlook could improve in the second half of 2019:
“If the trade talks simply drag on in coming months, there is a good chance the U.S. and global economy will gradually improve. As noted previously, there is a significant bifurcation between the manufacturing sector and service sector in the US, Europe, Japan, and China. Manufacturing represents just 11% of GDP in the US and about 22% in Germany. The key point is that services have so far proven resistant to the weakness in manufacturing in the U.S., Japan, and Eurozone, and will provide support going forward.”
With the onset of the Trade War, the weakness in manufacturing is going to gradually infect the service sector in coming months. The global economy has been slowing for more than a year even as the U.S. held up primarily due to the strength in consumer spending.
Although the July employment report released on August 2 was in line with expectations (164,000), there were signs of weakening under the surface. When uncertainty increases and signs of slowing appear in business, one of the first things businesses do is reduce overtime. A sharp fall in overtime hours is now apparent. Another indication of a weakening labor market is illustrated by the drop in Average Weekly Hours Worked by All Employees. The next shoe to drop is a falloff in job growth which is coming in the next few months.
If the 10% tariff on $300 billion of Chinese imports is triggered as expected, the burden will fall disproportionally on consumer products. Some of the increase in costs will be passed on to consumers and some will be absorbed by companies. This will cause prices to rise and profit margins to fall, which is not a desirable outcome for the economy or the stock market. I have expected earnings estimates for 2020 to come down before the end of 2019, as noted in the July 15 WTR:
“Sooner or later my guess is that estimates for 2020 are going to come down and make the S&P 500 look more expensive.”
The process of cutting estimates for 2020 and 2019 will begin soon and contribute to lower stock prices in coming weeks.
Stocks
Last week I noted that the 5 day (red) and 13 day (green) moving average on the S&P 500 would provide a level of confirmation that a correction had begun. In October and in May the 5 day MA dropped below the 13 MA just as the S&P 500 began to correct. I noted that a crossover would develop again if the S&P 500 dropped and held below 3001. The S&P 500 closed below 3001 on July 31 and the crossover occurred on August 1.
The expectation is that the S&P 500 has the potential to drop below the December low of 2347 in the next few months in wave E of the triangle that began in January 2018. Once this correction is over it will complete wave 4 from the March 2009 low, and be followed by a rally that carries the S&P 500 well above 3000 in 2020 and 2021.
Even if the S&P 500 does fall to 2350 or lower, it won’t be in a straight line and there will be violent bear market rallies along the way. If the Fed does surprise the markets with a rate cut before the September 6 meeting, the S&P 500 will retrace a large portion of the prior decline.
However, monetary policy is somewhat limited in addressing a Trade War. Investors want to believe the Fed can fix any problem which is why a Fed move will be greeted enthusiastically. Ultimately, the most intense selling pressure could follow the Fed induced rally, after investors realize it won’t be a panacea. The S&P 500’s 200 day average is 2790, which could be hit on August 6 and spark a very short term rebound. As noted last week:
“There are enough technical and sentiment warning signs to suggest that a pullback to 2800 is coming and possibly 2730 (Key Support).”
I just didn’t think it would happen in a week!
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. I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995 ($26.09). This position will be increased to 50% if the S&P 500 trades above 3028. Unfortunately, the high was 3017 so the increase in the short trade was not executed.
Treasury Bonds
Last week I thought the 10-year Treasury yield would drop below 1.943% in coming weeks. Over the weekend I planned in this week’s WTR to note that the 78.6% retracement from the July 2016 low yield of 1.336% to the November 2018 high of 3.248% was 1.745%. This level was reached today. If the 10- year Treasury yield falls much below the 78.6% retracement, the potential for a decline to the 2016 low would increase. If that develops the odds of the S&P 500 reaching 2350 would be high.
If the FOMC conveyed that additional cuts were not automatic, I thought the Dollar would rally, but stocks, Gold and bond prices would fall. In anticipation of a drop in bond prices, I recommended buying TLT if it fell below $128.40 using a stop of $126.60, since I expected TLT to post a new high above $134.29. Instead Treasury bond prices rallied even as the Dollar rose and stocks and Gold fell. TLT traded up to $138.99 on August 5.
Dollar
Last week I thought the Dollar could rally to 98.80 and tag the lower trend line, if the FOMC disappointed. The Dollar spiked up to 98.68 after Jay Powell indicated the FOMC would be data dependent going forward.
The Dollar reversed lower after President Trump announced the additional tariffs on China on August 1. As I wrote last week:
“Sooner or later the President is likely to talk the Dollar down, especially if the trade talks falter and he levies more tariffs on China.”
The Dollar is expected to fall as economists lower the GDP estimates for U.S. GDP in coming weeks. A drop to 95.00 seems likely.
Gold
Last week I discussed positioning and why it suggested that Gold was likely to experience a pullback:
“A period of consolidation including a test of the recent breakout level of $1360 to $1380 seems realistic.”
Longer term I expected Gold to move higher:
“After a pullback Gold is expected to retrace 50% or 61.8% of the decline from the September 2011 high of $1920 to the low in December 2015 at $1045. A 50% retracement would lift Gold to $1480, while a 61.8% recovery would target a rally to $1588. My guess the $1588 target is more likely, especially if the Trade War escalates and the Federal Reserve is forced to slash rates and potentially entertain another round of Quantitative Easing.”
The Trade War has escalated faster than I expected (days rather than weeks). Gold briefly dropped $1401.30 on August 1 but rebounded as the Dollar gave up its gains.
Gold Stocks
I thought the highs for GDX in the summer of 2016 ($28.70 and $28.56) would contain the advance and usher in a correction, once Gold began to correct. With Gold rallying to a new high, GDX rallied to $29.01 before dipping. Somewhere Down the Road the potential for a decline below $26.00 is lurking.
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.
I established a 25% short position in the S&P 500 through the purchase of the 1 to 1 inverse ETF SH on July 23, when the S&P 500 traded above 2995. This position will be increased to 50% if the S&P 500 trades above 3028.
The Megaphone pattern allowed for the S&P 500 to trade up 3000 and modestly above that big round number. The S&P 500 traded up to 3028 on July 26. Although the topping process took a bit longer than expected, the anticipated decline has begun which should include a test of 2730 at a minimum.
I thought volatility was likely to increase after the FOMC’s rate decision at 11am on July 31. That certainly proved true with a little help from a Tweet!
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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