August 7, 2018
So far, trade fears aren’t lowering earnings or GDP growth. For example, one reason behind Apple’s better-than-expected sales and earnings was the fact that its China revenue rose 19%. Furthermore, the fact that Chinese and U.S. trade negotiations are expected to re-open seemed to briefly calm investors.
There is no doubt that tariffs tend to force the country with the most to lose to the negotiating table, as the European Union (EU) recently demonstrated, so I expect that China will try to deter any new tariffs by resuming trade negotiations. In the meantime, China has purposely weakened the yuan to maintain its competitive trade advantage, which is why the U.S. continues to run record trade deficits with China.
Even though I am not spooked by trade fears, financial markets seem to want to be stressed about something, so trade fears will likely persist for a while, since it is an easy way for the media to bash President Trump. The truth of the matter is that many traders on Wall Street and in Europe will be on vacation for the next four to six weeks. That is one reason why August and September have been so weak in recent years. According to Bespoke Investment Group’s “August 2018 Seasonality” report, the Dow Industrials have posted an average decline of 1.01% and 1.07% in August and September, respectively, over the last 20 years (1998-2017), so we have now begun the two weakest months of the calendar year.
The talking heads on TV will continue to blame trade tensions for any market weakness, but in my opinion, the root cause is much simpler: Since many professional traders disappear in August through mid-September on extended vacations, there are fewer bids supporting some stocks. If I ever get to run the stock market, my first action will be to close it down in August, since trading volume typically drops dramatically, and unscrupulous short sellers like to try to jerk stocks around during very thin market days.
Turning to GDP estimates, U.S. exports have been steadily expanding, but on Friday the Commerce Department announced that exports declined by 0.6% in June to $213.8 billion, despite another surge in soybean exports. Unfortunately, a decline in the exports of autos, trucks, drugs, and passenger planes all contributed to the export slowdown. Imports rose 0.6% to $260.2 billion in June, so the trade deficit rose to $46.3 billion vs. a revised $43.2 billion in May. Since a shrinking trade deficit was a big contribution to robust second-quarter GDP growth, economists may have to trim their third-quarter GDP estimates.
I should add that the Atlanta Fed is currently estimating that third-quarter GDP is running at a 4.4% pace, so there is plenty of room to downgrade third-quarter GDP estimates and still have a healthy number.
Ironically, the preliminary third-quarter GDP report will be announced just before the November mid-term elections, so after two exceptionally strong quarters of GDP growth, it will be interesting to see how that ultimately impacts election results. Currently, the Republicans are expected to pick up seats in the Senate, due to the fact that there are many Democrats running for re-election in Red states. However, due to redistricting that favors Democrats in key swing states like Pennsylvania, as well as many key House seats vacated by Republicans, the outcome in the House of Representatives remains uncertain.
ISM Statistics Move Sharply Down: Temporary or Worrisome?
The Institute of Supply Management (ISM) reported on Wednesday that its manufacturing index declined to a four-month low of 58.1 in July, down from a robust 60.2 in June. This was a big surprise, as economists expected a reading of 59.5. The culprit was two-fold: ISM’s new orders component declined to 60.2 in July (down from 63.5) and its production component declined to 58.5 (down from 62.3).
More specifically, the main culprit was auto parts. Auto manufacturers reported that vehicle sales in July were lower than expected as many rebate programs ended, so an abrupt curtailment in auto parts orders apparently impacted the ISM manufacturing report. I should add that any ISM reading over 50 signals an expansion, so the manufacturing sector is still healthy, despite these near-term woes in the auto sector. Furthermore, higher gasoline prices and the 2019 model changeover can temporarily depress auto sales.
On Friday, ISM reported that its service index slipped to 55.7 in July, down from 59.1 in June. Once again, that was a disappointment, since economists were expecting a small drop to 58.6. Although any reading over 50 signals an expansion, the ISM services index is now at an 11-month low, due largely to the business activity component that declined to 56.5 in July, down sharply from a robust 63.9 in June. The new order component also declined to 57 in July, down from 63.2 in June. Due to the abrupt deceleration of both ISM indices, it will be interesting to see if economists start to trim their future GDP estimates.
The big economic news last week was Friday’s payroll report, in which the Labor Department announced that only 157,000 payroll jobs were created in July, substantially below economists’ consensus estimate of 190,000. The best news was that the June payroll report was revised up 35,000 jobs to 248,000. The unemployment rate declined to 3.9%, down from 4% in June. Average hourly earnings increased 0.3% or 7 cents to $27.05 per hour, so wage growth remains moderate. The best news was June’s upward revision.
I should add that on Wednesday, ADP reported that 219,000 private payroll jobs were created in July, the strongest month since February. ADP also revised its June private payroll up to 181,000, from 177,000.
The Conference Board announced last week that its Consumer Confidence Index rose to 127.4 in July, up from 127.1 in June, near an 18-year high. Especially impressive is that the “present situation” component rose to 165.7, up sharply form 161.7 in June. The gap between the “present situation” and “expectation” components is nearing a record, which essentially means that consumers are surprised at how well they are doing! As a result, I expect consumers will likely be spending more money, which is good for growth.
The National Association of Realtors last week announced that pending home sales rose by 0.9% in June, a bit better than economists’ consensus expectations of a 0.8% rise. The National Association of Realtors also reported that international purchases of U.S. homes fell 21% in the 12 months through March 2018. Major international markets, like London and New York City, are in the midst of a slowdown, especially for luxury properties. Eventually, as luxury home prices weaken, it might weigh down other luxury markets, such as Art and Collectibles. As long as the S&P 500 continues to pay a nice dividend yield, though, I do not expect that the stock market will be adversely impacted by the global housing slowdown.
On Wednesday, the Federal Open Market Committee (FOMC) left key interest rates unchanged. On Thursday, the Bank of England raised its key interest rate by 0.25% to 0.75%, the highest since 2009. The FOMC was largely quiet after their meeting, perhaps since President Trump signaled his unhappiness with rising interest rates. Due to the global economic slowdown and ongoing tariff concerns impacting global trade, the Fed has some excuse to postpone rate increases. However, most Fed watchers expect the Fed will likely raise rates at its September 24-25 FOMC meeting, but looking forward, after September, the yield curve will likely determine Fed policy, since the Fed does not like to fight market rates.
Finally, Iran’s currency, the rial, declined 18% early last week and is now down by almost 66% this year. U.S. sanctions are scheduled to be reimposed on August 6th and November 6th, but clearly the economic impact is already devastating Iran. The Trump Administration has offered to meet with Iran, but there are several preconditions that will likely delay any meeting. Iran replaced its central bank chief recently and has blamed currency volatility on the “enemies’ conspiracy” and is vowing fresh countermeasures “in the coming days.” The bottom line is that there is really no need to go to war when the economic sanctions are so powerful. It will be very interesting to see how Iran’s economic crisis will impact its leadership, but at this time, the country’s domestic crisis will likely force Iran back to the negotiating table.