Saw the headline. Had to be some kind of joke. I thought. Wait. Are we not trying to get the USMCA (aka NAFTA 2) ratified by this summer? Had it not seemed that progress had just been made on the Canadian side? The reaction across U.S. equity index futures markets told the truth. This was no prank. Asian markets and the European markets would stumble. Short weeks are always long, they say? This one just got longer.
Using Twitter as a means to disseminate news, President Trump announced the escalation of the trade war... with Mexico. The United States will on June 10th, impose a 5% tariff on all (as in every stinking thing) imports from Mexico. This tax on cross-border commerce will increase in increments of 5% every month thereafter on the first of the month until hitting 25% on October 1st. Of course, this is related to the crisis at the U.S. southern border, and should Mexico, in the opinion of the Trump administration, take effective actions that alleviate the migration of illegal aliens across that border, then these tariffs would be removed.
By the way, Mexico is the second largest trading partner for the U.S., exporting $346 billion worth of goods across the border in 2018. Mexico is number one for agricultural products. Your food (not just food) prices are about to spike. Oh, and U.S. Trade Rep Robert Lighthizer did send the necessary letter to U.S. Congressional leaders that opens up the process of getting the USMCA ratified. The goal would have been to get this deal done prior to summer recess. Yes, Congress goes on summer recess, kind of like what the rest of us did before we grew up.
Black Swan? It does usher in a new era, an era where the president is willing to use tariffs for purposes other than matters of trade. This has the potential to disengage a host of partners across many fronts. Could be a real doozy. At some point, the bough breaks. Investors need to watch the areas around the 200 day SMA and/or the 40 week SMA for both the S&P 500 (2775, 2769), as well as the Nasdaq Composite (7552, 7496). These are the most important large cap indices, and they have found recent support at these levels. This morning, we may look up at those levels. If they can not be retaken, our twelfth century Italian mathematician friend would have us looking at SPX 2720, and then 2650. Please don't make me look below 2650 for help.
Small Caps and Transports having long ago surrendered these focused upon lines in the sand, and can expect to see further acceleration in those declines as these actions will likely act to further slow down already sharply slowing economic growth.
My thoughts on the further deterioration of the trade condition? I can completely see where taking a stand against China came from. At least there is long standing evidence of anti-competitive and even abusive practice in trade. I don't think any sentient being can deny the crisis at the southern border. The problem there is that much of the flow of illegals is not Mexican in origin, presenting Mexico with a problem as well. Due to the environment created by the old NAFTA deal, many U.S. businesses to include many small U.S. businesses, are set up in such a way to take advantage of the existence of a North American block of free trade, and there may not even be a domestic option where these small business owners can turn. It would have probably been extremely helpful if such a move had been telegraphed well ahead of implementation. This one is going to hurt, gang. Swans are graceful creatures. This one is going to gracefully place a minus sign in front of your P/L.
Kind of Makes Me Wonder
Just what is the administration trying to force here? I mean besides the overt reason of making progress in slowing down illegal traffic of both human beings, drugs and potential terror at the border? Could this be an attempt to force the Fed to take action? To force consumer level inflation, itself? We have written often here about the U.S. Treasury security yield curve. It's absolutely frightening this morning. The 30 day T-Bill now yields 26 basis points more than the seven year note, 17 basis points more than the 10 year (now giving up less than 2.16%), and incredibly just 27 basis points less than the 30 year bond. Let me make that last point clear. Lending the Treasury Department your hard earned dough for an extra 29 years and 11 months will earn the investor a whopping 2.6% versus more than 2.33% for 30 day paper. I have warned over and over again that the Fed and Treasury needed to repair the yield curve. They have failed to heed this message. Now, due to their negligence on this point, the masses will suffer.
Since Thursday (yesterday), the probability of a cut made to the Fed Funds Rate (as priced in by futures trading in Chicago) has increased from 10% to 20% at the June 19th meeting. One has to wonder if that is truly the intent here. There is now, according to these same futures, a 91% probability of at least one rate cut this year, a 60% likelihood of two rate cuts, and a 24% chance that there will be three rate cuts. A market has even been opened for the possibility of four. Federal Reserve Gov. Richard Clarida spoke from New York on Thursday. Basically, Clarida got through his speech without making headline news, then during the Q&A session, he kind of let loose. The high ranking central banker allowed that the Fed is "very attuned" to risks against the economy, and domestic inflation, and he permitted that there could be a reason for a more accommodative stance on monetary policy.
The Atlanta Fed's GDPNow model has been a reasonably accurate model for economic growth in recent quarters. Far more accurate than competitors in my opinion. This morning, the Bureau of Economic Analysis will release their April data for Personal Income and Spending, as well as the much focused upon PCE data. That GDPNow snapshot now stands at 1.3%, but Atlanta has not revised this picture since last Friday. They surely will do so this morning. Personal Spending that is expected to slow from March will not help here. Central bankers will be watching the year over year Core PCE print. That line is running at 1.6%, and the expectation right now is that this is where it stays.
Treasury could help here, even if the Fed is slow to cut short-term rates, by over-issuing both 10 and 30 year debt while yields are depressed. As perverse as it is, and I understand that it is, the time has come to seriously consider a 50 or even a 100 year issuance. The problem there is that such behavior would only allow for even more irresponsible behavior by policy makers, especially if it went off well. Has to be considered through, in my opinion. Too late to buy gold? Probably not.
I was on a conference call when Zuora (ZUO) reported fiscal first quarter financial results. EPS of -$0.11, good enough for a one penny beat. Revenue of $64.11 million (+22.2% y/y) that met expectations. Okay. I thought, as I tried to continue my phone call from the back of a car, and work with the other hand... maybe this is going to be okay. Markets quickly let me know that this was not going to be the case. Yes, I am long ZUO. Yes, I named this stock my 2019 pick for the year, and this stock was beating the market until a couple of weeks ago. The fun stops there. This name, for me, especially in this risk-off environment, moves from my "hot ticket" list.. to what it will be for now... a project for risk management.
As followers know, I work often to reduce my net basis across my long positions through the sale of puts at levels where I think I would be willing to add, as well as calls that I hope will not be exercised against my position. These options expire. I keep the dough. My net basis is reduced. That's the plan. In the case of Zuora, the plan had worked well until now. I had driven my net basis over time, below the $15 level. The $15 level had been my panic point. More on this in a bit.
Though the shares are down nearly 30% from Thursday's close in early trade, there are some positives. Subscription revenue grew 32% year over year to $47.3 billion. Customers with an annual contract value equal to or greater than $100K grew 24% year over year to 546 in total. The key negative takeaway would be a rather significant guide down in full year revenue expectations, to a range between $268 million and $278 million. Wall Street consensus had been for something close to $292 million. The firm blames a lack of effective execution by new hires in sales. That does sound awful, but the firm is taking proactive steps to address this shortcoming. Interestingly, full year EPS is still expected to print somewhere between -$0.40 and -$0.44. The Street is looking for -$0.42, so now real guide-down there, meaning that CEO Tien Tzuo must be expecting margin expansion later in the year. The firm has also not reduced, but actually improved slightly their expectations for full year cash flow.
In short it would appear that lowering guidance for full year revenue by a rough $20 million has cost the firm some $660 million in market cap. Unless the markets see something that I am completely missing, this selloff is a severe overreaction to this news. So, how do I react, being my skin is in this game?
A Fine Pickle
First off, I come in long the equity at a now disadvantageous bet basis. Secondly, I am short some $17.50 puts that will expire this afternoon. Obviously, I either have to buy those back at a loss, or buy the shares at that strike price. Either way, my net basis is headed north in a name that is headed south in a market that is not helping. My panic point had been $15. My two rules here are that I always respect panic points, and that I always try to limit losses to 8% unless they happen due to an overnight. On a mark to market basis, this is a severe negative, as my P/L already reflects. In terms of actual wind and losses, what was a 10% gain on Thursday, looks like a 6% hickey on Friday, still less than my 8% rule, if I can properly manage those puts. Fortunately, I also come in short $22.50 calls, and $25 calls that also expire today. That helps as those will expire worthless, providing 100% profit each individually.
For those not so entrenched in options trading, you obviously will also have a problem here this morning. I don't worry about myself as I am fairly sophisticated and I think of myself as a risk manager. For you folks, I am deeply sorry for leading you here. I made the call, I still think the cloud and the subscription economy are paramount to the economic future of the still young generation we see before us. I also like Tien Tzuo. I think him an earnest leader with a good idea. I will be slow to sell shares on this discount. In fact, I am not selling shares at all to be honest. I will have to manage those puts, so I will likely add at least some of those shares at what once looked like an attractive discount. I will almost certainly guarantee that I sell both puts and calls today at expiration dates at least three months out if the premium is there. It may not be, especially on the call side, which is the safer side for those long, if they keep the size of that position correlated to the share count of the equity stake.
They'll come for us today, gang. They'll try to hurt us. They'll try to beat us. They never will defeat us. They can not defeat us. For those who know us, know we are the wrong door to knock. We know not fear, fear is but only for the wicked. Our hearts are pure. Now fight. Fight like I have taught you. Fight by my side. God bless.
Economics (All Times Eastern)
08:30 - Personal Income (April): Expecting 0.3% m/m, Last 0.1% m/m.
08:30 - Consumer Spending (April): Expecting 0.2% m/m, Last 0.9% m/m.
08:30 - PCE Price Index (April): Expecting 1.6% y/y, Last 1.5% y/y.
08:30 - Core PCE Price Index (April): Expecting 1.6% y/y, Last 1.6% y/y.
09:15 - Fed Speaker: Atlanta Fed Pres. Raphael Bostic.
09:45 - Chicago PMI (March): Expecting 54.2, Last 52.6.
10:00 - U of M Consumer Sentiment (March-F): Flashed 102.4.
12:00 - Fed Speaker: New York Fed Pres. John Williams.
13:00 - Baker Hughes Rig Count (Weekly): Last 797.
Today's Earnings Highlights (Consensus EPS Expectations)