May has been a much-needed eye-opener for many investors as they naively believed that the market had no downside. A positive trade outcome was priced in by the markets as it ground higher, despite valuations getting stretched. Over the past month, the U.S. markets are down 4% and the Chinese down nearly 10%.
There are various conspiracy theories about what happened, but only those present in the actual talks can and will know what caused Trump to lash out at the Chinese. He has shoved himself between a rock and a hard place. He was never going to get the deal of the century, as China does not buckle to U.S. bullying, but cannot show his face to the American people with anything less.
With this outperformance in U.S. markets, Trump must be feeling rather pleased with this false sense of security that there will be any contagion from a Chinese-led slowdown. Clearly the fourth quarter of 2018 wasn't convincing enough.
Trump knows that the only way to get markets higher is to get the Fed to panic. The Fed really has no clue and is too scared to do anything till it breaks. They are hoping that things just fade away before it gets worse. The latest minutes had been recorded prior to May headlines, so obviously there would have been no need for any hint of rate cuts.
Even prior to the May tariff tantrum, fundamental economic indicators were showing signs of stress. Global trade volumes have been dismal in Q4 2018. Even after China's gargantuan credit injection, nearly 4 trillion yuan in January alone, failed to boost the data significantly. As these new tariffs kick in, there is no doubt that global trade volumes will be at risk of a further slowdown. New export orders for global manufacturing has been weak, holding below the 50 level. U.S. manufacturing output fell to a 35-month low, printing 50.8 vs 52.7 in April.
U.S. Treasury yields are falling, with the 10-year trading below 2.3% -- a sign of economic slowdown. The probability of a Fed rate cut has risen to above 80%, only the Fed hasn't got the memo yet. Copper is down 10% in the last month, with the spot trading below $6000/tonne. All commodities and equities exposed to the "growth" cycle dependant on Chinese demand have been hit hard.
Semiconductor stocks (as measured by the VanEck Vectors Semiconductor ETF (SMH) ) are down 15%. Tech stocks are down. Ali Baba (BABA) , cheap as it may be, is down 18% compared Amazon (AMZN) , which is down 7%. The market is making a distinction between stocks and sectors. This rise in bond yields, rally in the dollar, and selloff in cyclicals over defensive all signify the market is starting to price in chances of a serious slowdown, and rightfully so.
The bond market has shown signs of stress for quite some time. As usual, equities ignored it as herd mentality took over. Tumbling yields could either mean the chance of a slowdown going forward or a real Fed policy mistake. Currently, the Fed employs a patient stance compared to all other central banks, which are leaning towards or actually lowering interest rates. This has pushed the dollar even higher vs. most of G-10 currencies, given the interest rate differential. The dollar crisis presents another problem for emerging markets and growth prospects as they hold dollar debt.
As China faces prospects of higher tariffs on additional $300 billion worth of goods, the yuan keeps falling. There is a school of thought that the Chinese are or could let the yuan fall deliberately to offset some of the pressure of higher costs from tariffs. This FX race to the bottom can end ugly for the U.S. PBOC overnight declared it would penalize speculators shorting the yuan. So much for free reserve currency status.
Oil and mining stocks are down about 15%-20%, and tech stocks are down 10% over the past month. We have normalized quite a bit of the excess run up to April. But if one were to believe what the bond and credit markets are telling us, the market is at risk of breaking 2800 on the S&P 500 to the downside. The real sell-panic, as one witnessed in December 2018, has not yet kicked in.
One thing is clear, if a trade deal is not reached by the end of June, this selloff can get a lot worse. Outside of stimulus boost, nothing will be able to get the market to break higher as companies are facing higher labour costs and margin pressure capping valuation upgrades.
This could either be a brilliant buying opportunity or a value trap. Valuations only tell us half the story. We need a macro trigger to convince us to pull the trigger. There are too many unknown variable factors to call it either way, as we are now in no man's land. Today, covering your shorts and being in cash makes the most sense for now, await a clearer entry point, either for the long or short side of the trade.
