the Fed’s dilemma

history

From almost my first day in the stock market, domestic macroeconomic policy has been implemented by and large by the Federal Reserve.  Two reasons:  a theoretical argument that fiscal policy is subject to long lead times–that by the time Congress acts to stimulate the economy through increased spending, circumstances will have changed enough to warrant the opposite; and ( my view), until very recently neither Democrats nor Republicans have had coherent or relevant macroeconomic platforms.

If pressed, Wall Streeters would likely say that Washington has historically represented a net drag on the country’s economic performance of, say, 1% yearly, but that it was ok with financial markets if politicians didn’t do anything crazily negative–the Smoot-Hawley tariffs of 1930, for example.

During the Volcker years (1979-87), money policy was severely restrictive because the country was struggling to control runaway inflation spawned by misguided policy decisions of the 1970s (Mr. Nixon pressuring the Fed to keep policy too loose).  Since then, the stock market has operated under the belief that the Fed’s mandate also includes mitigating stock market losses by loosening policy, the so-called Greenspan, Bernanke and Yellen “puts.”

recent past

We’ve learned that monetary policy is not the miracle cure-all that we once thought.  We could have figured this out from Japan’s experience in the 1980s.  But the message came home in spectacular fashion domestically during the financial crisis last decade.  As rates go lower and policy loosens, lots of “extra” money starts sloshing around.   Fixed income managers gravitate toward increasingly arcane and illiquid markets.  In their eagerness to not be left out of the latest fad product, they begin to take on risks they really don’t understand as  well as to forego standard protective covenants.

We could almost hear the sigh of relief from the Fed as the tax bill of 2017, which reduced payments for the ultra-rich and brought the corporate tax rate down to about the world average, passed.  Because the bill was so stimulative, it gave the Fed the chance to raise rates as an offset, meaning it could tamp down the speculative fires.

today

Enter the Trump tariffs.

Two preliminaries:

–tariffs are taxes.  Strictly speaking, importers, not foreign suppliers (as the president maintains (could it be he actually believes this?)) pay them to customs officials.  But the importer tries to ease his pain by asking for price reductions from suppliers and for selling price increases from customers.  How this all settles out depends on who has market power.  In this case,it looks like virtually all the cost will be borne by domestic parties.  Domestic economic growth will slow.  The relevant stock market question is how much of the pain consumers will bear and how much will be concentrated in a reduction of import business profits.

–I think Mr. Trump is correct that the US subsidy of NATO is excessive.  It represents the situation at the end of WWII, when the US left standing–or at best the time when the USSR began to disintegrate into today’s Russia (whose GDP = Pennsylvania + Ohio, or California/2).  I also think that China, with a population five times ours and an economy 1.25x as big as the US (using PPP), is a more serious economic rival than we have seen in decades.  It doesn’t have the post-WWII sense of obligation to us that we have seen elsewhere.  So we have to rethink our relationship.

Having written that, I don’t see that Mr. Trump has even the vaguest clue about how the country should proceed, given these insights.

To my mind, tariffs + retaliation mean both domestic and foreign companies will be reluctant to locate new operations in the US.  Tariffs on Chinese handicrafts may bring industries of the past back to the US, at the same time they force China to increase emphasis on industries of the future.  I don’t get how either of these moves should be a US strategic goal….

the dilemma

The question for the Fed:  should it enable the president’s spate of shoot-yourself-in-the-foot tariff policies by lowering rates?  …or should it let the economy slide into recession, hoping this will jar Congress into action?

 

what to do on a rebound day

It doesn’t appear to me that the economic or political situation in the US has changed in any significant way overnight.  Yet stocks of most stripes are rising sharply.

What to do?   …or if you prefer, what am I doing?

Watching and analyzing.

A day like today contains lots of information, both about the tone of the market and about every portfolio’s holdings.  Over the past month, through 2:30 pm est today, the S&P is down by 4.8%.  The small-cap Russell 2000 has lost 7.7%, NASDAQ 7.8%.   All three important indices are up significantly so far today—NASDAQ +2.2%, Russell 2000 +1.9%, S&P 500 +1.8%.  So this is a general advance.  Everything is up by more or less the same amount, meaning investors aren’t homing in on size or foreign/domestic as indicators for their trading.

What we should all be looking for, I think, is what issues that should be going up–either because they’re high beta or have been beaten up recently–are shooting through the roof and which are lagging.  (“Lagging” means underperforming other similar companies or underperforming the overall market.)  The first category are probably keepers.  The poor price action for the latter says they should be subjects for further analysis to figure out why the market doesn’t appreciate their merits.  Maybe there aren’t any.  

We should also note defensive stocks that are at least keeping up with the S&P.  That’s better than they should be doing.  They may well be true defensives, meaning they stay with the market (more or less) on the way up and outperform on the way down.  This is a rare, and valuable, breed in today’s world, in my view, and can be a way to hedge downside risk.

 

 

Another topic:  Over the past few days, I’ve been in rural Pennsylvania filming my art school thesis project–yes, I’ve gone from stills to video–so I haven’t kept up with the news.  I’m surprised to see that the UK, which still remembers the enormous price it paid a generation ago resisting fascism, has done an abrupt about-face and allowed Mr. Trump to make a state visit.  The anticipated consequences of Brexit must be far more dire than the consensus expects.

more tariffs?

Wall Street woke up today to an announcement from Mr. Trump that he intends to place a tariff on all goods coming into the US from Mexico.  The levy will be in effect until that country prevents immigrants/asylum seekers from reaching its border with the US.  The initial rate will be 5%, escalating to 25% by October.

As an American, I think I can understand the issues the administration wants to address.  But I find it more than a little unsettling that there seems to be no coherent, well-reasoned plan being implemented.  I’m pretty sure tariffs are not the way to go.  Also, both sides of the aisle in Congress appear to be eerily content to watch from the sidelines, rather than make it clear that Mr. Trump does not have authority to levy tariffs without legislative consent (my personal view, for what it’s worth) or limit/revoke that authority if the president does have it now.

 

As an investor, however, my main concern is the much narrower question of how Washington will affect my portfolio.

As to Mexico:  let’s say the US sells $300 billion yearly to Mexico and buys $350 billion.  Most of that is food and car parts.  Even if we sell less to Mexico because of retaliatory tariffs and if imported goods are 15% more expensive–to pluck a figure out of the air–the total direct negative impact on the US + Mexican economies would probably be a loss of around $100 billion in GDP.  How that would be split between the two isn’t clear, but the aggregate figure is 8% of Mexican GDP and 0.5% of US GDP.  So, potentially much worse for Mexico than for the US.

Given the nature of US-Mexico trade, the negative economic impact in the US will be concentrated on lower-income Americans.  If earnings reports from Walmart and the dollar stores are to be believed (I think they are), these are people whose fortunes have finally, and only recently, begun to turn up post-recession.

From a US stock market point of view, neither autos nor food has large index representation.  My guess is the negative impact will be roughly equally divided between negative pressure on directly-affected stocks, including names that cater to the less affluent, and mild downward pressure on stocks in general from slower domestic growth.  Because small caps are more domestically focused than the S&P 500, only half of whose earnings come from the US, the Russell 2000 will likely suffer more than large caps.

 

There are deeper, long-term questions that Washington is raising–about whether the US is an attractive place to establish manufacturing businesses and whether it can be relied on as a supplier to buy from.  In addition, it’s hard to figure out what government policy today is–for example, how new tariffs on Mexican imports square with just-reworked NAFTA, or how imposing tariffs that hurt domestic car manufacturers square with the threat of tariffs on imported vehicles, which do the opposite.

Neither of these concerns are likely to have a significant impact on near-term trading.  But heightened Washington dysfunction must even now be becoming a red flag in multinationals’ planning.

 

 

comment from a long-time reader

Hi Alan,

You always have interesting questions/comments.

“Is putting an embargo on selling electronic components to Huawei very different than China deciding to embargo rare earths?”

My short answer is “No.”  In both cases, a country is seeking a strategic advantage by denying a rival an essential material used in making a key product.

To my mind, there is a difference, though.  In the Huawei case, the US is not just trying to make it harder for the Chinese company to make telecom equipment by denying it raw materials.  We are also threatening other OECD countries with reprisals if they buy Huawei products, whether they contain US-made components or not.  The ostensible reason is the worry that programs buried deep in the Huawei network software will give Beijing the ability to monitor communications or even shut the networks down if it so chooses.  I have no idea whether this fear is well-grounded or whether the attack is designed mostly to buy time for US competitors to catch up with Huawei technology.

Also, adding Huawei to the “entity list” effectively cuts off access to all technology from US companies, including the Google Android operating system which drives Huawei phones.  UK-based ARM Technology has also withdrawn the use of its chip design cores, which seems to me to be at least as damaging as the Google action.  (The ARM decision is not the clear-cut condemnation of Huawei it might seem.  ARM is owned by Softbank, which has been aggressively, and so far unsuccessfully, lobbying Mr. Trump to green-light the merger of T-Mobile with Sprint, which Softbank owns and which has been an albatross around its neck because of its lack of scale.)

 

As to Mr. Trump himself, I personally think history will regard him as an important transformational figure, not only for American national policy but also for the structure of both major political parties.  For good or ill, he’s laid bare how inadequate and dysfunctional the status quo is.

 

My main question about Huawei is whether this action is part of an overall government plan or whether it’s a more or less random event.  I really don’t see any overarching strategy in the changes the US wants to make in the relationship with China, so my guess is the latter.

We can look into Mr. Trump’s business career for evidence of his strategic acumen and business savvy.  The case we have the most information on is his foray into Atlantic City casino gambling, which to my eye shows neither:

–By 1985, eight years after the first Atlantic City casino opened, the limitations of this market–lack of road, rail and air infrastructure to deliver gamblers to the city; lack of hotel rooms to allow more than day trips; the beach in the summer as the only non-casino attraction (meaning that the resort was half-empty for maybe 40% of the year)–were very well-know.  The savviest operators had already begun to withdraw from AC in favor of redeveloping Las Vegas.  That’s when Donald Trump bought in.

–Trump added capacity and spent lavishly on decor with an eye to attracting high-end clients, despite accumulated evidence that this strategy didn’t work.  This created overhead that would be impossible to cover during the long off-season. He took out very large loans that he personally guaranteed–an unusual and risky move.  He was saved from personal bankruptcy when his public company, Trump Hotels and Casinos (DJT), collapsed only by his creditors’ decision that loan collateral would be worth less if the Trump myth were shattered.  To give him credit, he survived and ultimately did not lose the money he inherited.  Equity and junk bond holders, however, lost virtually everything.

 

 

 

 

the Huawei questions

Huawei is a Chinese telecom company.  It makes niftier smartphones than Apple and has 5G technology that’s better than anything US companies can offer.  The company is certainly a competitive threat to US cellphone makers, as well as to manufacturers of telephone equipment worldwide.

The question that arises with a firm like Huawei, also the perennial question raised about dominant US tech companies since WWII, is the degree to which Huawei will act in the national interest of China.  That is, can/will Beijing eavesdrop on conversations or collect/alter data being carried on Huawei networks–maybe even stop them operating, if Beijing so chooses.

The Trump response to Huawei’s technological edge has been two-fold:  to blacklist Huawei, and to aid its US rival, Qualcomm.

Two questions:

1.is this the proper response?   …or is it like Mr. Trump’s invoking national security to price better-performing Asian and European cars to unaffordable levels, forcing citizens to buy US automobiles that three-quarters of the population now shun?

I’m guessing the former.

 

2. does Mr. Trump have a strategy?   Has he thought out the consequences of what he’s doing?

Here my guess is no.  Otherwise, he would have been promoting science education and welcoming skilled foreign scientists, rather than compelling tech firms to relocate their tech hubs to Canada and elsewhere.

(An aside, sort of:  I was recently listening to a podcast which dealt with Mr. Trump’s weak record in real estate by saying that he was rich before he started in the family business and he remained rich after negotiating treacherous waters during the 1980s.  Really?

My read of the president’s career:  he ended (prior to licensing his name and performing in a reality show) with about as much money in real terms as he started with.  So in that highly technical sense what the podcast said is right.  Over the same period, however, a run-of-the-mill real estate developer made, adjusting for risk, four times what Trump did.  A really competent real estate person might have made 10x.  In achieving his result, Mr. Trump was also aided by the public listing, debt refinancing and subsequent bankruptcy declaration of his Atlantic City casinos.  Although Mr. Trump prevailed in the litigation that ensued, as a professional investor I find this an eyebrow-raising episode.

Mr. Trump was “successful” in running a business in the sense that he went fishing during a time when tons of fish were jumping into the boat and he came back with the boat.  Nothing in it …though he was in the area where the most fish were to be had   …and he was soaking wet in a way that suggested he fell out at some point.

I’m also extrapolating from that.)

investment implications?

Throughout my investing career, politics has never made much of a difference.  In fact, to my mind professional investors who based their decisions on reading Washington’s runes simply revealed the poverty of their thought.  I think now is different.  Mr. Trump has exposed the surprising weakness of Congress.  The reality of China as a rival superpower to the US has been made clear.

Unfortunately, Mr. Trump is executing an early twentieth-century strategy to solve a twenty-first century dilemma.  Arguably, but not necessarily, this is a drama where the US is playing the role of post-WWI Britain and China is the 1920s US.  We all know how that worked out. By simultaneously discouraging innovation at home and forcing China to up the pace of its own tech progress, I think the administration is auditioning for the UK part, and thereby potentially doing significant long-term harm to the economy.  Ironically, those hurt most badly will likely be Mr. Trump’s most rabid supporters.  Withdrawal from the Trans Pacific Partnership, for example, is already putting US farms at a disadvantage vs. Australian, Canadian and New Zealand rivals.

What to do?

I’m taking a two-pronged strategy in the US.  I’m looking for companies with worldwide reach and innovative products.  For domestically-oriented companies, I’m taking an approach that might be called, for lack of a better term, “value with a catalyst” (regular readers will likely know that I don’t believe traditional value works any more in the US).  This term usually means a value stock where a turnaround has progressed far enough that the path for the firm to return to health can be identified.  E.g., the stock is trading at 20% of book value in an environment where healthy firms are trading at book.  Only “deep” value investors might be interested.  Then the company recruits a CEO who’s a turnaround expert and the stock begins to trade at 30% of book–this is value with a catalyst.  I’m not so interested in book, though.  I’m looking at price/cash flow.

I’m also looking harder in the Pacific Basin.  I’m even thinking about the EU, although that’s an area where market participants have a thorough value orientation and where lots of local market lore is needed to be successful.  So I find it a bit scary–better said, the rewards not worth the effort.

 

 

 

Trump, tariffs, trading

There’s no solid connection among the three topics above, but the title gives me the chance to write about three only-sort-of connected ideas in one post.

The crazy up-and-down pattern of recent stock market trading in the US is being triggered, I think, by Mr. Trump’s tweets about trade–and about tariffs in particular.  I think a lot of the action is being caused by computers trading on the President’s tweets themselves, or some derivative of them–likes, media mentions, reflexive response to stock movements (or a proxy like trading volume).

my thoughts

–it’s hard to know whether the misinformation Mr. Trump is spewing about tariffs is art or he simply doesn’t know/care.

Tariffs are paid to US Customs by the importer.   In some small number of instances, a Chinese exporter may have a US-based, US-incorporated subsidiary that imports items from the parent for distribution here.  In this case, a Chinese entity is paying tariffs on imported Chinese-made goods.  To that degree. Mr. Trump is correct.  Mostly, however, the entity that pays a tariff on Chinese goods is not itself Chinese.

This is not the end of the story, however.  The importer will attempt to recover the cost of the tariff through a higher price charged to the US consumer and/or through a discount received from the Chinese manufacturer.  In the case of washing machines, which I wrote about recently, for example, all US consumers ended up paying enough extra to cover the entire tariff  …and some paid more than 2x the levy.  The prime beneficiaries of this largesse were Korean companies Samsung and LG.

–one of the oddest parts of the current tariff saga is that Mr. Trump has decided not to work in concert with other consuming nations.  In fact, one of his first actions as president was to withdraw from the international coalition attempting to curb China’s theft of intellectual property worldwide.  The Trump tariffs are only bilateral, so there’s nothing to stop a Chinese company from shipping a partially assembled product to, say, Canada, do some modification there and reexport the now-Canadian item to the US.

The administration has been artful in selecting intermediates rather than consumer end products for its tariffs so far.  This makes it harder to trace price increases back to their source in Trump tariffs.  However, the fact that the administration has taken pains to cover its trail, so to speak, implies it understands that tariff costs will be disproportionately borne by Americans.

 

–in trading controlled by humans, a lot of tariff developments should have been baked in the cake a long time ago.  Continuing volatility implies to me that much of the reacting is being done by AI, which are learning as they go–and which, by the way, may never adopt the discounting conventions humans have employed for decades.

 

–I think it’s important to examine the trading of the past five days (including today as one of them) for clues to the direction in which the market will evolve.  Basically, I think the selling has been relatively indiscriminate.  The rebound, in contrast, has not been.  The S&P and NASDAQ, for example, are back at the highs of last Friday as I’m writing this in the early afternoon.  The Russell 2000, however, is not.  FB is (slightly) below its Friday high; Netflix is about even; Micron is down by 4%.  On the other hand, Microsoft and Disney are 1% higher than their Friday tops, Paycom is 2.5% up, Okta is 5% higher.

No one knows how long the pattern will last, and I’m not so sure about DIS, but I think there’s information about what the market wants to buy in these differences.   And periods of volatility are usually good times for tweaks–large and small–to portfolio strategy.  This is especially so in cases like this, where the movements seem to be excessive.

One thing to do is to confirm one’s conviction level in laggards.  Another is to check position size in winners.  In my case, my largest position at the moment is MSFT, which I’ve held since shortly after Steve Ballmer left (sorry, Clippers).   I’m not sure whether to reduce now.  I’d already trimmed PAYC and OKTA but if I hadn’t before I’d certainly be doing it today.  I’d be happiest finding areas away from tech, because I have a lot already.  On the other hand, I think Mr. Trump is doing considerable economic damage to American families of average or modest means, with no reward visible to me except for his wealthy backers.  Retail would otherwise be my preferred landing spot.

–Even if you do nothing with your holdings now, make some notes about what you might do to rearrange things and see how that would have worked out.  That will likely help you to decide whether to act the next time an AI-driven market decline occurs.