Week of May 27, 2019 – Lecturing Trader – Medium


Photo by Rick Tap on Unsplash

The United States’ stock markets closed down for the third consecutive week last week, with the S&P 500 down about 3.3% from the high it made on May 1. The trade war between the US and China doesn’t look like it’s going to end anytime soon — contrary to just a few weeks ago when expectations were high that the negotiations would be successfully resolved “any time now” — as there are no additional talks planned between the two sides. The earliest meeting between President Donald Trump and President Xi Jinping is scheduled to occur on the sidelines of the G20 summit in Japan at the end of June, and given the hardline positions taken by both sides, it is unlikely that this meeting is going to make any difference. This situation is less about specific trade-related grievances and more about re-factoring global trade with a view of dominating the world for the foreseeable future. The now dominant USA is being challenged by relative newcomer China on the world scene in the areas of trade, defense, and technology.

While China has been pursuing a strategy of building relationships (to put it kindly) with various countries across the world with missionary zeal, President Trump, in contrast, has been alienating time-tested allies (mainly the Eurozone and other developed countries) on various issues rather than nurturing those relationships and building global consensus around China’s rise. Fortunately, he has now postponed imposing duties on European automobile imports for six months, a significant move in its own right, as automotive goods are a bell-weather for the EU and a broad duty on automotive goods would likely have tipped the EU into recession.

The trade war is already hurting the US economy. According to the latest IHS Market survey, the Flash US Composite Output Index fell from 53.0 in April to 50.9 in May (a 36-month low). Flash US Services Business Activity Index also fell from 53.0 in April to 50.9 in May (a 39-month low), and Flash US Manufacturing Purchasing Managers’ Index fell from 52.6 in April to 50.6 in May (a 116-month low). Any value above 50 is considered expansionary and values below 50 indicate economic contraction. PMI and business activity numbers are beginning to trend towards contraction, and these disappointing numbers can be attributed to slowing demand and subdued growth in new orders. The most alarming observation in this month’s IHS report pertains to the softest rise in new business since recording of this data point began in October 2009. The pace of hiring was also the lowest in more than two years. Durable goods orders — excluding defense — was down 2.5% for the month of April and this is the largest fall since January 2018. Economists at J.P. Morgan now expect slower second quarter growth at just 1.0%, which is way off the 3.2% growth reported in the first quarter.

The US 10-year treasury yield has fallen further to a 19-month low to close last week at 2.324%, which is a drop of nearly 28% from its recent high of 3.230% made in November 2018. This strongly indicates that investors are moving to lower-risk assets. The price action from last week indicates further weakness as the 10-year bond broke a key support level at 2.355. Further, we witnessed yield inversion again between the 1-year note and 10-year bond; this is yet another signal of caution, but it is important to note that this alone does not signal an impending recession.

As I’ve written several times previously, I believe a more definitive (and leading) indicator is the small cap stock index, the Russell 2000, which has been bearish for a few months now, despite the all-time highs made by other indices. Since February 25, the Russell 2000 has been moving in a narrow band between the 1500 and 1600 levels (except for a small excursion upward during the first week of May). Since then, it has been making lower lows and last week it briefly touched the 1500 level before closing at 1514. Breaching of this 1500 level will mean further price weakness, and I’m going to watch this index closely in the coming weeks.

Why does this matter? Small capitalization stocks are more sensitive to taxes and tariffs and provide more realistic — and realtime — feedback on the impact of trade. The price movement of the Russell 2000 contrasts with that of the S&P 500, which gained 5.3% between February 25 and May 2, during which period the Russell 2000 was virtually flat. It is not surprising to me that economists are now expecting second quarter results to disappoint. Lastly, the fact that inflation has remained subdued even with higher tariffs on products imported from China indicates that demand is deteriorating.

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