Take That, China

In last week’s commentary I mentioned that the Treasury does a biannual review on the currency practices of foreign governments. In five such reviews under the Trump administration, the Treasury department has declined to label China as a currency manipulator. That all changed yesterday.

For most market watchers, it seems rather obvious that China does indeed manipulate their currency. As one of the few currencies that is not allowed to float freely (the PBOC sets a reference rate each day and allows the yuan to trade 2% above or below that level), China’s yuan is at the very least “managed.”

However, there are three main criteria used to determine currency manipulation, and until recently, China was not meeting these criteria. They include active intervention in the currency market, having large trade surpluses with the U.S., and having large overall current account surpluses.

It’s the first and third of these criteria that China has generally failed to meet. In the chart below, which shows the strength of the yuan, we can see that from the end of the financial crisis until about 2015, the yuan appreciated strongly against the dollar – hardly the doing of a “currency manipulator.”

Yuan vs. Dollar Exchange Rate

In addition, while China does maintain a large trade surplus with the U.S., it’s total current account surpluses have been falling steadily over the past decade (chart below). This suggests that the yuan is more fairly priced against the currencies of other countries with which China trades.

China's Current Account Surplus

But yesterday, in response to the yuan falling below the highly watched 7 yuan-to-the-dollar level (see first chart above), the Treasury Department officially labeled China a currency manipulator. What does this mean? In reality, not a whole heck of a lot.

Any time a country suffers an exogenous shock to their ability to export, a drop in the currency exchange rate is expected. The U.S. just administered this type of shock via the proposal for additional tariffs. However, because China’s central bank closely monitors the currency, and has the ability to intervene, they are being viewed as complicit in the move because they passively allowed the currency to fall.

So China is now officially labeled a currency manipulator by the U.S., but as I just mentioned, this doesn’t mean much. The primary goal of applying that designation is to justify some form of retaliation. But as we know, the U.S. doesn’t need, or really even care about, any such justification.

Thus, the main question is, what happens from here? And the first thing to note is that China can’t really let their currency continue to fall. As we saw back in 2015, a big drop in the yuan has the potential to increase capital outflows, which causes its own set of problems. In addition, China must be wary about putting too much pressure on both importers and Chinese companies that have issued dollar-denominated debt.

Here in the States, this latest bout of action is driving increased expectations for further Fed easing. Market participants now expect a 100% chance of a rate cut at the upcoming September meeting, with 16.5% of those folks anticipating a 50 basis point cut.

Target Rate Probabilities for September 2019 Fed Meeting

The expectation of easier monetary policy is helping to buffer the market, but with corporate profit growth remaining flat, valuation levels somewhat elevated and leading indicators continuing to deteriorate, it seems near-term risk is to the downside.

Before we shift our focus to the stock market, I briefly want to point out the massive inversion this has caused in the yield curve. As you can see below, the yield curve (red line) is now inverted all the way out to almost the 20 year mark.

U.S. Yield Curve

In addition, as you can see from the historical black shadow, the entire yield curve has come down substantially in recent weeks. This reflects pessimism with respect to U.S. economic prospects, but remember that this move also reflects economic stimulus. Lower rates facilitate increased spending and investment, and we are seeing lower rates across the board.

Thus, as is typically the case (scratch that – always the case), we have competing forces trying to pull the economy in different directions. Which forces will win out? If only we could know that with certainty …

Here are a few things we need to consider. While most coincident economic data remains fine, one of the more troubling developments we’re seeing is the deterioration in the ISM services index, pictured below.

ISM Services Index

We know that manufacturing has been on the ropes for some time, but manufacturing only accounts for 11.6% of U.S. economic output (Bureau of Economic Analysis), and about 8.5% of the workforce (Bureau of Labor Statistics). The vast majority of our economy is service based, and services have, until recently, remained resilient.

To be clear, the services component of the economy continues to expand, but its rate of expansion is slowing. Interestingly, this metric’s sister index – the IHS Markit Services PMI – is in a three month uptrend, but the latest reading for July was quite similar at 53.0.

This same dynamic is evident at the global level as well. As we can see from the JP Morgan global PMI below, global manufacturing (thin, dark line) is now contracting, while services (thin, gray line) have slowed but remain in expansion territory.

JP Morgan Global PMI

The composite line (thick, dark line), which tracks services better than it does manufacturing (since the global economy is also weighted toward services), remains in a downtrend, but is beginning to show signs of life. Last month’s reading was essentially flat from the prior month, but the most recent reading showed an uptick from 51.2 to 51.7. Could we be in the process of a troughing of global economic activity?

That’s certainly possible, but it’s still too early to tell. Even if global conditions are beginning to improve, the latest ratcheting up of trade tensions could put the kibosh on any nascent growth. But at least for the moment, it seems the global economy continues to expand.

Now let’s check in on price action to see what the major averages are telling us. After a big fall yesterday, volatility has continued today, but the bias has been to the upside. This could be nothing more than a dead cat bounce, but so far we remain in a longer-term uptrend (higher-highs, higher lows) and we have solid support beneath us.

S&P 500 Index

Both the 200-day MA (at 2790) and recent support near 2730 should act to slow downside momentum, but it wouldn’t surprise me to see us reach those levels. The retaliatory nature of this trade conflict seems to have shifted up a gear, and negative developments could easily take another 5% off the market.

That said, U.S. economic fundamentals remain okay for now, and so if we do reach those levels it will likely provide a good entry point. Recall that at least thus far, every drop that we’ve seen on trade worries (or even Fed concerns) has turned out to be a buying opportunity. That won’t always be the case, as inevitably the economy will roll over, but for now I believe the probabilities are still weighted in favor of that.

If that suggestion makes you nervous, remember that prior to Trump’s tariff tweet, the S&P was above 3000 and moving higher for the day. We also have a Federal Reserve that is very market conscious, and who is willing to use their ammo in the near-term to help abate trade-related risks. Finally, let’s also not forget that stocks remain the only game in town, since most bonds offer essentially a 0% real return.

Another chart that is likely to please many of you is that of gold. Gold built out a nice base above strong 5-year support during the past month, and is heading higher. It’s nearly impossible to predict how far the run will go, but we’re in the type of environment that gold thrives in – low interest rates (low opportunity cost) and loads of uncertainty.

Gold Spot Price

So enjoy the rise in gold, maintain your core positions in equities, and if you’ve raised any cash as the market hit new highs recently, you can begin looking for an opportunity to put some of it back to work at lower levels.

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