WEEK OF DECEMBER 10, 2018 Weekly Relative Value · 2016 when China’s economy and capital markets were reeling in the aftermath of the yuan devaluation and Shanghai Composite bubble

Weekly Relative Value

Tom Slefinger is Senior Vice President, Director of Institutional Fixed Income Sales at Balance Sheet Solutions.

www.balancesheetsolutions.org

WEEK OF DECEMBER 10, 2018

The Tariff Man

Look, up in the sky! It’s a bird, it’s a plane, no, it’s Tariff Man!

America, meet your newest superhero. Okay, it’s not a real superhero. But it is Trump’s latest nickname — for himself.

“Tariff Man” seems to be a bit hazy on what his superpowers actually do. He believes in protectionist trade policies even though it’s not clear he understands why.

This is the reality. Tariffs are taxes paid by Americans. Tariffs raise costs for U.S. consumers and businesses. And the U.S. economy is highly dependent on consumption. It’s just another example of Trump taking a tiny germ of truth and blowing it up to the point where it’s absurd, for political purposes.

THIS WEEK… • Presidents and the Stock

Markets

• Trade Deficits Explode

• Payrolls Underwhelm

• More on the Yield Curve

• Is a Recession Coming?

• More Warning Signs

• Think About This

PORTFOLIO STRATEGY

“I am a Tariff Man. When people or countries come in to raid the great wealth of our Nation, I want them to pay for the privilege of doing so. It will always be the best way to max out our

economic power. We are now taking in $billions in tariffs.” – President Donald Trump via Twitter

“That’s not really how tariffs work. The U.S. may be generating some revenue from tariffs, but billions of dollars aren’t pouring in. Moreover, a lot of the money that is made off of

tariffs comes from U.S. consumers — not Chinese companies.” – Emily Stewart, Vox journalist

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 2

www.balancesheetsolutions.org

U.S. manufacturers have complained loudly about the impact of the recent tariffs on steel and aluminum on their cost of materials relative to that of their foreign competitors. The tariffs have spread to cherries, soybeans, Harley Davidsons, lobsters, nails and countless other products.

Tariffs are also a form of government meddling in economic activity: Applying different tariff rates to different items from different countries interferes with market signals and reduces efficiency. The net effect of all this, at least in standard economic theory, is that tariffs make society poorer.

This textbook argument against tariffs is widely accepted among academic economists. It may be one of the least controversial claims within the profession.

And clearly the stock market wants nothing to do with tariffs. The week actually started on a high note following the apparently positive meeting between President Donald Trump and his Chinese counterpart, Xi Jinping, amidst the G20 Summit in Buenos Aires, Argentina the previous weekend. The truce in the trade wars ended abruptly Tuesday, with a 799-point plunge in the Dow Jones Industrial Average, after Trump declared himself “a Tariff Man.”

PRESIDENTS AND THE STOCK MARKET

The graph below shows S&P 500 returns measured from each presidential election day to the next presidential election day. As one can glean from the graph, under the leadership of Presidents Bill Clinton, Ronald Reagan and Barack Obama, the S&P generated gains of 171.6%, 92.1% and 91.8%, respectively. On the losing end of the spectrum, Presidents George W. Bush and Richard Nixon sat in the Oval office as the S&P dropped 31% and rose only 1.1%.

Regardless, U.S. presidents, for better or worse, get too much credit for the economy and stock market performance… unless they really mess up. Perhaps Nixon goes in that category, and the jury is still out on the current occupant of the White House.

Nevertheless, it’s instructive to recall the touches — some light, some heavy — that presidents have had on the markets.

If this current mess gets much worse, don’t be surprised if history holds “Mr. Tariff Man” accountable.

S&P Performance by President

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 3

www.balancesheetsolutions.org

TRADE DEFICITS EXPLODE

Donald Trump has done so much in the name of protectionism to reduce the U.S. trade deficit, yet the gap actually hit a 10-year high in October — widening 1.7% to $55.5 billion — on the back of the tariff induced run-up in import demand. The wider trade gap comes at the start of a quarter in which the economy already is projected to moderate.

But the most notable, and politically-relevant observation by far, was the sharp plunge in Chinese imports from the U.S., which tumbled 25% in November from a year earlier. This was the single biggest monthly decline since January 2016 when China’s economy and capital markets were reeling in the aftermath of the yuan devaluation and Shanghai Composite bubble bursting.

As a result of this plunge in imports from the U.S., the trade surplus with the U.S. was almost $35.6 billion, facilitated by the 9.8% rise in exports, and the goods trade gap with China widened to a record of $43.1 billion in October from $40.2 billion.

Record Deficits with China

“No one wins in a trade war.” – The National Association of Manufacturers

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 4

www.balancesheetsolutions.org

PAYROLLS UNDERWHELM

November non-farm payrolls came in at +155 thousand — the consensus was closer to +200,000. Looking at the more meaningful three-month moving average, growth in payrolls has slowed to 170,000 through November from the average of 200,000 through most of 2018. Despite the lower-than-expected job gains, one could argue these are solid results, particularly given the constrained supply of skilled labor. The headline unemployment rate stayed at its drum-tight 3.7% level.

However, beneath the surface, signs of weakness are appearing. One can detect some labor market slack creeping back in as the broader U-6 index rose from 7.4% to a five-month high of 7.6%. And those working part-time “for economic reasons” surged by 3.9% or 211,000. This is another metric foreshadowing tougher times ahead.

But the real kicker, according to David Rosenberg, was the 0.2% shrinkage in the workweek to a 14-month low of 34.4 hours from 34.5 in October. While that doesn’t sound like much, it’s the equivalent of 370,000 people getting laid off, he writes.

On the all-important wage front, the average hourly earnings figure rose 0.2% instead of +0.3%. Year-over-year wages have risen 3.1%. This is great news for Americans. However, average weekly income dipped 0.1% last month. This was the first negative reading in work-based pay since the turn of the year.

Meanwhile, layoff notices, as compiled by Challenger Gray & Christmas, total 495,000 so far this year – up 28% from the comparable period a year earlier, and the highest 11-month total since 2015, when there were 475,000 job cuts. Challenger’s data show that corporate cost-cutting spiked to a 12-month high. These are the early signs of an economy making the transition out of a long expansion, just as the stock market has been making this same transition all year long out of the elongated cyclical bull market.

MORE ON THE YIELD CURVE

Last week, the most widely discussed topic was the flattening of the Treasury yield curve. Of special note, the 2s/5s and 3s/5s curves actually inverted as shown below.

Yield Curve Inverts in the Short End

“The economy is poised to weaken… The Treasury yield curve from two- to five-year maturities is suggesting total bond market disbelief in the Federal Reserve’s prior plans to raise rates through 2019.”

– Jeffrey Gundlach (aka the Bond King)

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 5

www.balancesheetsolutions.org

And the highly watched, all-important 2s/10s curve flattened sharply. Historically, the spread between the 10-year and two-year Treasury rates has been a good predictor of economic recessions. Five quarters ago, the 2s/10s Treasury curve was over 80 basis points. Today, that spread has since narrowed to a mere 14 basis points. We are now deep into the warning zone. Every time the 2s/10s spread has turned negative, a recession has followed.

That said, it takes on average 12-18 months between inversion and a recession. The shortest length of time has been nine months. Therefore, the countdown hasn’t started but it’s getting closer. And while the curve is not inverted as of yet, the trend of the spread is clearly warning the economy is much weaker, as many mainstream economists suggest. (The boosts to economic growth from tax cuts and fiscal spending are now all beginning to fade and will begin to become more problematic starting in the fourth quarter.)

Recession on the Horizon?

The bottom line: Whether or not the curve inverts, its pattern of flattening bakes in the cake a meaningful economic slowdown in 2019.

Furthermore, we have seen double-dip downturns in the euro area and Japan without their curves inverting, so the lesson is that it may just take nothing more than a general rise in the interest rates. And the entire interest rate structure in the U.S. has risen a non-trivial 200 basis points — and that turns into more than 300 basis points of equivalent central bank tightening once the effects of the balance sheet unwinding are considered.

Will the Fed Hike Until Something Breaks?

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 6

www.balancesheetsolutions.org

IS A RECESSION COMING?

Trump has proclaimed this is the strongest economy ever. The reality is that much of the current strength in economic activity is not from organic inputs in a consumer-driven economy, but rather from one-off impacts of several natural disasters, a surge in consumer debt, and a massive surge in deficit spending. The problem is the massive surge in unbridled deficit spending only provides a temporary illusion of economic growth. Over the long-term, debt leads to economic suppression.

There are many who continue to suggest “this time is different” and the yield curve is not signaling a recession. But it is unwise and perilous to bet against a leading indicator that has worked with near precision over the past seven decades. And while the Fed believes they can engineer a “soft landing,” a quick trip though the Fed’s rate hiking history and “soft landing” scenarios gives you some clue as to their success. In fact, 10 out of 13 rate hike cycles have led to a recession. In other words, 84% of the hiking cycles have ended with the U.S. economy in recession. Then again, if it weren’t for consensus economists, Albert Einstein never would have felt it necessary to publish his own definition of insanity.

Fed Rate Hikes and Recessions?

First Hike Last Hike Result

Oct -50 May-53 Recession

Oct-55 Aug-57 Recession

Sep-58 Sep-59 Recession

Dec-65 Sep-66 Soft Landing

Nov-67 Jun-69 Recession

Apr-72 Sep-73 Recession

May-77 Mar-80 Recession

Aug-80 Dec-80 Recession

Mar-83 Aug-84 Recession

Jan-87 May-89 Soft Landing

Feb-94 Feb-99 Soft Landing

Jun-99 May-00 Recession

Jun-04 Jun-06 Recession

Dec-15 ??? ???

The current economic cycle will soon rival the 1990s cycle, which was built off the productivity and wealth effects of the Internet mania, whose economic benefits were real. This is in stark contrast to this cycle, which has been built on a house of straw from relentless central bank liquidity infusions.

And while economic cycles don’t die of old age, if history has taught us anything, it is that cycles, up or down, do not last indefinitely — they all die at the hands of the Fed, and this one is no different. Not to mention, at 10 years of age, this current one is very old, and the laws of longevity are taking over.

“This is the greatest economy that we've had in our history, the best.” – Donald Trump

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 7

www.balancesheetsolutions.org

Investors shouldn’t panic purely on the basis of what the yield curve is telling them. However, it makes sense to gradually shift to a more defensive stance as the economic cycle matures. In other words, now is not the time to be a market-timer, but rather, a risk-manager.

MORE WARNING SIGNS

Treasury yields and the yield curve are pointing to slower growth. And there are many other indicators suggesting higher rates are impacting economically important areas of the economy. As has been noted in this space quite recently, housing and auto sales have weakened. In addition, we are seeing falling commodity prices — notably key industrial inputs such as crude oil and copper. This is consistent with signs of a slowdown.

And last week, we received new that U.S. factory orders tumbled in October – dropping 2.1% month-over-month (worse than expected), the biggest drop since July 2017.

Furthermore, the final durable goods orders data dropped 4.3% month-over-month (much worse than the 2.4% drop expected). All of which is sending warnings about the U.S. economy.

Is this the same U.S. economy that has “never been better”? Is this the same economy that the Fed was so exuberant about just a month ago?

Likewise, the stock market is a strong leading indicator of economic turns, and the turmoil this year may be signaling that the economy is slowing rapidly.

Last week’s equity losses ranged from 4.5% to almost 5% for the major U.S. equity indexes, the worst showing since the week ended March 23. In dollar terms, investors in U.S. stocks wound up the week some $1.4 trillion lighter in their portfolios. The S&P 500 is down 1.5% for the year (and recall it enjoyed a nearly 8% surge in January).And that made this the worst start for a December (historically the market’s best month of the year since 1950, according to the Stock Trader’s Almanac) since 2008, when the major averages fell from 5.1% to 5.9% in the first four sessions of the month.

Stock Market Anxiety

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 8

www.balancesheetsolutions.org

The list of worries is very, very long.

Whether it’s the China trade deal, Brexit, the inverted yield curve, excessive valuations, peak growth, monetary policy or the next Presidential tweet, stock investors are on pins and needles worried about something at all times.

Keep in mind that there is nothing the Fed can really do at this point unless it decides to ease policy, which would be lunacy at this point given a 3.7% jobless rate. The market has all but priced out the central bank as it now stands, so this source of support is already “in the price.”

THINK ABOUT THIS

At the July 31-August 1 Federal Open Market Committee (FOMC) meeting, the Fed economics staff delivered a presentation to the Committee titled Monetary Policy Options at the Effective Lower Bound. Here’s the rub: The Fed is already talking about the next recession, probably coming sooner than many expect, and that the policy thrust will be back towards zero rates. The only debate is what else will be in the policy toolkit and will it be enough to put a floor under the economy.

But if in the next couple of years, the policy rate heads back to the zero bound, Treasury yields will melt, and even large-scale fiscal deficits will not prevent this from happening. Note that quantitative easing, or other balance sheet adjustments, will come back to the fore.

So, what if we end up in a recession and the Fed comes to the rescue?

What can we expect will happen with interest rates?

The recent past may provide the best clues.

In the seven-year period when the Fed held the funds rate near zero from December 2008 to December 2015: the two-year Treasury note yield averaged 0.5%; the five-year averaged 1.5%; the 10-year averaged 2.6%; and the long bond averaged 3.5%. Those were the averages, but the lows were 0.15% for the two-year note; 0.54% for the five-year; 1.39% for the 10-year; and 2.22% for the long bond.

It is key to note that the Fed is already talking about the next recession, what to do about it in addition to cutting rates back to zero, and openly questioning whether any such action will work! Not just that, but these periods of unconventional policy easing are likely to be the norm for some years to come (does sound a bit Japanese, doesn’t it?).

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 9

www.balancesheetsolutions.org

You don’t need to be a market timer to know that now would not be a bad time to add some duration to your portfolio.

Clearly, the bond market has picked up on that realization as the 10-year interest rate has declined from 3.23% in early October to back below the 3% mark.

Mr. Bond Says...

MARKET OUTLOOK AND PORTFOLIO STRATEGY

The November jobs report was good enough for the FOMC to raise its federal funds target rate range by 25 basis points to 2.25%-2.5% at its December 18-19 meeting. Fed fund futures are assigning a 76.6% probability, down from 82.7% a week earlier but up slightly from 74.6% a month ago.

The big change has come in expectations for 2019. The futures market is giving a bit better than even-money odds for one additional hike of at least of 25 basis points by the end of next year. A month ago, the futures market put nearly two-to-one odds (a 62% probability, to be precise) for two 25-basis-point hikes by the end of 2019. That still was short of the median projection of three hikes by the end of 2019 in the FOMC’s most recent “dot plot,” released following its September 25-26 meeting.

One and Done?

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 10

www.balancesheetsolutions.org

From a broader perspective, the highly leveraged U.S. economy seems to be slowing, falling under the weight of higher borrowing costs. The sugar high from the tax cuts and fiscal spending will be waning. Outside the U.S., global economies are weakening and could get weaker.

Meanwhile, inflation is well-contained. Keep an eye out for the Producer Price Index and Consumer Price Index releases this week. For all of you who left town riding on the “inflation train,” welcome back. More recent data suggest that concerns about the economy overheating and inflation breaking above the Fed’s 2% target were premature at best. Even within the Phillips Curve model — which holds that inflation is caused by too many folks working — there seems little cause for concern.

All of which bolsters the likelihood that the Fed will go slow on rate hikes in the new year. “One and done” has become the new mantra in the markets. That was reflected in massive short-covering in the euro-dollar futures market on Thursday, as indicated by a huge decline in open interest (the number of open contracts.)

The overriding theme as we move forward will be quality and liquidity. In terms of portfolio strategy, we continue to recommend that credit unions remain fully invested while maintaining a risk appropriate high-quality ladder strategy.

PREMIER PORTFOLIO

For the first time, Balance Sheet Solutions, LLC credit union clients are now able to perform many of their daily investment activities all in one location, including…

• Access Documents and Reports Easily access key documents, monthly statements and overall market analyses.

• View Portfolio Holdings See current investments online and easily export into a spreadsheet format.

• View and Buy Offerings Review a list of available security offerings and highlighted specials – place “buy” orders right from the convenience of your desk, AND… connect directly into the SimpliCD website to make CD purchases.

• Quickly View Current Rates Stay in the know – view daily rates in the same location where purchase decisions are made.

• Read Daily Commentary & Weekly Relative Value Gain access to educational content that tracks market and economic trends, analyzes key releases and watches ongoing political developments. Understand the impacts of current events on credit unions.

Watch the overview video here: www.alloyacorp.org/premierportfolio

MORE INFORMATION

For more information about credit union investment strategy, portfolio allocation and security selection, please contact the author at [email protected] or (800) 782-2431, ext. 2753.

Tom Slefinger, Senior Vice President, Director of Institutional Fixed Income Sales, and Registered Representative of ISI, has more than 30 years of fixed income portfolio management experience. He has developed and successfully managed various high profile domestic and global fixed income mutual funds. Tom has extensive expertise in trading and managing virtually all types of domestic and foreign fixed income securities, foreign exchange and derivatives in institutional environments.

BALANCE SHEET SOLUTIONS WEEKLY RELATIVE VALUE | 11

www.balancesheetsolutions.org

At Balance Sheet Solutions, Tom is responsible for developing and managing operations associated with institutional fixed income sales. In addition to providing strategic direction, Tom is heavily involved in analyzing portfolios, developing investment portfolio strategies and identifying appropriate sectors and securities with the goal of optimizing investment portfolio performance at the credit union level.

Information contained herein is prepared by ISI Registered Representatives for general circulation and is distributed for general information only. This information does not consider the specific investment objectives, financial situations or needs of any specific individual or organization that may receive this report. Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities. All opinions, prices, and yields contained herein are subject to change without notice. Investors should understand that statements regarding prospects might not be realized. Please contact Balance Sheet Solutions to discuss your specific situation and objectives.