Tail Risks: Trade War

Tail risks for August - the monthly Merrill Lynch fund manager survey is out. As you can see from the chart below, the August risks have changed from July. The risk of a trade war is about the same. This makes sense because there hasn’t been a resolution nor an escalation to the point where it affects the economy in a substantial way.

We seem to be at the edge of the proverbial cliff where in a few months the trade skirmish will either become a real trade war or there will be a resolution. Personally, I think neither option will happen in the near term because politicians love to kick the can down the road.

President Trump certainly has no reason to give in because the American economy is doing well. China is doing poorly, but the tariffs are too small to be the main reason why it is floundering.

Trump could be considering issuing a major tariff to force China to act because China is already in bad shape. However, it will hurt him politically if China doesn’t give in right away. Therefore, he might be waiting for its economy weaken further before trying this tactic.

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Tail Risks: QT

The two new risks listed in August are quantitative tightening and a China slowdown. The quantitative tightening has been ongoing since October in America. However, I think it’s better to look at all three major central banks’ balance sheets. As you can see, the year over year increase in their assets has declined sharply from late 2016.

The Fed has unwound part of its balance sheet and the ECB has tapered its buying. The ECB’s purchases will end in December. The American economy has done fine during this period. You would think it would be hurt the most since its central bank is pulling back the most.

You can make the case that the decline in the growth of the major central banks’ balance sheets is causing emerging market weakness, but I don’t like to follow the train of thought which blames everything that has gone wrong on QE.

The Fed’s rate hikes have more of an impact on their markets than letting some of the long-term treasuries and mortgage-backed securities on its balance sheet expire without being bought again. If the market was going to crater because of the decline in the major central banks’ balance sheets, it would have done so by now. The rate of increase is down by more than half and it’s widely expected that growth will be negative next year.

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Tail Risks: China

You can look at the Chinese economic data or the markets to see the country’s economy is falling back after it outperformed in 2017. Retail sales in July were up 8.8% which was 0.2% less than in June.

The top 50 retailers had a 3.9% decrease in sales. Car sales were down, partially because of tax subsidies last year bringing demand forward and partially because of expensive housing. The debt to income ratio for the Chinese hit 107% at the end of 2017. Investment in infrastructure from January to July was only up 5.5%. This is the slowest growth rate since it started being tracked in 1995.

Growth is down 0.5% from the January to June period. Regional governments and state-run banks are trying to reduce their debt instead of invest.

Exports were up 12%, but in areas where the tariffs occurred, growth was stunted. It shows how bad a real trade war would be for the beleaguered economy. Robot exports were only up 7% in June and 6% in July after increasing 35% in May.

This deceleration occurred because of the 25% tariff America put on robots in July. Shenzhen had an 11% decrease in exports from April to June. Finally, unemployment in the top 31 cities increased 0.3% in July to 5% which is the highest rate since December.

As I mentioned, the weak economic stats aren’t the only way to tell China is flailing. The markets say the same thing. The Bloomberg commodities ETF is down 3.14% year to date as Chinese demand isn’t where it was expected to be. Oil prices are about to be down 7 weeks in a row as global growth is expected to disappoint.

China has been the biggest driver of global growth in this cycle. The Shanghai Composite index was down 2.08% on Wednesday and it is very close to its recent low made on August 9th. The data suggests it will fall below that trough. The headlines are focusing on the weakness in Turkey, but China is the key driver of the emerging market declines.

Tail Risks: U.S. Small Businesses Are On Fire

The bears have been incorrect for a few quarters in their claim that small business optimism is bad news for the economy because it’s a sign of a peak. If optimism is based on sustainable factors like the tax cuts and the regulation restrictions, there’s no reason to believe the economy will suddenly implode because small businesses are doing well.

As you can see from the chart below, the July NFIB index increased from 107.2 to 107.9. It beat the high end of the consensus range which was 107.5. This is the second best report in the history of this survey. It is 0.1 away from the July 1983 record high, meaning it is the highest in this cycle.

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Three of the ten components were up 3 points, driving the overall index slightly higher. The three were net plans to increase employment (23%), net expecting real sales to be higher (29%), and net saying now is a good time to expand (32%).

Small businesses are creating an impressive amount of jobs. Small businesses added 0.37 workers per firm on average which is the largest increase since July 2006 and almost double June’s rate. As you can see from the chart below, 60% of the small businesses in the NFIB have 1-5 employees.

Very few have more than 100 workers. Each worker that is hired is a big deal on a percentage basis.

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