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Good news! June’s US unemployment rate rose to 4.0% from 3.8% in May.[i] Yep, you read that right: The rising unemployment rate was good news. You see, though a higher unemployment rate sounds bad, a dive into the data can reveal that isn’t always true. Calculation quirks mean the rate can rise for perfectly positive reasons. We believe June is an example—a stark change from nine years ago when the reverse was true. Back then, unemployment rates of 9 – 10% drove fears of high unemployment whacking consumer spending—and those figures likely understated unemployment. Since consumption is 69% of US GDP, many worried joblessness would prolong the recession and bear market.[ii] Today, by contrast, folks often cite jobs data—like June’s report or Thursday’s news initial unemployment claims hit their lowest in almost 50 years—as a reason to be optimistic about stocks or the economy. However, in our view, forecasting where economies and markets go using unemployment data is backwards. The data are late lagging, telling you more about the past than the future.
That investors pay significant attention to unemployment is understandable but, in our view, misplaced. GDP data, consumption, industrial output, purchasing managers’ indexes and most economic data are abstract and hard to relate to. If you, your child, your neighbor, friend or third cousin[iii] lose (or get) a job, that seems more real. Moreover, the notion more employed people means more spending and, hence, economic growth and corporate profits—boosting stocks—seems intuitive. Yet history and how businesses operate suggest it is more the reverse.
Before we go further, let’s discuss what the unemployment rate is—and isn’t. The unemployment rate isn’t the percentage of the population out of work. It is the percentage of the labor force. To be in the labor force, the government says you must either be employed or jobless and actively seeking work in the last four weeks. Hence, if an unemployed person gets discouraged and doesn’t look for a couple months, he or she isn’t counted as unemployed. However, when a healthy economy gives discouraged workers hope—and they start looking—they are added back into the labor force, boosting the unemployment rate. That happened in June, when 204,000 people rejoined the labor force—the reason we called rising unemployment good news. This isn’t unique to America—most developed countries, including eurozone nations, the UK and Japan, compute rates this way.
This week, we offer you quick coverage of the EU once again fining a big tech firm, the hullaballoo over two words the Fed head uttered, trade talk[i] and the “Three California” initiative’s death. As ever, none of these are huge market movers, but they are a collection of small observations we hope are enjoyable—and help inform your market views.
EU Gets Bored, Fines Tech Firm for Being Tech Firm
By now you have probably heard that the EU fined a Tech firm whose trading name rhymes with Floogle for doing what basically all companies who sell an operating system do: Preloading a bunch of hardware with said operating system and pre-installing its own apps. The EU has decided this runs afoul of antitrust laws and ordered the company not to pass Go until it pays $5.1 billion. As this follows the EU’s decision to slap fines on companies whose names rhyme with Flapple and Flarbucks for allegedly avoiding corporate taxes, some observers are worried about an increasingly adventurous Brussels whacking Tech giants with regulatory uncertainty.
Just in time for summer road trips, gas prices are on the rise. Whenever this happens, folks tend to fret fuel expenses eating into their monthly budgets. Many also wonder about its implications for the economy—and right on cue, we have seen a fair amount of fearful headlines in recent days. But while paying more at the pump isn’t pleasant, for the economy overall, spending on gas is still consumer spending that contributes to economic growth. Pricier gas isn’t happy, but the economic and stock market impact is far less than many think.
From the US national average low of $1.72/gallon February 2016 to its recent $2.96 high in May, gas prices have risen 72.1%.[i] Seems like a lot! Some analysts think if they rise closer to $4, economic trouble will follow. They point to rising gas prices in 2000 and 2008 and say they corresponded with subsequent recessions, but that would be cherry-picking. The coincidence of rising gas prices and stock market peaks means nothing without causation, and gas prices had basically nothing to do with the bursting Tech Bubble (2000) or the imposition of mark-to-market accounting on banks’ illiquid, held-to-maturity assets, which led to 2008’s financial crisis. Gas prices nearly tripled from 2002 to 2006, but that didn’t stop a bull market from beginning in October 2002 and running until October 2007. Gas also tripled from 2009 to 2011, and recession didn’t ensue. The economy fared fine while gas was solidly above $3 from March 2011 to October 2014.[ii] Moreover, the recent rise is coming off levels that were low relative to recent history, tied to 2014’s oil price crash.
Exhibit 1: Gas Prices and Growth
Is the Health Care sector under siege from President Trump’s Twitter account? Last Monday, Trump tweet-slammed a large pharmaceutical company (whose name rhymes with Visor) for its recent drug price hikes, seemingly leading the firm to announce the next day it would reverse course.[i] On the surface, this might seem bad for Health Care firms: Trump appears to be making drug policy via tweet, using his bully pulpit to badger companies into cutting prices for fear of bad PR. In our view, however, reality doesn’t quite match that perception. Both the tweet and the company’s response were mostly symbolic. We don’t believe either signals rising regulatory risk in the Health Care space.
While debate abounds over the societal merits of lowering prescription costs (which we aren’t weighing in on), from an investor’s viewpoint, sweeping reform could be a risk. On the campaign trail, Trump’s bold promises to push for such reforms sparked worries of political intervention potentially slashing Health Care earnings. Since taking office, Trump has occasionally talked up policy changes, but little action has followed. First, a May 11 Rose Garden announcement—and Health and Human Services policy blueprint—contained a fairly unambitious slate of prescription drug policy proposals. They were mostly about increasing competition—far tamer than common fears of letting Medicare negotiate drug prices, loosening drug import restrictions or the biggie: imposing price caps. The blueprint’s more substantive changes require Congressional action—a long shot, especially in a midterm year (more on this below). Unsurprisingly, nothing has yet come of either the announcement or blueprint.
Jitters resurfaced on May 30, when Trump predicted “voluntary massive drops in drug prices” in the next two weeks. But those weeks came and went uneventfully. It might seem that things are heating up now, though—what if Trump tweets at other drug companies, or they act pre-emptively to avoid unwanted scrutiny? Might they cave, too? This strikes us as improbable—and we think it misreads the recent tweet tiff. The target company (whose name, may we remind you, sounds a lot like Geyser) rescinded and delayed its hike but didn’t cancel it altogether—it is presently scheduled for the start of 2019. Turns out there is a big gap between short-term moves to sidestep bad press and permanently altering drug pricing plans. Elsewhere in the sector, scheduled price increases have mostly gone on as planned, suggesting President Trump’s supposed “bully pulpit” powers are modest. Although his tweets may be #exciting—and ready headline fodder—they aren’t where major pharmaceutical reforms come from. The executive branch can do little in this (or any) domestic policy area by itself. To the extent tweets and talk have an impact, it is probably superficial, PR-focused and centered around preserving goodwill and lobbying abilities.
Chinese GDP growth slowed by a whisker to 6.7% y/y in Q2, just barely behind Q1’s 6.8%. Ordinarily a teensy Chinese slowdown wouldn’t be huge news, as it is par for the course of the last six years. But throw in a couple softer monthly data points and lingering handwringing over the latest tariffs (and tariff threats), and you get a proper “China’s economy is stumbling hard” freakout. However, a closer look shows this is less about trade and more about Chinese officials’ ongoing war on junky debt. It was largely a foregone conclusion that their efforts would inflict some collateral damage. The latest economic data are about what we would expect in that regard. And they are largely in line with the past several years—not a brewing negative shock in the world’s second largest economy or, in our view, the death knell for this global bull market.
Exhibit 1 shows the past 10 years’ worth of GDP growth. Since 2010, growth has slowed steadily—largely by design. Chinese officials decided several years ago that in order to maintain social stability and avoid getting caught in the proverbial middle-income trap, they would have to engineer a shift away from heavy industry and exports and toward services and consumption. Growth slowed as they curbed overcapacity in several key domestic industries, like steel, while the service sector slowly ascended to the country’s largest economic segment. GDP growth didn’t accelerate as services expanded, largely because the effects of compound growth make it difficult to keep notching double-digit growth rates off a larger base. But growth was somewhat higher-quality. The country continued prospering. And its dollar-based contributions to global GDP—which is what ultimately matters for global stocks—remained robust.
Exhibit 1: 10 Years of Chinese GDP Growth
Happy Friday! While many folks see the summer as the “doldrums”—an idle period featuring beaches, umbrella drinks and air conditioning—this summer is off to quite a newsy start. This week was no exception. Here is our attempt to round up some biggies—US inflation data, the Supreme Court nominee, UK political hijinks and more tariff talk.
US CPI inflation hit 2.9% y/y in June, notching another six-year high and creating a bit of fear because June’s wage growth didn’t keep up. Keeping with the human tendency to extrapolate all recent moves forward, media coverage warned more price rises could be in store, bringing consumers great pain.
Over a month after Italy’s populist government took office, debt fears are still commonplace as investors grapple with a potential for tax cuts and big spending. We think the likelihood of such sweeping changes to fiscal policy is low, considering how gridlocked the coalition appears to be, but that isn’t the only reason we think debt fears are probably unnecessary. A quick look at a recent bond auction and a measured analysis of Italian government finances reveal a landscape far different from common media portrayals. Italian debt is just one of many areas where Italy’s economic and political reality exceeds expectations. We think this is a bullish disconnect that bodes well for Italian and eurozone stocks.
At June 28’s bond auction, Italy’s Treasury sold €2.5 billion in 10-year debt and €2.0 billion in 5-year debt. Some coverage sounded a skeptical note because the bid-to-cover ratio, which tallies the number of bids per bond sold, fell to 1.26 for the 10-year Italian Treasury’s Buoni del Tesoro Poliannuali (BTP) auction, down from 1.48 a month ago and its lowest since January. The 5-year BTP auction’s bid-to-cover ratio was 1.34, the lowest in a year. That is one way to look at it, we guess. But here is another: A surplus of investors were willing to lend to a shaky, populist government widely feared to blow debt through the roof—and to do so at lower rates than they did a month prior. Plus, these issues refinanced maturing debt at lower rates. The 10-year notes auctioned on June 27, 2008 carried an interest rate of 5.1%. The 10-year notes issued two weeks ago, some of which replaced those maturing notes, cost just 2.8%. Similarly, on June 27, 2013, the Treasury sold 5-year notes at 3.5%. June 28’s replacement notes carried an interest rate of just 1.8%. In other words, a piece of Italy’s debt stock just got a bit cheaper.
Exhibit 1: Italian Bond Yields Near Their Lowest in Decades
Are Chinese markets the first domino to fall in what will become a global bear market? That question seems to be on many pundits’ minds lately, with tariff fears swirling, the yuan tumbling and mainland Chinese markets dropping -24.4% since January 26.[i] Many suspect China’s “bear market” is an advance warning of huge problems for the world’s second-largest economy—with major implications for the global economy. However, we believe history and current economic fundamentals suggest otherwise.
First, consider: Is China’s market downturn really a bear market, or is it part of the ongoing global stock market correction that began in late January? At the risk of seeming pedantic, during corrections, not every country or index falls the same amount. While a correction is technically a sharp, sentiment-driven drop of about -10% to -20%, that general parameter refers to a broad index like the MSCI World, MSCI All-Country World (ACWI) or S&P 500 (for those more US-focused). In a global correction, it isn’t unusual for individual countries to fall more than -20%. In the correction from May 21, 2015 to February 11, 2016, the MSCI World Index fell -17.9%.[ii] Yet 14 of 23 constituent country indexes fell more than -20%.[iii] In 2012’s April 2 – June 4 correction, the MSCI World dipped -12.5%.[iv] However, 7 of 23 nations breached -20%, led by Finland’s -26.4% swoon.[v] Often, this is due to country-specific quirks. Many national indexes aren’t diversified. In China’s case, the Shanghai Index (the media’s main reference point) represents A-shares, which are traded on mainland exchanges and therefore largely inaccessible to foreign investors. As a result, mainland Chinese markets tend to be less efficient and often suffer big swings tied to speculation, as many domestic investors prefer property as a long-term investment vehicle. Sentiment, therefore, can have an outsized impact, making the Shanghai Index’s swings much more akin to corrections than bears. This is why whether an individual country’s index breaches a -20% decline—a somewhat arbitrary bear market qualifier—is much less significant than whether a major, multi-trillion dollar economic negative few see accompanies it.
No matter what you call the downturn in Chinese stocks, we believe it is unlikely to prove a prelude to deeper problems in the rest of the world. Consider recent history. From the global bull market’s birth on March 9, 2009 through this year’s start, there have been four Shanghai Index “bear markets.” Not even five months after this bull began, Chinese stocks fell -23.2% August 4 — 31, 2009.[vi] The MSCI World Index didn’t even suffer a correction. Yet another Chinese “bear” started on November 23—less than three months later!—and ran through July 1, 2010. Global markets experienced a correction in early 2010, but not a bear. In November 2010, yet another Chinese “bear” started, with the Shanghai Index falling -33.5% through December 2012.[vii] While broader markets endured three corrections over that span, the MSCI World rose 4%.[viii] Similarly, the Shanghai Index fell -51.5% from June 12, 2015 – January 28, 2016—a period largely coinciding with the aforementioned world stock market correction.[ix] But there was no global bear.
If you have at all glanced at financial media in recent weeks, you have likely read (or heard) the yield curve is in imminent danger of inverting, bringing recession to the US economy and havoc to stock markets. Some coverage points out that the curve is at its flattest in 11 years, with that reference point being the eve of the last bear market, which began in October 2007. Public Service Announcement: These warnings are based on a flawed version of the yield curve that doesn’t have much bearing on the real world. Moreover, they ignore the global yield curve and its increasing relevance to the world’s capital markets. When viewed in proper perspective, we don’t believe the yield curve is flashing warning signs today.
We aren’t pooh-poohing the yield curve as a leading economic indicator—indeed, it is one of the best! An inverted yield curve—with short-term interest rates higher than long-term interest rates—has preceded all US recessions since World War II, which is around the time quality national economic data begin. This isn’t just coincidence—it makes logical sense, since the yield curve drives bank lending. Banks borrow at short-term rates, either from each other or from business and household deposits. They lend at long-term rates. The spread between short and long rates is their potential profit on the next loan made. When the yield curve is steep, the spread is big and positive, and banks lend plentifully. The flatter it gets, the smaller potential profits are, and banks become more judicious when making lending decisions. They aren’t charities, after all, so if profits are small, they will likely determine there isn’t enough potential reward to make the risk of lending to less creditworthy borrowers worthwhile. At these times, as a tired joke says, you can get a loan only if you don’t need one (see: 2010, 2011, 2012). When the spread is negative and stays that way for a while, lending is a money-losing proposition, and banks curtail it. Credit locks up, capital-starved businesses can’t invest, and markets and the economy generally go kaput.
So from a philosophical standpoint, we tip our hat to all the financial commentary that is watching the yield curve like a hawk. And we concede that as they present it, things don’t look so good. The yield spread isn’t yet negative, but to the untrained eye it appears headed that way on a straight shot.
This holiday-shortened week had no shortage of financial news. Here is an attempt to round up a few for your Friday reading pleasure.
It seems no one can pen a financial news column these days without discussing something about tariffs. So here is your obligatory tariff discussion for today: $34 billion in Chinese imports are now subject to new US tariffs—and an equivalent amount of US goods are subject to new Chinese tariffs in response. In the run up, media treated tariff implementation like it was make-or-break for markets. Huge news. But, in my view, that misunderstands how markets work.