'America First'

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In “Run Over By A Benz“, I suggested the Trump administration is likely to keep pushing the envelope on trade up to and until the risk-off sentiment that’s showing up in Chinese equities (FXI) and in emerging market assets finally spills over materially into U.S. stocks. Specifically, I said this:

Assuming this is all brinksmanship from Trump, the worst-case scenario will be averted, but as ever, the problem is knowing when to quit. The longer U.S. markets hold up in the face of increasingly contentious rhetoric, the more inclined the Trump administration will be to keep pushing the envelope.

I wrote the “Benz” post on Thursday as European automakers were being pressured lower by the Daimler guidance cut and while I knew it was just a matter of time before the next shoe dropped, I didn’t think we’d get anything else material in terms of escalations before the end of the week.

Well, I was wrong. On Friday morning, Donald Trump tweeted the following (and this is verbatim):

Based on the Tariffs and Trade Barriers long placed on the U.S. and it great companies and workers by the European Union, if these Tariffs and Barriers are not soon broken down and removed, we will be placing a 20% Tariff on all of their cars coming into the U.S. Build them here!

He would go on to delete that (I guess to fix the “it” typo) and retweet it on Friday evening, but the original hit at roughly 10:20 AM in New York and the reaction in European automakers was immediate:

(Heisenberg)

By the close of the European session, the SXAP would trim some of those losses, but it was a miserable week for the index. In fact, it was the worst week since January of 2016. Volume on Friday was 157% of its 30-day average.

(Heisenberg)

That’s emblematic of global sentiment when it comes to what’s become a day-to-day struggle to discern exactly what Washington’s position is both with respect to Beijing and also vis-à-vis America’s European trade partners. Just to underscore how confusing this situation really is, allow me to present the following actual header from BofAML’s latest Rates weekly note for those who might have missed it when I tweeted it out on Friday morning:

If you’re wondering whether sell-side shops are prone to slapping ostensibly witty titles on strategy notes, the answer is “yes”, but at the same time, use of the (non)word “covfefe” there betrays a certain sense of frustration on the part of analysts when it comes to knowing what to say to clients.

I realize it’s easy for U.S. equity investors to dismiss all of this as long as Wall Street holds up, but don’t let it be lost on you that Chinese equities are on the verge of falling into a bear market:

(Heisenberg)

Obviously, part of the problem there is rampant uncertainty around the trade spat.

So why are U.S. stocks resilient? Well, investors continue to point to earnings and on that front, the outlook is pretty rosy thanks in no small part to the tax cuts. Here’s Bloomberg, from a piece out Friday:

Of all the forces swaying equity prices, earnings expectations are the hardest to see. They don’t make headlines, are difficult to quantify and get lost in the din around trade wars and politics.

Yet ignoring them is to miss the biggest part of what influences the market — the force that keeps the peace in a week like this. Stocks twist and turn, Donald Trump tweets about China and Europe, the Fed ponders higher rates. Then a five-day chart shows major U.S. indexes have barely budged, because nothing has happened to cause earnings estimates to change.

I would take issue with a lot of that. For one thing, earnings expectations do make headlines and are inherently quantifiable by virtue of being numerical. But let’s just ignore that in the interest of focusing on the overarching point in those excerpts which is simply that as long as earnings estimates aren’t revised lower, investors aren’t going to be inclined to forgo their “rightful” share of those earnings by selling.

Notably, Goldman was out on Thursday ratcheting up their EPS outlook for the S&P (SPY). Here’s the call:

We are boosting our S&P 500 EPS forecast for 2018 to $159 (from $150) reflecting a 19% jump from last year. Stronger-than-expected earnings in 2017 and 1Q 2018, faster US and global growth, higher oil prices, and a slightly larger boost from corporate tax reform explain the upward revision. We also lift our 2019 EPS forecast to $170 (from $158) for 7% growth, and our 2020 estimate to $178 (from $163) for 5% growth. Despite the large positive revisions, our top-down estimates are still below the consensus bottom-up forecasts of $161, $176, and $192, respectively.

There’s a ton more on that here, but what you should be aware of is that Goldman did not raise their S&P price target despite the upward revision to profit forecasts. Why not? Well, for a number of reasons including, but not limited to, the notion that margins have likely peaked and valuations are stretched to extremes across multiple metrics:

(Goldman)

The problem with this setup is glaringly obvious. If you’re ratcheting up your EPS estimates but leaving your price target unchanged, that by definition means you see no scope for multiple expansion. If there’s no scope for multiple expansion and earnings disappoint, well then you’ve lost both pillars of price support.

I would argue that Daimler’s guidance cut will eventually be echoed by other multinational corporations unless trade tensions abate in a hurry. And look, the writing is on the wall here. Bloomberg uses a simple comparison of the Dow (DIA) and the Russell (IWM) to illustrate the extent to which multinationals are more nervous than small caps:

(Heisenberg)

But a better visual is the Russell versus the MSCI World:

(Heisenberg)

That outperformance is pretty telling. As Goldman notes in the piece mentioned above, small business sentiment is indeed euphoric. Specifically, the NFIB Small Business Optimism Index rose last month to the second highest level in the survey’s 45-year history:

(Bloomberg, NFIB)

And apparently, there has literally never been a better time to expand:

(Bloomberg, NFIB)

In my opinion, the “stratospheric trajectory” (to quote the NFIB) of Main Street optimism is misplaced. The U.S. economy is overheating and if it’s not, it’s well on its way to overheating thanks to the decision to pile fiscal stimulus atop a late-cycle dynamic.

The Fed knows this and as I’ve detailed on countless occasions (see here for an in-depth take) the combination of a more data-dependent regime under Powell, the distinct possibility that the Phillips curve is above to reassert itself with a vengeance and the fact that beyond the initial list (i.e., beyond the first $50 billion in goods subject to levies), slapping China with tariffs will put upward pressure on consumer prices in the U.S. thereby raising the risk of a sudden surge in inflation, the FOMC is going to err on the side of tightening, not on the side of preserving what is already the second-longest expansion in U.S. history and especially not on the side of propping up the S&P.

Powell did suggest this week in Sintra that the Fed may ultimately be forced to revise its outlook if trade tensions persist. But my assessment of Powell thus far is that it’s going to take a lot to force a Fed relent. One or two guidance cuts from major U.S. multinationals isn’t going to be enough.

“Unlike the ECB, the FOMC is looking through the external risks, comforted by the positive impact of the fiscal stimulus on the economy,” Deutsche Bank wrote, in a note dated Friday, adding that “as the front-end is unlikely to rally substantially as long as the impact of the trade concerns remains muted, the curve is likely to bull flatten in moderate risk-off scenarios.”

In other words, up to and until something forces the market to start taking some of the hikes out, fleeting risk-off episodes will show up at the long end and the curve will continue to exhibit a flattening bias. I’m not in the camp that thinks a curve inversion will necessarily presage a recession in the post-crisis world (the dynamics have changed), but it would certainly be cause for concern.

In any event, it’s the U.S. versus the rest of the world at this juncture when it comes to markets and what I would encourage investors to keep in mind is the fact that markets are more interconnected than they’ve ever been. That interconnectedness is mirrored in global supply chains and all other aspects of global trade and commerce.

Desirable or not, “America first” probably isn’t going to end up being a viable strategy precisely because the globalization of markets means negative spillovers are inevitable.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.