Perhaps President Trump is Getting the Message.

We believe the thought process surrounding the virtues of trade wars and their ease of implementing have changed in the White House. We continue to postulate that trade wars do not have an economic benefit attached to it nor can there be a true winner. We are seeing the effects of trade uncertainty affecting corporate spending and hitting the global manufacturing sector especially hard.

Wolf Richter of Wolf Street presented several gauges of manufacturing health across the globe. He points out, “On Friday, two major beholders released their views on the US manufacturing sector: The IHS Markit US Manufacturing PMI, which saw growth in October picking up a tad for the second month in a row, from stall-speed over the summer; and the ISM Manufacturing PMI, which saw manufacturing declining in October but declining at a slightly slower rate than in the month before. The IHS Markit US Manufacturing PMI first”

“The ISM Manufacturing Report, had a drearier view of the US manufacturing sector, with October being the third month in a row of declines, but the decline was slightly less fast than the month before – that’s the good news, so to speak, “but sentiment remains more cautious than optimistic” (data via YCharts):”

For any that are unfamiliar with these measurements, the monthly data are derived from surveys of senior executives at private sector companies. The datasets feature a headline number, which indicates the overall health of the manufacturing economy. Any figure above 50 indicates the sector is expanding, any figure less than 50 states the sector is contracting.

But the dismal readings get worse globally.

“The preliminary IHS Markit/BME Germany Manufacturing PMI for October, at 41.9, along with September (41.7), remained at the lowest point since the Financial Crisis, confronting Germany with the sharpest contraction among the manufacturing powerhouses”

“The doom-and-gloom situation in Germany, the largest economy in the Eurozone, is dragging down the overall manufacturing sector of the Eurozone, with the preliminary IHS Markit Eurozone Manufacturing PMI remaining deeply in contraction mode, at 45.7 for October, same as in September, the ninth month in a row of shrinkage”

“The China Manufacturing PMI, released by China’s National Bureau of Statistics, remained in contraction mode in October (49.3) for the sixth month in a row. Particularly ugly is the steep multi-month plunge in export orders (red line)”

“The export-focused manufacturing sector in Japan slid at the fastest rate in 40 months, according to the Jibun Bank Japan Manufacturing PMI, at 48.4 for October, contracting for the sixth month in a row. New orders were “the primary reason underpinning this marked decline,” with manufacturers reporting “the sharpest fall in demand since May 2016.” The “accelerated drop was broad-based across consumer, intermediate and investment goods””

“South Korea is in distant fifth place behind the big four manufacturing countries China, the US, Germany, and Japan. The executives of South Korean companies are a rather negative bunch, giving the IHS Markit South Korea Manufacturing PMI the peculiar look of a manufacturing sector shrinking much of the time since 2012 (with the majority of PMI values below 50). In October, the PMI of 48.4, while up a tad from September, signaled “challenging operating conditions.””

Indeed, the latest jobs numbers confirm the manufacturing softness. While the headline number was higher than expectations and the stock market rallied on the good news (two very good things), deeper within the report confirmed our manufacturing slowdown thesis. According to the Bonddad Blog by New Deal democrat, “many leading indicators overall strongly suggest that an employment slowdown is coming. The following more leading numbers in the report tell us about where the economy is likely to be a few months from now. These were mixed [emphasis added]

• the average manufacturing workweek fell -0.2 from 40.5 hours to 40.3 hours. This is one of the 10 components of the LEI and is negative.

• Manufacturing jobs declined by -36,000 (but would have risen by +6,000 were it not for the GM strike). YoY manufacturing is up 49,000, a sharp deceleration from 2018’s pace.

• construction jobs rose by +10,000. YoY construction jobs are up +148,000, also a deceleration from summer 2018. Residential construction jobs, which are even more leading, rose by +2,900.

• temporary jobs declined by -8,100. September’s strong number, however, was revised even higher to +20,100.

• the number of people unemployed for 5 weeks or less rose by -100,000 from 1,868,000 to 1.968,000.”

He concludes, “This was a very good report with few negatives, which were chiefly in manufacturing.

In particular, it is looking even clearer that we may be at practical “full employment.” The prime age employment population ratio has matched its high point of the 1980s and 2000s expansion, and was only higher for 15 months in 1999-2000. Those not in the labor force but who want a job now are also at a 25 year low as a share of the labor force. Meanwhile, nonsupervisory wages remained at an expansion high YoY at +3.5% (except for one month, and still below peak YoY changes in the past 3 expansions).

The negatives were the slight tick upward in the unemployment and underemployment rates (and the GM strike was not big enough to account for those). The manufacturing workweek declined further, a bigger warning for job losses to come. Temporary jobs, including revisions were flat, so they are above July’s trough but below last autumn’s peak.

Reasonably speaking, with revisions, this report paints a portrait of a full or nearly full employment economy with a few soft spots, and wages that still ought to be making more progress.”

Is this indicative of a coming full-blown economic recession?

The following tweet by @Not_Jim_Cramer tends to tilt in that direction.

Other indicators are also raising red flags. The 10-Year Treasury Constant Maturity Minus 2-Year Treasury Constant Maturity and the 10-Year Treasury Constant Maturity Minus 3-Month Treasury Constant Maturity have inverted recently and have been strong and early indicators of economic recessions.

Payroll trends, while coming in stronger than expected recently are showing year-over-year deterioration. According to The Capital Spectator, “Private payrolls rose 1.5% in October vs. the year-ago level. That’s a respectable increase, but the problem is that a clear downtrend remains in force. Indeed, the 1.5% gain reflects the weakest annual pace since 2011. For much of the past year, in fact, the annual pace has been losing altitude. Given the slowdown in economic activity generally this year, it’s reasonable to assume that the labor market’s deceleration will continue next month.”

“Eyeballing this indicator during the last three recessions suggests that somewhere at roughly the 1% mark signals the point of no return.”

They are not predicting a coming recession but certainly trends that are worth watching.

Lively Debate

I’m not sure the recent slowdown and increased risk of an economic recession is resonating on main street quite yet. Many relay optimistic political talking points i.e. “strongest economy in American history” and the new highs in the stock market. While it is true that the US economy continues to expand (although I’m not sure which metric is used to claim it’s the strongest economy in US history) and the stock market is definitely making new highs. I’m very pleased about that (although there has been excessive volatility since the trade war started in January 2018 and the S&P 500 is only up about 7% from that level from two years ago).

The cheerleading continues and we want to see the US economy growing. But there appears, at least in my opinion that there has been a change in perception within the current administration. For one, Larry Kudlow, President Trump’s top economic aide has been pressing hard for another fiscally stimulative tax cut. According to Bloomberg, “The White House is holding informal talks about a second round of tax cuts to announce during the 2020 presidential campaign, President Donald Trump’s top economic aide Larry Kudlow said Friday, reiterating previous remarks…Kudlow said the plan will be released next year, in time to be a campaign issue ahead of the 2020 election. Republicans are hoping to run on the message of a strong economy and draw comparisons with their Democratic rivals who are proposing tax increases to pay for expanded government services.”

Perhaps we all remember Mr. Kudlow prior to the Great Recession. He completely missed the greatest financial crisis in modern times by a few months. From the Washington Examiner, “NBC host Chuck Todd reminded White House economic adviser Larry Kudlow of his ill-fated prediction in 2007 that there was "no recession coming," as Kudlow praised current economic forecasts.

"This is what you wrote," Todd said on Meet the Press. "‘There’s no recession coming.’ This is in December of [2007]. ‘The pessimistas were wrong. It’s not going to happen. The Bush boom is alive and well. It’s finishing up its sixth consecutive year with more to come.’ The more to come was a massive downturn. I admire your optimism, but the data is pointing in another direction."

“I plead guilty to that late 2007 forecast,” Kudlow said, while noting there were other economists who were blindsided by the recession.”

True he wasn’t alone in predicting blue skies ahead right before running into the greatest economic storm of our generation.

Now he is front and center and has the national spotlight on him as the rest of the country and the world listen to his sage wisdom. This is a man, in my opinion that can’t get it wrong again! All credibility will be lost at that point.

So, I can understand that there may be, at least within the inner circles of the executive branch, some concerns about the recent economic trends, despite displaying a Panglossian public message. The fiscal stimulus of a tax cut may be just what the doctor ordered just in time for re-election season.

But there is more to the current actions within the administration that leads me to believe there is a bit of concern that has crept into the impenetrable perfection that is the Trump economy. This has to do with our current trade skirmish with China.

Throughout the negotiations, President Trump wanted a grand deal that addressed fair trade, intellectual property rights and the theft and transfer of technology. All worthy issues to be addressed and we commend the current administration for their courage to tackle such an enormous issue, albeit I believe we could have gone about the task in a different way that would have been more effective, in my opinion.

But now we have a pending “phase one” of a trade deal. In grand fashion, we witnessed on live TV, President Trump announcing phase one of the trade deal with China. This included China committing to purchase $50 billion annually of US agriculture, concessions on intellectual property and stabilizing currency agreements.

$50 billion annually is a large increase to what was the norm prior to the trade war. They were averaging about $22 billion between 2013 and 2017.

Source: Bloomberg

Their peak purchases occurred in 2012 with $25.9 billion.

Source: Bloomberg

But these additional purchases are not going to come into effect until 2021, if at all and well after election day. From Bloomberg, “As Trump and Chinese Vice Premier Liu He stood face to face in the Oval Office on Friday, a reporter asked whether the agreement was for $40 billion to $50 billion in purchases every year. Trump turned to Treasury Secretary Steven Mnuchin and asked him to “define that, please.”

“It will scale up to an annual figure. Yes,” said Mnuchin, who later added it would hit that higher level “within the second year."

A spokeswoman for the U.S. trade representative said Thursday that China had committed to $40 billion to $50 billion a year, “scaling up over two years,” implying purchases would be significantly higher by 2021.”

The truth is that the Chinese have committed to purchase approximately $20 billion in US agriculture annually as the trade talks continue. From Reuters, “Trump has touted purchases of $40-50 billion annually — far above China’s 2017 purchases of $19.5 billion as measured by the American Farm Bureau.

One of the sources briefed on the talks said that China’s offer would start out at around $20 billion in annual purchases, largely restoring the pre-trade-war status quo, but this could rise over time. Purchases also would depend on market conditions and pricing.”

From Forbes, “China is returning to the U.S. soybean market, and other major farm commodities like pork. But the $50 billion worth Liu He said China would buy is now $20 billion, which means China is basically agreeing to return to the market and that’s it.”

And in terms of lifting existing tariffs, “Yesterday we got some reports that China is willing to buy at least $20 Billion USD worth of American agricultural goods in year one, should they find a trade war deal with the U.S. soon. However, the Chinese are looking for more U.S. tariff cancellations in order for them to commit to buying more American soybean exports and other products.

President Trump has only agreed, so far, to cancel the increase in tariffs on $250 Billion of Chinese goods that was set to come into effect on October 15th. China is supposedly looking for the U.S. to walk back on two major items: first, the September 1st tariffs on $125 Billion of Chinese products, and, second, the planned tariffs on an additional $156 Billion of Chinese goods set to go into motion on December 15th.”

Source Farmlead.

As far as the concessions on intellectual property, these are processes that have already been set in motion prior to the announcement of phase one and were readily known to those that have been following the situation. We are still awaiting what the currency stabilization part of the deal will look like.

Thus, on the face of it, it looks like we are right back to where we were at the start of the trade war. I believe President Trump and his advisors underestimated the impact of the trade war on our economy. I believe he has learned that trade wars are neither good for the economy nor are they easy to win. The deterioration of the global economy (specifically the manufacturing sector) and the devastation within our farmland has him rethinking the strategy in my opinion. Within the farmland, as this process draws on, he is losing a key part of his base as our nation’s farmers have gone on welfare. Read: Farm-state fury creates pressure for Trump as trade, energy pain collide, Farm bankruptcies jump to highest level since 2011 as Trump’s tariffs bite, and U.S. Farm Bankruptcies Surge 24% on Strain From Trump Trade War.

Granted, President Trumps popularity within the farmland remains high, but I suspect this is the type of support that he needs to protect to win re-election and the sentiment within that part of his base is souring quickly.

Even more importantly, the desired effects that President Trump sought to garner from the tariffs are not materializing. From Forbes, “As many had predicted, the U.S. trade deficit, which depends more on fiscal than trade policy, is larger than when the President took office. Tariffs are not reducing imports. Tariffs are shifting the source of imports to third parties, such as Vietnam, and increasing their cost for U.S. consumers.”

“As for fair treatment of U.S. firms, according to Global Trade Alert, nearly 18 percent of U.S. exports were at risk from tariff increases by other Group of 20 countries last month compared to about 8 percent in 2016. According to the Peterson Institute, while China’s average tariffs applied to all other WTO members have been cut to 7 percent, those applied to the United States have more than doubled, to 20 percent, and over the last year, China’s imports from the United States have declined by 12 percent but have increased by the same amount from third parties. China appears to intend to buy food for its 1.4 billion people anywhere but the U.S. New compensation schemes for U.S. farmers, who are hit hardest, are expensive, insufficient and inequitably distributed.

Rather than favor U.S. firms, trade policy has placed most at a disadvantage as the costs of their imported inputs has risen and their competitors benefit from deals that do not include them.

Europe has concluded trade deals with Japan, Canada and Mexico and has reached an agreement in principle with Mercosur. Japan has formed a new trade alliance with ten countries that were initially part of the Trans-Pacific Partnership (TPP) Agreement, and which the president abandoned. Dozens more countries, including G-7 member Italy, have joined China’s global infrastructure and trade scheme, the Belt and Road Initiative.”

It is my opinion that the Trump trade policy is “off the rails” and it could threaten his re-election. And it would seem that some in his administration are voicing the opinion. I say this because of recent reports that Peter Navarro, Assistant to the President, and Director of Trade and Manufacturing Policy has vehemently opposed phase one of the china trade deal. He has long been the “hard-liner” on China trade policy and is now being rebuffed everyone else within Donald Trump’s inner circle.

I remember reading an opinion piece in the Wall Street Journal entitled A Navarro Recession? In the article they note, “CEO confidence and capital spending have tailed off since the trade war escalated in 2018, and the falloff is beginning to affect economic growth. The near-3% surge in GDP has slid to 2%, and average monthly job growth has declined to 165,000 this year from 223,000 in 2018.

Exports have subtracted from GDP as global demand slumps, especially for manufactured goods. If oil demand stays low, the oil and gas industry will have to begin layoffs. The 10-year Treasury yield dipped below 1.6% Wednesday morning, another sign of slower growth ahead.

Oh, and has Mr. Trump noticed that the trade deficit hasn’t improved? Global supply chains are moving out of China to third countries such as Vietnam. But the overall U.S. trade deficit is steady.

We aren’t predicting a recession, but then few thought we were in a recession in mid-2008 either. Economic downturns can sneak up on the smartest policy makers. Dan Clifton of Strategas Research Partners has begun noting that Mr. Trump is “‘trading away’ his re-election” as his trade policy erodes what was a strong economy. Mr. Clifton is a supply-sider who supports Mr. Trump’s tax and deregulatory agenda.

This is a warning the President should heed, and probably one Mr. Navarro won’t tell him. If Mr. Trump can’t strike a broader trade deal with China before the election, he should at least call a trade truce to reduce the damage. Economic expansions don’t end on their own. They almost always end due to policy mistakes. Mr. Trump’s willy-nilly trade offensive could be the mistake that turns a slowdown into the Navarro recession.”

I believe the ensuing storm on the horizon that threatens our economic prosperity is all too recognizable by the Trump administration by now. Let’s not forget those US Presidents that faced re-election during economic slowdowns. Herbert Hoover (1929 – 1933), Gerald Ford (1974 – 1977), Jimmy Carter (1977 – 1981) and George H.W. Bush (1989 – 1993). What do all these former

Presidents have in common?

One-Term.

I believe now that this is not lost on the current administration and they are in need to alter the current course of trade policy as it is clearly not working as intended and will now accept smaller political wins (no matter how cosmetic) to regroup and change direction.

This is why I believe we will get a smaller phase one deal completed and also believe that the tariffs targeting consumer goods just in time for Christmas will be lifted under the veil of progress.

John Mauldin from Mauldin Economics summed it up better than I could ever imagine. He writes, “I believe in free trade. I think David Ricardo was right about comparative advantage: Every nation is better off if all specialize in whatever they do best. The Chinese at one point were very good at large-scale, labor-intensive manufacturing, although they are losing their cost advantage now. We in the US have other strengths. Given time, these things sort out and everyone prospers (though it is true we have done a terrible job helping American workers make the transition. We have to improve there).

However, free trade doesn’t mean nations need to arm their potential adversaries. Nowadays, military superiority is less about factories and shipyards than high-tech weapons and cyberwarfare. Much of our “peaceful” technology is easily weaponized.

This means our response has to be narrowly targeted at specific companies and products. Broad-based tariffs are the opposite of what we should be doing. Ditto for capital controls. They are blunt instruments that may feel good to swing, but they hurt the wrong people and may not accomplish what we want.

We should not be using the blunt tool of tariffs to fight a trade deficit that is actually necessary. The Chinese are not paying our tariffs; US consumers are. It is only because the dollar is the world’s reserve currency that we have the exorbitant privilege of running a trade deficit. We need a large trade deficit to finance our debt.

Importing t-shirts and sneakers from China doesn’t threaten our national security. Let that kind of trade continue unmolested and work instead on protecting our advantages in quantum computing, artificial intelligence, autonomous drones, and so on.

The Trump administration appears to (finally) be getting this. They are clearly seeking ways to pull back the various tariffs and ramping up other efforts.

I know there are those who want total economic disengagement. I’m sorry, but that cure might be worse than the disease. Our economies are simply too intertwined and co-dependent. Forcibly separating them would set off a cataclysmic global recession—and weaken the US at a time when we need all our strength. It would also justify the paranoia already prevalent in China’s hawkish leaders.”

We have seen the market hit new highs with positive sentiment around the cooling in the trade war. I think it is smart to address the many concerns as it related to Chinese business tactics and admire the administration for tackling such a complex issue. That said, their definition of fair trade and their policy methods have been less than desirable at best and a complete failure at worst.

I think they may be finally coming around to that fact and are looking for a way to reconfigure their approach while saving face. Perhaps too, the political pressure resonating from the left and MSM have the administration clamoring for a political win. If I am correct in my assumptions, I think the US and global economies will be much better off in the long run.

Joseph S. Kalinowski, CFA