The VIX and the S&P 500-An Equity Market Duet

Most market participants have accepted that 2018 is unlikely to be another low-volatility year like 2017, but how do we translate the rising volatility into our market forecast? Some Wall Street bulls such as RBC’s Lori Calvasina have revised their year-end forecasts down recently.* Are those revisions because of the higher VIX?

First, given that the VIX measures the implied volatility of the S&P 500, the negative correlation between the VIX and the S&P 500 is no surprise. Moreover, not only is the correlation significant, the co-movement between the daily changes of these two indexes is rather close. Metaphorically, if we consider these two indexes as if they were two sound waves, as shown in Figure 1, then both the timing and the intensity of the movements in the indexes make the VIX and the S&P 500 an equity market duet. (Data source: Bloomberg)


Figure 1. Co-movement between the S&P 500 and the VIX

 

Does a rising VIX signal lower equity returns? This may be a misconception among many investors. A rising VIX is usually accompanied by sequential negative market returns, the magnitude of which can be substantial, particularly during a rapidly increasing VIX environment. Therefore, we tend to associate lower returns with higher VIX. However, by definition, higher VIX is only a reflection of volatile movements in the market – it is not a predictor of future returns.Nevertheless, the VIX is still powerful in terms of explaining market returns. If we assume that the relationship between the VIX and the S&P 500 is linear for the sake of simplicity, then we can capture a -1:0.1145 movement ratio between the VIX and the large-cap index. In another words, a roughly 9% increase in the VIX translates into a 1% drop in the S&P 500. But this oversimplification is not realistic, since we can see from Figure 2 that the distribution of the VIX is rather skewed compared to the S&P 500. Statistics 101 tells us that the relationship is not linear. Instead, if we look at the sunflower plot in Figure 3 (yes, sunflower plot is a scientific term), the relationship is also unlikely a complex curve; rather, the VIX is more subject to drastic movements than the S&P 500 is.


Figure 2. VIX distribution vs. S&P 500 distribution

Figure 3. Sunflower plot of the S&P 500 and VIX

Knowing the characteristics of the relationship between the S&P 500 and the VIX, we can now explore what opportunities are hidden in a rising VIX market. Although the historical average of the VIX is about 19.35, the VIX certainly has felt feverishly high relative to the market in the past two months. That impression is understandable, because the VIX has more than doubled since the single-digit VIX period not long ago. Fortunately, a doubled VIX may not be bad news for the market. Historically, the S&P 500 has had a 6.31% six-month return, on average, following a doubled VIX within a three-month horizon, while the S&P 500’s average six-month return is 4.37% since 1990. Additionally, if the one-month average of the VIX reaches above 25 after the VIX doubles, the S&P 500 has had a 9.90% six-month return on average in the past. That return is more than twice the average six-month return in the market.

Historically, if the six-month average in the VIX drops more than 30% and the VIX dips below 13, the following six-month S&P 500 return has never seen a loss and has averaged 7.09% since 1990. Uncanny, isn’t it?

Leo Chen, Ph.D. 
Portfolio Manager & Quantitative Strategist
Email | Bio
*Source: https://www.cnbc.com/2018/04/10/rbc-cuts-sp-500-forecast-for-2018-as-political-obstacles-for-stocks-pile-up.html.

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Lunch in Punta Gorda

OMG! What a wonderful lunch. Nine people total in a private room at a restaurant in Punta Gorda. Martin Barnes organized it, and Danny Blanchflower seeded the idea. Joining were Tim Dalton, Ned Davis, Bob Eisenbeis, Jeff Saut, and a certain ancient one who must remain anonymous but who calls himself “economist 63,” and another one who calls himself the “Swiss Gnome,” and, lastly, me. Travel was all by car. Punta Gorda was the selected as the halfway point between Naples and Tampa. Three others couldn’t make it. We decided to give them another chance at a dirty dozen luncheon next year.

We agreed to publish takeaways if we would be careful about attributions. We laughed about how that was like the dot plots where Feddies contribute but don’t reveal who is the producer of the dot.

Takeaways:

1. The talk about the Fed was really driven by the two former central bankers in the room: Blanchflower and Eisenbeis. But no one could recall any time in history when the Fed presidents outvoted the governors on the FOMC. Also noted was the lack of sitting governors’ experience in challenging staff projections. Fed policymaking by staff forecasts is dangerous when the driver is a Phillips curve model. Most agreed that there are well-trained regional bank presidents who can challenge the staff, but there are not enough governors in place to do it. The fact that the Board of Governors is so vacant and that the politics are so nasty, hampers the ability of the Fed. Congressional and presidential politics are hurting the central banking functions of the United States. This was a nearly unanimous view.

2. There was also talk at the table about the sequence that had Williams in play for a governor spot and now as the new president of the NY Fed. There was lots of talk about why Trump hasn’t filled the vacant governors seats and why the Goodfriend appointment is trapped or blocked in the Senate. The conclusion is that Williams at the NY Fed is in an even stronger position than as a governor when it comes to policymaking. NY has a special standing on the FOMC. Some were silent on this issue, so it was not clear there was unanimity.

3. Politics were discussed, of course, and the views ranged widely, but all were polite. The bottom line was a real mix. Many wished that Trump would behave in a better way and felt that his antics hurt him. Others said they like his policies even as they dislike him. Some worried about the consequences of extremes in behavior, including risk of a war. Others said that they wouldn’t vote for an old-line Democrat, and they thought that sentiment was the reason why the country rejected HC and picked DT. What would happen at the midterm if the Dems took the House? Mixed opinions again. A few thought the Repubs would hold the House. Others said it was still early and there are a lot of things that could change the outcome.

4. The Senate was seen as much more problematic, and there wasn’t much support for the notion that the Senate will swing to a Democrat majority.

5. Jeff was decidedly the most bullish among the group and argued that another 7 years or so remain in this bull market. He noted how so many investors do not remember the long bull market cycles of the past. The most pessimistic in the group see a recession in less than two years; that would hurt the earnings growth story. Most think that a recession is a few years away. The common view was that repatriation (which fuels buybacks), the fiscal stimulus (tax cuts), and gradualism by the central banks mean a few more years of higher stock prices, with inflation and much higher interest rates a future worry, if they come at all. Estimates of S&P 500 earnings for 2019 were centered at $170, with a band of maybe $5 on either side. All agreed that if the earnings momentum growth slows, the stock market will stumble. Few expect it to slow.

6. The gold bug in the room was bullish on gold prices for next year. There was little enthusiasm for the gold discussion. Hmmm… Maybe it’s time to own more gold?

7. Lots of opinions about trade and trade wars and whether this is a new “cold war” – or is it just lots of bluster? Many remember the stories of Smoot–Hawley in the Depression era. A few cited data. Clearly, the folks in the group have been diving deeply into the trade issues. And this group knows how dangerous a trade war can be. One said that Smoot in the ’30s had the ultimate effect of cutting both exports and imports in half in only four years. No one disputed that.

8. There was a really mixed analysis of banking systems around the world. The US’s is strongest. Europe will reveal how weak their banking system is when they have the next recession. China has a troubled system, and several argued that you don’t become a world reserve currency as a communist country with a troubled banking system.

9. Ned talked about the low savings rate and produced a chart to back up his argument. There was mixed opinion about how much dissaving is taking place when the deficit is heading for a $1 trillion number.

In the end this was a sobering gathering, notwithstanding the diverse and lively opinions. It was a welcome gathering of old and new friends for candid conversation and exchange of views. Sort of reminds me of one of our fishing trips. I looked around and saw that half the group had been to Camp K, with several planning to attend this year.

Thank you to Martin and Danny for the idea. In good health let’s do it again in 2019. BTW, the collective age of the nine-person group is about 675 years.


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Trump, Trade, T, T, T

“China’s reaction to Mr. Trump’s legitimate defence of the American homeland has been a Great Wall of denial – despite incontrovertible evidence of Beijing’s illicit and protectionist behaviour. Instead, China is attacking American farmers with the threat of retaliatory tariffs in the apparent hope of rattling a key component of the coalition that put Mr. Trump in office. There is a reason, however, that the president sits behind the Resolute desk in the Oval Office. And when he stands, Mr Trump stands up for the American people – and American farmers.” Peter Navarro writing in the FT.

President Xi used his “Davos East” gathering to stake out the other side of the turf. He was nuanced, calm, and very comfortable. I lost a little sleep but listened to the interpreter as Xi delivered his speech. According to the Wall St. Journal, after the speech the People’s Daily “declared the notion that China’s moves were in response to U.S. pressure was ‘fantasy without regard for facts’.”

Trump stands up for farmers, says the key US spokesperson. Fantasy without regards for facts, says the official China news organ.

Xi talked about autos and reducing China’s tariffs on them. “We will considerably reduce auto import tariffs,” he claimed. To the unsophisticated American viewer, this prospect might seem like a Trump victory. Maybe so. But Peter Boockvar noted that China’s 25% tax on US imported autos “mostly impacts German car makers like BMW and Mercedes.” Peter notes that “GM and Ford” already have factories in China.

One little historical note about trade wars, courtesy of the Economist, April 7–13 issue – in an article entitled “Blow for Blow,” the writer discusses Canada’s response to the American Smoot-Hawley tariff of 1930, when Canada raised the tariff on eggs in retaliation for America’s doing the same: “Douglas Irwin of Dartmouth College reports that the number of eggs Canada exported to America fell 40% between 1929 and 1932. But the number going the other way plunged 99%” (http://www.economist.com/news/finance-and-economics/21739975-two-countries-threaten-descend-sequence-tit-tat-retaliations). Tit-for-tat retaliation has its risks.

In Florida, some folks remember that the Europeans threatened a tariff on oranges from America during President George W. Bush’s first trade spat. I wonder what Senate-aspiring Florida Governor Rick Scott will say about trade and Trump when he is asked about that history.

Anyway, markets seem to have calmed down a little following Trump’s Timely if Truculent Trade Tirade (Alliteration, anyone?). Of course, calm is short-lived when missiles are flying in the Middle East.

We remained concerned about US policy and the volatility of tweeted diplomacy. That said, we also like the outlook for the forthcoming earnings reports, and we remain nearly fully invested. Our energy overweight position is starting to feel good.


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Trump, Trade, Will Rogers

“It was a tumultuous first week of the quarter that has left the markets caught between more truculent tweets on trade from President Trump, and slightly more diplomatic messages from his advisors. Predictably China countered with $50 bln in tariffs of their own against a variety of U.S. imports, while the White House threatened to lump on another $100 bln tariffs to the $50 bln already on the table. Advisors Navarro and Kudlow, along with Treasury’s Mnuchin, said this was not a full blown “trade war,” but were vague as to whether negotiations had even begun, while China’s commerce ministry denied any talks had been launched.” – Action Weekly! Global Edition, April 9

“Trump’s ‘Good’ And ‘Easy To Win’ Trade War Actually Might Be Neither. States that had voted for Obama and then swung Trump’s way could be hit the hardest.” – Huffington Post headline, April 4

“White House Press Secretary Sarah Sanders said Friday that the president doesn’t want to enter a trade war with China, but if he does, he’ll win. Key quote: President Trump ‘absolutely’ still believes trade wars are easy to win. ‘If he is in charge of those negotiations, then absolutely. He’s the best negotiator…’” – Axios.com, April 6

“Donald Trump is right – the United States is not in a trade war with China. At least, not yet. As the rhetoric has flown back and forth between Washington and Beijing, breathless news coverage has made it seem as though the war of tariffs has already begun. It has not – hardly any new duties have been levied. At most, the world is in its July 1914 moment, with the clouds of trade war gathering but shots not yet fired. We’ll know soon enough whether that is indeed the correct historical analogy. For now, the war is just words, and it would be best for the planet if that’s as far as it goes, because the only way to win a trade war is not to fight it.” – Politico, April 7

“Just six words suffice to sum up President Trump’s approach to trade (and, you may mutter, too much else): make threats, strike deals, declare victory.” The Economist, March 31

We thank our friends at TLR (The Liscio Report) for their kind words about our commentaries about trade (and we thank David Blond, Bob Brusca, and Mike Drury for their guest pieces on trade and Trump). By the way, in our opinion TLR is one of the highest-frequency reports (it’s weekly) that might discern some impact on the US economy from the trade war or trade rhetoric. This research publication tracks employment data in each of the 50 states. I read it regularly and recommend it highly. Call 518-827-7094 to obtain subscription information or a trial. So far it is too soon to see any signs of trade war talk-induced change in the employment data. Our view is that it won’t be long before we see the first signs of negative impacts from Trump’s destructive bluster.

That is why the White House has already started to warn about some short-term pain for the sake of long-term gain. Larry Kudlow knows the pain is coming. He has seen the impact on the stock market, and he has seen the dramatic swings in certain commodity prices. He knows that an expectations-induced retrenchment is underway. Why would a farmer order a tractor today to plant a legume crop tomorrow when he is uncertain about future demand and prices? Why would a pig farmer build a new barn? If you made a specialty part for an airplane that was purchased by Chinese users, would you adjust your business model? Would you still order that new robot, or would you delay?

The first negative reactions to a trade war threat are changes in business expectations. And they are happening fast now.

US exports to China are varied and substantial:

“American exports of agricultural and other primary products to China totaled nearly $20 billion in 2016, which accounted for 25 percent of the industry’s exports in that year. There were also significant amounts of exports of aircraft (nearly $15 billion), motor vehicles and parts (about $11 billion) and chemicals (more than $13 billion) in 2016.” – Wells Fargo special commentary, April 5

Remember that these figures represent only exports to China, which receives just 7.8% of total US exports. Also remember that the US economy is 70% services, and services are a minuscule part of exports. The pain mentioned by President Trump and his advisers will be levied directly on the American manufacturing and goods-producing sectors and on American agriculture. My dentist in Sarasota is not impacted, but my friends in the heartland of America are already hurt because of the price changes in their markets. And every 401k in the United States has been hurt by an amount that equals all it gained in anticipation of economic growth and the benefits of tax cuts, repatriation, and fiscal stimulus. Yes, Mr. President Trump, there will be pain. You have brought it upon us.

It is clear that nobody wins a trade war. No credible person can point to net gains. A trade war is never a zero-sum game; it’s a loser’s game on both sides. So the big talk about who wins is actually a debate about who will lose more, and that’s about as dumb a debate as anyone can imagine.

Okay, what happens next? The US would like to see a negotiation and an agreement so Trump can declare victory and tell everybody how great a negotiator he is. He might get to that result with some of his other trade talks, for example those regarding NAFTA or trade with Europe; and he did enjoy a positive outcome in his talks with South Korea.

But with China the test is different.

Chinese policymakers know the US system and thoroughly understand US politics. They know what the midterm elections mean, and they see how Trump has intensified the political activism of the Trump haters while not energizing the Trump lovers. They know that presidents are vulnerable in midterms to start with – history demonstrates that fact. They know that a Democratic party swing in the midterms means a Pelosi-led House and a bill of impeachment on Trump. And they know the midterm elections are only six months away.

The Chinese political leadership doesn’t face midterms. Xi is now president for life if he wants to be and is commander in chief of the armed forces and the head of his political party, which is the only party in China. He is patient. He also knows that in another 5–6 years the Chinese economy will be the largest in the world, and the US will be second. And he knows that China is already the largest if you measure by manufacturing alone rather than including services. He knows that in the US 17% of GDP is produced by the healthcare sector. Xi knows. His advisers know. Many of them were trained in the US. Those of us in the economics field and financial markets know several of those key people. We have met with them and have visited them in China and hosted them in the US.

Rest assured that Chinese policymakers have a multi-year war plan for trade-related conflicts with the US.

We refer the president’s advisers to the Bully Buster Program. The program emphasizes control and prevention. The purpose of control is to reduce occurrences of bullying. The aim of prevention is to promote conditions in which bullying is less likely to occur. You can check it out, too. Read Bully Busters: A Teacher’s Manual for Helping Bullies, Victims, and Bystandershttps://www.researchpress.com/books/455/bully-busters.

By the way, Mr. President, the Koch brothers have read this book, too.

For our market comments let’s just summarize. We remain invested in our US stock market ETF accounts. We think the power of the tax cuts, repatriation, and fiscal stimulus may be blunted by the Trump trade rhetoric, but it won’t be killed. And a midterm election swing will not be enough to repeal those laws. A midterm swing means a stalemate in Washington and an ugly political scene – if one can imagine it more ugly than it is at present. But the economics of the new tax law will not change.

Finally, we want to leave our readers with a bit of wisdom that has been attributed to Will Rogers. We are drawn to this quote because our president is reputed not to read much and to limit his viewing to only one TV channel:

“There are three kinds of men: The ones that learn by reading. The few who learn by observation. The rest of them have to pee on the electric fence and find out for themselves.”




More on Trade Wars

Well, well! Who’d a thunk it?

First we must thank David Blond and Bob Brusca for engaging in a debate for our readers. For those who missed it, the links to the David Blond essay and the Bob Brusca response are here:

Blond: “Winners and Losers from Global Trade” – http://www.cumber.com/winners-and-losers-from-global-trade/

Brusca: “Why David Blond Is Wrong on Trade” – http://www.cumber.com/why-david-blond-is-wrong-on-trade/

We also want to thank our readers for the array of views articulated on all sides of this discussion. We thank the pro-Trump and the pro-Obama and the anti-Trump and the anti-Obama readers and the others who cited history. We had a minimal number of nasties this time. Maybe that is because we block them and have culled some of those people off our lists. We invite debate and discussion and ask only that discussion be respectful and polite. In other words, disagree but not with sharp knives and loaded guns. We have enough of that in our daily life in America without adding to it.

Today we want to add two points to the debate.

The first is our agreement with both Blond and Brusca. Neither supports a trade war. Both see the risks in such a contest. Both agree that no one wins a trade war and that all sides lose in the end. My friend Megan Greene and I discussed this hard reality during our panel at the GIC conference in Salt Lake City. She reminded me of the famous line about the direction in which the guns are pointed in a trade war.  That observation leads me to muster a few quotes in support of this viewpoint.

Mar. 5, 2018 – “In particular, we should avoid the urge to levy tit-for-tat tariffs on imports of products from the United States, such as the Europeans are threatening to impose on American motorcycles, blue jeans and bourbon. Trade war is unlike real war in one crucial respect: the guns are pointed inward.”
Source: http://nationalpost.com/opinion/andrew-coyne-how-should-canada-respond-to-trumps-tariffs-there-arent-many-options

Mar. 2, 2018 – “So if there’s one thing that most economists agree upon, it’s no one wins a trade war. But President Trump doesn’t believe that. He tweeted out Friday morning that for the United States, a trade war is ‘good’ and ‘easy to win.’”
Source: http://money.cnn.com/2018/03/02/news/economy/why-no-one-wins-trade-war/index.html

Mar. 23, 2018 – “Historically, both sides usually lose in trade wars. But, one side often loses more than the other. While China could be hurt by the Trump administration tariffs, U.S. consumers, companies and our allies could end up being damaged more.”
Source: https://www.npr.org/2018/03/23/596529795/trade-war-could-damage-u-s-consumers-more-than-china

Mar. 15, 2018 – “President Donald Trump has not yet started a global trade war. But he has started a frenzy of special pleading and spluttered threats. In the week since he announced tariffs on steel and aluminium imports, countries have scrambled to win reprieves.”
Source: https://www.economist.com/news/finance-and-economics/21738906-if-china-cannot-placate-donald-trump-it-will-fight-him-instead-lose-lose-trade

Five days ago – “Why China Will Lose a Trade War With Trump. Beijing can huff and puff, but America holds the high cards. Expect the Chinese to back down quickly – or watch their economy and political system fall apart.”
Source: https://www.thedailybeast.com/why-china-will-lose-a-trade-war-with-trump

Four days ago – “The overwhelmingly negative reaction from US businesses and lawmakers to this abrupt policy shift tells the real story — a trade war with China will hit the US where it hurts, and will do far more harm than good to consumers.” Source: http://www.chinadaily.com.cn/a/201803/28/WS5abae5d7a3105cdcf6514b62.html

Mar. 23, 2018 – “Boeing has become an unofficial proxy for fears about an escalating U.S.-China trade war. Investors are right to be worried.”
Source: https://www.wsj.com/articles/what-boeing-has-to-lose-in-a-u-s-china-trade-war-1521823499

Let me move to my second point.

The selection of words is a powerful tool in the hands of politicians. It is really part of the skill set, just as style also helps establish a politician’s rapport with his/her “base.” In the trade debate the selection of the word deficit is a key example.

I tried this question by asking for a show of hands at the GIC conference in Salt Lake City. When I asked the audience “How many think a deficit of some type is bad?” most of the hands in the room went up. The word deficit has a pejorative connotation.

I then asked how many thought the word surplus was good. Again, most of the hands went up. I then asked the questions in reverse. Only three thought the word surplus could be bad. A similar number thought the word deficit could have a positive connotation.

Now let’s get to the economic issue. No politician stands up and says, “We have to shrink the capital account surplus.” They like to say we have to reduce the current account deficit. The term deficit is alarmist. The term surplus gives comfort.

But we’re talking about an economic identity, and so to say either one of these things is to say the same thing. The difference is how it sounds to the unskilled (in economic terms) listener.

No politician says it is “unfair” to have the money we spend abroad recycled into the US domestic economy by foreign parties buying US Treasury bills, notes, or bonds. Or by their buying American stocks or real estate or other ventures. Nope. That side of the identity is not deemed unfair.

But the same politician, who calls trade policy unfair and wants to shrink trade and, therefore, the current account deficit, doesn’t offer the other side of the money flows to the listener. But with an identity you cannot have it both ways. If you want the flows of foreigners to be invested in your country and its enterprises, you have to get the money to them by buying their stuff or investing in their enterprises. This is a two-way proposition.

It seems that there is more bluster about trade than there is an actual full-scale trade war. But we are not sure. These things progress, and history shows they worsen in a tit-for tat manner. History is very unkind to those who launch trade wars and trade war threats and likewise to those who respond in kind. The debate has raised risk premia in markets. When that happens, every investor and every business loses.

We again think the Blond / Brusca duo for their words, and we think readers for their responses. More is coming from us on this subject, as a trade war poses a major economic risk that is evolving. We cannot yet size up the trouble that lies ahead down a thorny and ill-advised policy path.


Today’s comments were written before the last 24 hours’ news flow.  The most recent round of China-US tariffs war is alarming. Trump’s trade policy is failing and harming the United States.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Tactical Trend, Q1 2018

Well, that didn’t take long! The secondary indicators (sentiment) we mentioned as a concern in our 2017 year-end commentary (see Tactical Trend, Q4 2017) proved to be a bit too much for the equity markets to digest during Q1. The extreme bullish readings in late December and early January were a warning that capital had already been committed and a near-term pullback was possible. The timing of these sentiment indicators is not precise and is used only to add color to primary market-trend and relative-strength analysis. The short-term indicators tend to be self-correcting as greed quickly turns to fear and the market creates new opportunities.

As a strategy that attempts to identify strengths and weaknesses among the primary asset classes, Tactical Trend has a flexible asset allocation approach. The asset classes we analyze and allocate to can include US equities, international equities, fixed income, commodities, and cash. Within the selected asset classes, we use trend and relative-strength analysis to measure risk vs. reward and determine capital allocations. While no strategy is perfect, this analysis tends to highlight broad market changes, and it focuses our attention on where capital is being treated best. Although the strategy raised cash during Q1, our favored asset classes have not changed vs. last quarter. Domestic equity and international equity remain our preferred asset classes, and we view the current market volatility as normal from a historical trading perspective. The past 24 months of little downside volatility have perhaps heightened the emotional response to current action. Please review our current strategy allocations below, but realize that positions can and will change as risk levels change.

US Equity: (50%) Broad market exposure through QQQ & RSP. We would look to add Banks on further weakness. Our primary concern is weakness in Basic Materials (XLB).

International Equity: (30%) 50/50 exposure to developed vs. emerging with a tilt towards Asia in overall weighting. We would look to add to emerging markets (VWO) on further weakness in a solid long-term trend.

Fixed Income: (0%) No position currently, although muni spreads are attractive.

Commodities: (0%) No position currently, but oil trades well and is the midst of a pullback. It may be attractive on further weakness, as we tend to buy commodities on pullbacks vs. runs.

Cash: (20%) Up from 7% at year-end. Represents capital raised from Consumer Discretionary (VCR) in early 2018.

Matthew C. McAleer
Managing Director & Portfolio Manager
Email | Bio


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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




More on Muni Credit

My colleague Patty Healy discussed the muni sector’s credit scoring and status in her recent quarterly commentary. See http://www.cumber.com/q1-2018-municipal-credit/. Readers who missed her missive may want to take a look at it, as it recites lots of evidence of upgrades and downgrades in municipal credit and why they happened. Patty is an expert on municipal credit.

Let me address a market reaction to these credit changes and why that gives separately managed accounts an edge over certain mutual funds and passive muni portfolios. In the latter there are often a set of fairly rigid allocation limits. We know that edge is real from our observation of funds.

When a fund has an allocation method that is rigid, it must watch the weights of its holdings. Thus it may have an allocation to California and another to New Jersey and so forth. Now what happens in the marketplace when California gets a credit upgrade and New Jersey gets a credit downgrade? The market values of California bonds go up while the market values of New Jersey bonds go down.

For a separately managed account this credit shift doesn’t require an allocation change if there are no allocation constraints. The manager can adjust in anticipation and will quite likely use an advanced forecasting credit-scoring system to make those adjustments prior to the actual credit-rating changes. At Cumberland, we try to do that all the time. We want to be ahead of the tsunami.

The passive mutual fund faces a different situation. It is governed by the rules in its prospectus and must comply with them. If it is a state-specific fund, it has to continue to own the New Jersey bond whether it wants to or not. The same is true for a California state-specific fund.

But if it is a national fund, it may encounter a different problem. The fund’s holdings are imbalanced after the credit-rating changes. The New Jersey allocation is down in price while the California allocation is up. Thus the weighting scheme, which is required by the mutual fund’s specific rules, may be out of whack. The fund must make an adjustment, and that usually means the trader has to do something he doesn’t want to do. He has to reduce the position of his higher-rated California bonds because it is now overweight, and he has to increase the position in his lower-rated New Jersey bonds. Additionally, there are usually time limits that govern how long a trader has to make these changes.

Market agents like Cumberland know this and can therefore anticipate that certain bonds may become cheap while other bonds become more richly priced. These distortions affect the entire muni bond market but are not well understood by the retail bond buyer or by the passive-allocation community of family offices and consultants. The nuances are frequently missed. The distortions create market inefficiencies, which can then be seized upon by a separate account manager.

The evidence of these distortions is seen in muni pricing. Remember, this is a freely operating market. The price and yield of any single municipal bond that trades is a direct result of a market transaction between a buyer and a seller. That seller or buyer may be a separate account manager like Cumberland, or it may be an uninformed or unskilled individual, or it may be a passive family office. It makes no difference that the players are diverse or have different levels of skill: It is the price that reveals the market’s inefficiencies.

Here is a recent example:   A very-high-quality housing finance agency bond came to market with a yield above 4%. The bond was secured by a block of mortgages, and most of the collateral had the direct or contingent guarantee of the federal government. At the same time the new issue was coming to market, the US Treasury 30-year bond was trading at about 3%. The housing agency bond became available when the market was experiencing reallocations, so that meant that its pricing was a second-order derivative of the reallocation of other bonds.

Why was the housing bond in excess of 4% tax-free versus the 3% taxable Treasury? On the face of it, this makes no sense at all. But when the muni market is distorted, the ripples of those distortions impact many bonds, and such opportunities to present themselves to those prepared to seize them. At Cumberland we bought the 4% plus tax-free housing bond for our clients. We avoided the 3% long-term US Treasury bond. Note that the actual credit exposure taken by our client was about the same.

Patty has explained the dynamics of muni credit in her quarterly piece. All we want to add to her excellent commentary is that there are market dynamics that allow an active separate account manager to seize opportunities. The bottom line is the same: Dig deep in the weeds and understand the credit and the dynamics of its market pricing. Thorough research works to your advantage.




Why David Blond is Wrong on Trade

We thank readers for their thoughtful responses to David Blond’s guest paper on trade and tariffs, Winners and Losers from Global Trade. That paper triggered debate. Below is Bob Brusca’s rebuttal. Enjoy the debate as each person can decide her/his own viewpoint.

David R. Kotok
Chairman and Chief Investment Officer
Email | Bio


Why David Blond is Wrong on Trade

 

I have just been sent a link to this paper, Winners and Losers from Global Trade, by David Blond. Reading it so upset me that I have prepared a rejoinder…

There is nothing an economist likes more that to use a number of quantitative techniques and numbers to dazzle people when some simple understandable observations would do just fine.

I do not need to think about input-output tables or to look at employment output vectors to know that the US is more trade dependent on the import side than just about anybody else and will be hurt a lot by a trade war.

The US has been riding massive consistent deficits on current account since the early 1980s.

There are several points to be made about trade and Free trade quite apart from Mr. Blond’s approach.

The first is to note that however you want to think about a trade war, the best way is to consider that it is being contemplated by adults with some understanding of the process and not to plow straightaway into a ‘I hit you’, ‘you hit me’, so ‘I hit you back’ exchange. We know where that leads.

Before Daniel Ellsberg was known for the Pentagon Papers he was known for some insightful thinking about statistics and for thinking about thermonuclear war. Ellsberg pointed out that the ‘usual approach’ to look at the expected value from this conflict made no sense since the condition really had no real probability distribution. It was not an ‘experiment’ that would be run over and over. It either would happen or it would not. It was binary in nature. And that if it happened the destruction would be terrible all around and if it did not happen, life would go on untainted by it. So he concluded that you have to think about thermonuclear war in a different way and one cannot think in terms of expected values.

I would argue that the same is true of trade and trade wars. You do not threaten one to start one any more that Kim Jung Un is really threatening that he will launch a missile at the US. He has a different objective in mind. He is trying to get our attention. Job done.

Trump did push Europe over NATO. And this I think is the model for trade. The US was in the right on NATO. Europe and Germany were in the wrong. The US funds most of NATO but each member is supposed to spend monies on defense as well. Obama had pushed Germany to no avail. Other US presidents before him had pushed them to spend more too. But Trump put his foot down prompting Angela Merkel to call Trump and the US a bad ally. Really? I bet that that is not how history will see it.

So this is a similar strategy to the NATO gambit applied in another situation where the US (or Trump and his advisors if you prefer) think America has gotten a bad deal.

One thing Blond does not do is to look at the trade system or result and critique it. He runs models and accepts today’s factor prices as a baseline…WHY?

The export-led growth model
The world matrix of trade we have today is not what any free trader would have expected or would recognize. We have countries that run unstoppable deficits and others with relentless surpluses. The question is not can a country get better growth by having export led growth. It is think obvious that an export led growth economy is easy to maintain and one of the easiest ways to jump-start growth in an underdeveloped region. That does not make it right. You get foreign technology and capital to come in and combine it with your cheap labor. They train your labor force that uses their technology. If you are unscrupulous you also steal their technology… They make stuff export it cash rolls in, Viola! The exporting nation needs to manage its exchange rate so that it does not get too strong from all the exporting. And it needs to make sure wages do not rise too fast. But there is not much internal balancing required.

Unbalanced prices and wages stem from unbalanced development!
Blond speaks of the imbalance between wage and prices. Well this is a problem if you run a balanced growth model. You need wages cheap enough to continue to export but high enough to afford a domestic demand for your people to buy some of the things they make. I don’t think that because China wanted to develop so fast that it should be allowed to run roughshod over what used to be free trade rules. Blond seems to want to defend that. But in free trade with a market-determined exchange rate, rapid production in China would cause its exchange rate to rise and increases wealth in China would permit the consumption of more good including imports and likely undercut competitiveness and lower the proportion of growth that could be achieved by an export-led program. Blond seems to be looking at China’s numbers and arguing BACKWARD that because China has done this we have to let it go on because the export to price ratio is out of whack. Really? What else could have happened under that strategy?

I refuse to take the current ‘market’ prices and wages as given. Why do China’s actions that have created all these factor price relationships become enshrined? China has acted in a very, shall I say, China First fashion. And some will say that developing economies have always been allowed to play by ‘special rules.’ And I will not deny that. But China, as such a huge country, has a much more pronounced impact on the global economy than Thailand or Taiwan or South Korea.

The knock against Trump is not that he wants to start a trade war although I am aware that he says that they are good and easy to win. They are not good nor are they even winnable.

The fact that a tit-for tat trade war makes everyone worse off is not the point either. There is plenty of literature from collective bargaining that shows that strike behavior by unions usually makes both the firm and the union worse off in the long run even if the union gets better benefits for its members. There is the loss of income/output from having a strike to be considered.

Strike or trade confrontations are usually about a lack of information or about credibility. I think that as in the case of NATO, the US complaint that trade is not free or fair is obvious. That US jobs are lacking because of it is obvious- so obvious as to not even need any statistical work to prove it! What is it about 35 years of unrelenting current account deficits that does not look like free trade to you?

What has been expected?
When fluctuating exchange rates were considered it was thought that exchange rates would shift to balance current account deficits. But that is not the case. Countries with export-led growth models hang on to their ‘excess dollars and reinvest them in the US effectively doing an end run around the exchange rate adjustment mechanism. The Chinese do not buy our treasury securities because they are trying to help us. They are trying to help themselves (…to our demand and to our jobs). And if they could find a way to do it without buying so many US securities you can bet they would!

My point is that you cannot BEGIN to understand the current global trading system without understanding what drives it and what sustains it. And if you want to be an advocate for manipulated trade you can join Mr. Blond and support China and others. You may support Germany with the largest current account surplus to GDP ratio among all developed countries.

I suppose one problem with ex-ante thinking about the exchange rate system is that it was done by academics in a fixed rate regime/gold standard where current account balance really meant something.

Many actors and interests
The politics of trade are complicated. US multinational corporations have been active forces in using cheap production locations overseas to beat down unions in the US and curtail wages. Why do you think that the Phillips curve no longer works. XYZ Corp, Inc. can just pick up the phone and order output from China instead of paying a penny more in the US.

Chuck Schumer every year would rattle his saber on FX manipulation then do nothing as he and fellow Democrats pocketed millions in campaign donations from multinational ‘free trade loving’ (wink, wink) corporations.

If there were a real trade war I doubt that anyone would fare well – I don’t need a model to see that. China would be less affected because its import side is not so stacked, But its exports (read jobs, output and income generation) would come to a halt and that would not be good. Americans would spend more time trading with one another on eBay. We have so much surplus stuff a fashion industry could rise up on the idea of recirculation. We have food and oil. We are militarily strong. Really who is going to be hurt the most?

No I do not think the input-output tables tell the tale of who gets hurt in a trade war-not really.

But I still think that this is not about trade warfare. I think Trump picked a few innocuous industries to make a point. The Chinses previously were flooding the market with cheap solar panels. And yes it was nice to buy them cheap- but it’s not fair. China has been dumping steel made in outmoded plants forever!

I think it is very hard to envision a world with real fair trade.

Dollar supply?
As for the argument that we need to supply dollars to the world, that is bogus. Right now so many countries are adding dollar assets only because they have to in order to keep their desired foreign exchange peg. Dollars are not created by a current account deficit they are created by the Federal Reserve and by a fractional reserve banking system. His dollar supply argument is upside down and wrong. We do not need to ‘supply dollars through our current account deficit. Besides… the current account deficit implies a capital account surplus: monies are flowing INTO the US to fund our Current Account deficit and to fund our fiscal deficit and to keep our interest rates low and to keep the dollar from falling and becoming cheap and undercutting competiveness overseas.

A lot of observers try to salve our pain about having a large deficit by arguing that the strong dollar gives the US great purchasing power. Well that is great if you have dollar assets and dollar income and want to buy stuff. But if you are a worker and need a job that strong dollar prices you OUT of the global labor market. The strong dollar does make imports cheap and that encourages us to over consumer and to under save. And it reinforces a lot of bad habits we need to break. So where is the advantage?

Hoodwinked?
This past week I wrote about the consumer sentiment index with some record high standing components. How is that possible? Real wage growth has been stunted. Real wages are not growing well at all. There are myriad jobs available but few of them good. Yet since Trump took office and started to verbally warn companies about going overseas and targeting Mexico and trying to stop the outflow of manufacturing, the growth in manufacturing employment has been rising more rapidly. The service sector job creation rate has slowed but goods sector job creation is up. Still, it is such a small portion of the economy that it will win Trump few plaudits and does not explain the reading for consumer sentiment which to me is a reflection of reduced expectations. Young people do not realize how much the President and Congress are mortgaging their future based on the debit profile we now have and the off balance sheet liabilities of government. How can people claim to feel so good when things are so mediocre?

I do not think that the markets the public or the Fed have much of a handle on what is going on. And I think that many people dislike our President and for that reason have too easily fallen into the trap of hatting Trump and hating what he does.

But I not think he is wrong on trade. The unemployment rate does not tell the real story because too many people have dropped out of the labor force. It’s become a labor farce.

In Adam Smith’s famous treatise known by its short title ‘The Wealth of Nations’ at the very beginning cites ‘the proportion of the population that is engaged in commerce’ as an important determinant of the wealth of a nation. The chart above recasts the unemployment rate as a ‘not employed rate (red). I plot the conventional U3 number of unemployed VS the whole of the age 16+ non institutional population eschewing the notion of a labor force. Then also, using the same denominator, I calculate the number of people NOT employed (those unemployed plus those not in the labor force and not working). The result is stunning. Since the early 1980s the two series have roughly the same behavior but for very different rates (note the right sale left scale differences). But until this cycle the signals for each one for policy were roughly the same. Now the signals are very different.

Trade and technology together have been huge disruptive forces. Some nations have used very self-serving policies to preserve or to expand their growth environment at home while pushing the adjustment off to the overseas markets. The Trump Administration has just terminated a set of ongoing trade talks with China because it no longer sees China as making progress but as backtracking. I agree with this my article (here). In it I argue that China’s belt and road policy is big red herring for backsliding. I think that taking a more aggressive posture on trade is appropriate.

Let me close with an example. I love basketball and ‘tis the season for it. But it is more than one kind of game. The game you see on TV is one kind of basketball. In that game there are officials and they interpret and enforce the rules. If someone slaps you while you are shooting the referee does not blow the whistle, then you were not fouled. Its simple: what the refs say goes. But there is another kind of basketball called pick-up, it’s played informally without referees. If someone grabs your shirt while you are shooting then you grab his while he is shooting. If someone steps in your foot to keep you from jumping and you let him get away with it then that’s on you, not on him. Trade is more like a pick-up game even though there is a WTO. Some of the rules and market practices are hard to enforce. The most difficult one is about exchange rate values. But there is nothing in trade like the study of Industrial Organization and its mantra of “structure conduct and performance.” If there were, maybe more people would look at long strings of surpluses and smell a rat. But people are instead schooled in the counterargument to protect and defend our current system and to call it free trade. Well you can call my cat a dog he still is not going to bark. In this scheme of things the US must stick up for its own interests or it will be exploited and marginalized.

When we were a wealthier country and before we had gotten used to our economic mortality there was a lot that we used to do that we can no longer afford. Some want Trump to continue to dole out foreign aid in fistfuls and for the US to continue to be the great benevolent nation it used to be. But the government’s own deficits are huge; its off-balance sheet liabilities are shockingly large. And our ability to the play the role we used to play is more limited. We need our allies to pitch in and pay their fair share. We no longer can look the other way when they game us on trade. I understand that other countries like playing the game under the old rules, but they just do not work for us anymore. If America is going to keep its place in the world it must first preserve its own economic strength. And having 2% to 5% worth of GDP siphoned off into foreign economies each year through a hole in the current account no longer works for us. Trade/Current Account deficits are neither good nor bad. But these deficits of ours have only financed current consumption at an excessive pace and at the cost of leaving a bigger legacy of debt for future generations. That violates a whole lot of economic rules on fair play. Our deficits are bad because they do bad things to us now and because they are instrumental in placing the debt for today’s good times on the backs of future generations. Something has got to give and Trump is on the right track. It may be for the wrong reasons but he is the right track.

Robert Brusca – Chief Economist – FAO Economics
Email: Robert.Brusca@verizon.net


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Q1 2018 Municipal Credit

Ratings, Teachers’ Strikes, Pensions, Higher Education

During the quarter, Moody’s and S&P reported that upgrades of municipal bonds continued to dominate downgrades in 2017. For S&P it was the sixth year in a row, with California leading the way in the number of upgraded issuers, followed by Florida and Texas. For Moody’s it was the third year in a row that upgrades surpassed downgrades. Moody’s noted, however, that the dollar amount of downgrades did exceed that for upgrades. The downgrades of New Jersey, Illinois, Connecticut, Puerto Rico, and related issuers accounted for almost 70% of downgraded debt. As our readers know, we have avoided the mentioned issuers’ bonds – except for selected insured bonds of Puerto Rico. Overall, the positive ratings environment is expected to continue with projected economic growth, although S&P notes that the tax reform limits on the deduction of interest for mortgages larger than $700,000 could constrain home prices in high-cost places like California (limiting the flexibility to raise property taxes); and the cap on federal deductions for state and local taxes could also produce stress in high-tax states, thus limiting upside ratings movements and potentially resulting in downgrades. Notwithstanding the positive growth, outlooks show that pockets of weakness are expected to remain in healthcare and higher education.

State Ratings

We noted in our last quarterly municipal credit commentary (http://www.cumber.com/q4-2017-credit-commentary-taxes-pensions-ratings/) that state rating activity had waned; and now the first quarter of 2018 is the first quarter in at least seven when there was no rating action on any state by Moody’s, S&P, Fitch, or Kroll; and that includes trend changes.

There was plenty of state news, however, focused on teachers’ strikes.

The West Virginia teacher’s strike closed all schools in the state for nine weekdays ending March 6th. The teachers prevailed and secured a 5% pay increase for public employees and a pledge to review healthcare coverage. The raises will likely come from reductions in other services. Oklahoma teachers have a strike planned for April 2nd, and although the state did grant a pay raise to public employees on March 26th, as of this writing the strike has yet to be called off. The pay increase will be funded by increasing taxes on oil and gas production, hotels, tobacco, diesel fuel, and gasoline. Arizona teachers are looking for pay raises, too, and a strike could be on the horizon after teachers’ success in West Virginia. There are also rumblings from teachers in Kentucky, who are worried about potential changes to their health and pension benefits. K–12 education is one of the largest spending items for states, second only to Medicaid, though it declined from 22% of states’ spending in 2008 to 19.4% in 2017, according to a report by the National Association of State Budget Officers. Overall spending on education increased 3.9% in 2017; however, the growth in Medicaid spending was 6.1%.

Pensions and OPEB 

Wages are only one form of compensation that public teachers receive. They also receive pensions and other post-employment benefits (OPEB) such as healthcare. For the past three years, governments have been required to report pension liabilities in greater detail, with historical information and illustrations of how their pension liabilities will change with changes in assumptions (such as a 1% change in the discount rate). As we have commented in the past, the lowering of the discount rate increases a future pension liability and raises the annual amount that must be paid into the pension plan to keep the liability from growing further. This factor is important, as the funded level of many plans is below 100% and the average was just 72% for fiscal 2015, as reported by Pew Charitable Trust. According to the Government Accounting Standards Board (GASB), accounting standards 67 and 68 are designed to improve the decision usefulness of reported pension information and to increase the transparency, consistency, and comparability of pension information across state and local governments. Starting in fiscal years ending June 30, 2017, GASB statements 74 and 75 require similar reporting of OPEB obligations. Although OPEB obligations are less contractual than pension promises are, they are not politically easy to reduce, and they are generally lower-funded or not funded and paid on a pay-as-you-go basis.

Reducing benefits is one way governments have been trying to reduce growth in unfunded liabilities. As governments are challenged by the decline in the ratio of current employees to retirees, as well as by competing demands for resources, the greater transparency required by GASB is welcome to analysts and stakeholders alike.

Speaking of Education

In February, Moody’s published an article, “Declining international student enrollment dampens US universities’ tuition revenue growth,” that cited two studies showing declines in international student enrollment. The Council of Graduate Schools found that international undergraduate applications declined by 3% and enrollment at the graduate level fell by 1% in 2017, reversing a decade-long expansion. In a January report, the National Science Foundation (NSF) found that international undergraduate enrollment declined by 2.2% and international graduate student enrollment declined by 5.5% 2017. Variations in the two studies are attributed to the different samples used. International students generally pay full tuition; and although international students account for less than 5% of overall enrollment, they represent good business in the margin. Declines were most noticed in schools with less brand recognition and in non-research-intensive programs. The NSF report concludes that the effect of new immigration policies, changes to visa regulations, and uncertainties around job opportunities post-graduation may continue to hamper application and matriculation rates of international students over the next several years. In January 2017 we noted the potential risk to higher education in a commentary “Higher Grounds for Higher Education” (http://www.cumber.com/higher-ground-for-higher-education/) and emphasized that our strategy is to invest in larger, well-established institutions with strong demand characteristics.

Notwithstanding the international student effect, increased competition due to declining student populations and ever-rising tuition costs have caused some smaller private colleges to struggle financially. In an early March article, Bloomberg noted that these challenges have led to some schools merging with each other or being absorbed into larger institutions. There were at least 55 merger and acquisition transactions among colleges and universities between 2010 and 2017. The Northeast is particularly affected since it has a high concentration of colleges while the number of high school graduates is expected to decline. A number of years ago we decided to avoid small private colleges noting declining enrollment trends, higher costs, and increased competition from public institutions.

Cumberland is sponsoring the second annual Financial Literacy Day on April 5th at the University of South Florida Sarasota Manatee campus. The event is open to public participation. All are invited and welcome. You can make your reservation online and learn more at https://www.interdependence.org/events/second-annual-financial-literacy-day-update-financial-markets-economy/.

Patricia Healy, CFA
Senior Vice President of Research and Portfolio Manager
Email | Bio


Links to other websites or electronic media controlled or offered by Third-Parties (non-affiliates of Cumberland Advisors) are provided only as a reference and courtesy to our users. Cumberland Advisors has no control over such websites, does not recommend or endorse any opinions, ideas, products, information, or content of such sites, and makes no warranties as to the accuracy, completeness, reliability or suitability of their content. Cumberland Advisors hereby disclaims liability for any information, materials, products or services posted or offered at any of the Third-Party websites. The Third-Party may have a privacy and/or security policy different from that of Cumberland Advisors. Therefore, please refer to the specific privacy and security policies of the Third-Party when accessing their websites.

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Cumberland Advisors Market Commentaries offer insights and analysis on upcoming, important economic issues that potentially impact global financial markets. Our team shares their thinking on global economic developments, market news and other factors that often influence investment opportunities and strategies.




Asia Equity Markets: Solid Economic Growth Versus Political Risk

Asian economies have begun the year with continued solid – and in some cases robust –performance. Yet the major Asian stock markets have diverged, with some significantly outperforming and others underperforming. In this note we focus on Japan, China, and India.

As this note was written, President Trump announced his administration’s intention to impose tariffs on $450 billion of Chinese imports, lodge a WTO dispute against China, and impose restrictions on Chinese investments in the US. Global markets tumbled last Thursday and Friday as fears of a world trade war surged. We share those fears, regretting that the Trump administration had not done as US allies had urged and taken a less risky, multilateral approach, which would have had a better chance of success. Then China responded in a surprisingly moderate way, and over the weekend the US reported that positive talks with China were underway. Also, an important bilateral trade agreement was announced between the US and South Korea, covering steel, autos, and other areas. In addition the European Union, Brazil, and Argentina were exempted from the steel and aluminum tariffs, joining Canada, Mexico, and Australia in that regard. Global equity markets, including those in Asia, recovered since the weekend as fears of a trade war have receded. They then declined again, this time on concerns about the technology sector. We will be writing separately on global markets and trade developments.

While all the stock markets in Asia together do not reach the size of the US equity market, some of them are quite large. Using data provided by the World Federation of Exchanges for year-end 2016 domestic market capitalization (reported in millions of US dollars), China’s equity markets, at $7,311,460 million, are the region’s largest. Japan’s equity market is second largest, at $4,955,300 million. Hong Kong’s market, at $3,193,235 million, is third, with fourth place India being very close at $3,106,267 million. Fifth and sixth largest are Australia, at $1,268,494 million, and Taiwan, at $928,366 million. It is noteworthy that the aggregate capitalization of China, Hong Kong, and Taiwan’s markets is about the same as the aggregate capitalization of all the European equity markets.

The Japanese economy has looked relatively robust in the first quarter, although the pace of improvement in business conditions appears to have moderated somewhat. In the manufacturing sector, output, new orders, and employment growth rates have all slowed. Looking ahead, firms are anticipating increased skill shortages in a very tight labor market. Yet according to the HIS Markit Japan Business Outlook for February, firms are optimistic about demand growth and profits and expect to increase their workforce numbers and capital expenditures. Despite some slowing in the first quarter, then, overall economic growth for the calendar year 2018, as measured by real GNP, could well surpass the 2017 pace, 1.8% versus 1.7%. While these growth rates look quite modest compared to those of many other advanced countries, they represent full-capacity growth for Japan, with its aging population. The forthcoming March Bank of Japan Tankan report should give further information as to whether business sentiment is becoming more negative.

The slight slowing recently in the still strong pace of economic activity in Japan probably is not the most important negative factor affecting business and equity market sentiment. Rather it has been the political storm winds confronting Prime Minister Abe and concerns about whether his economic policy, “Abenomics,” which has been very beneficial for the Japanese economy, is now at risk. The so-called Moritomo Gakuen scandal, which involved possible political influence exerted by Prime Minister Abe’s wife in a land deal, worsened when it was reported that Ministry of Finance officials admitted to a cover-up attempt by altering public documents. Abe’s voter support, as indicated by several polls, plummeted with this news; and fears grew that Abe might be forced out of office. Should that happen, he would very likely be followed by a more fiscally conservative successor. Abe’s expansive economic policies probably would not continue.

This is a risk confronting Japanese markets, and it is still evolving. However, we have not yet altered our base-case assumption that Abe will survive politically and be able to win his LDP Party’s leadership election in September. Moreover, and perhaps more importantly, the governor of the Bank of Japan has been reappointed to a second five-year term, along with two deputy governors, Masayoshi Amamiya and Masazumi Wakatabe. The three share a strong determination to continue the Bank’s reflationist policy, which has been the most effective element in Abenomics. A continuing feature of that policy is the Bank’s periodic significant purchases of Japanese equity ETFs in addition to bonds. ETF purchases by the Bank in March have been at a record level.

Last week Japanese equity markets joined the global market pullback in response to increased fears of a possible trade war. Foreign investors were reported to have sold over 2 trillion yen of Japanese stocks during the week.The iShares MSCI Japan ETF, EWJ, fell about as much as the 3.8% drop in the benchmark MSCI All Country Ex United States ETF, ACWX and is participating in this week’s global recovery. Before last week, Japan’s equity markets had been underperforming other Asian markets since the beginning of the year, with EWJ’s increasing barely 0.025%, compared with the 4.29% gain for the iShares MSCI All Country Asia ex Japan ETF, AAXJ. The political scandal, the softness in some economic indicators, and the almost 7% year-to-date strengthening of the yen have all been headwinds. We are maintaining our Japan positions in our International and Global portfolios, as we anticipate stronger economic performance in the coming months and a continuation of Abe’s and the Bank of Japan’s expansionist economic policies.

China, Asia’s largest economy, continues to expand at a rapid rate, contrary to predictions by some for a sharp slowdown. China’s macroeconomic fundamentals remain robust. Economic growth has accelerated in the opening months of this year and looks likely to average 6.7% for the year, just slightly below last year’s 6.9% pace and above the government’s target of 6.5%. Strong global trade momentum will permit exports to continue to support the economic expansion. The government is taking measures to gain better control over excessive credit growth and to reduce financial risks, which have been an area of concern. Yi Gang, China’s new central bank chief, has stressed his intention to address the challenge of the high debt levels of state-owned companies, local governments, and households. Reforms to further open the economy to promote competition and to cut excess capacity are continuing.

Up to last week’s global equity tumble, China’s stock markets had been outperforming strongly this year. For example, the iShares MSCI China ETF, MCHI, was up 8.5% year-to-date. Last week it dropped 7.5% in the wake of Trump’s announcement of trade measures against China. This week China’s stocks joined in the recovery as trade war fears eased but then joined the tech sector swoon that started in the US.

India’s economy is likewise expanding rapidly. Indeed, it led the globe in the final quarter of 2017 with a growth rate of 7.2%, an expansion to which all sectors except mining contributed. The economy is recovering from a marked slowdown in the first half of 2017, triggered by a new goods and services tax and the government’s demonetization action in November 2016, which required most cash holdings to be deposited at banks. The latter move was intended to reduce India’s huge informal economy. Growth in the first half of this year looks likely to accelerate further to a 7.8% annual pace and then possibly moderate to a 7.6% rate in the second half of the year and in 2019. This growth performance would still lead the globe.

There have been some indications that business confidence among Indian firms softened in the first quarter, despite the strong macroeconomic prospects. That may have been one factor behind the underperformance of India’s equity markets in the first quarter. The iShares MSCI India ETF, INDA, was down 5.4% year-to-date before last week, when it lost an additional 2.8%. Probably more important was the unexpected return of the long-term capital gains tax in the budget. Also, there was a major fraud case involving the second largest state-run bank. This scandal countered the positive effects on market sentiment of a $32 billion capital infusion for state-run banks. We are maintaining our India positions in our International and Global portfolios.

We are also our maintaining our positions in the iShares MSCI All Country Asia ex Japan ETF, AAXJ. This ETF provides wide exposure to Asia, excluding Japan and Australia. Over the past 12 months, including this year’s volatile period, this ETF gained 19.9%, much better than the benchmark ACWX’s gain of 12.2%. The country weights in AAXJ for the top six markets are China, 39%; South Korea, 17.5%; Taiwan, 13%; India, 10%; Hong Kong, 5.75%; and Singapore, 4%. Note that China’s 39% weight appears to consist of about 7% Chinese firm stocks listed in Mainland China markets and 32% Chinese firm stocks listed in Hong Kong. We use this ETF to add to our China market exposure while diversifying risk. In last week’s market swoon, the positions in less volatile markets such as Taiwan, India, and Hong Kong certainly helped moderate the fall in AAXJ. Going forward, the substantial South Korea position should benefit from the US–South Korea trade agreement and the appearance of some easing of the political tension with North Korea.

Overall, Asian economies are likely to continue to play a leading role in the global economic expansion, which we expect to remain robust despite some recent signs of deceleration, mostly due to seasonal and weather-related factors. Asian equity markets should benefit from fundamental growth forces, but individual national markets will continue to have differing performances due to domestic developments. We expect market volatility in the emerging markets of Asia to continue to be relatively high.

Bill Witherell, Ph.D.
Chief Global Economist & Portfolio Manager
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