Let’s talk Turkey!
So, how did a country that represents just about 1.4 percent of the world’s economy spark a global selloff?
Turkey was once a rising star. The country’s Prime Minister Recep Tayyip Erdogan took office in 2003 and his “conservative, pro-business policies helped pull the country back from an economic crisis,” reported Financial Times.
As Turkey’s economy strengthened, investors saw opportunity. Investments from outside the country averaged about $13 billion a year, according to World Bank figures cited by Financial Times, although investment slowed after terror attacks in 2015.
Bloomberg reported Prime Minister Erdogan has become more authoritarian since being re-elected in 2018, giving himself power to name the head of Turkey’s central bank. Financial Times reported the Prime Minister’s “…unorthodox views on interest rates…has proved disruptive for monetary policy, leaving…Turkey’s central bank, struggling to contain inflation that is running at close to 16 percent.”
Lack of central bank autonomy concerned investors. The Turkish lira began to weaken against the U.S. dollar, making it costly for businesses to repay dollar-denominated debt.
Politics have factored into the situation, as well. During 2018, negotiations were underway to secure the release of an American pastor who was arrested on “farcical terrorism charges,” reported The Economist. However, talks collapsed early in August. Asset freezes and sanctions followed, along with promises of additional tariffs on Turkish goods imported by the United States.
The subsequent steep drop in the value of Turkish lira sparked concerns that rippled through global markets. Financial Times reported:
“Turkey’s deepening crisis punished emerging market currencies and sparked a global pullback from riskier assets on Friday…The S&P 500 fell 0.7 percent in New York on Friday. Treasury yields also moved lower, with the 10-year dipping below 2.9 percent for the first time this month, as investors sought safe assets…Investors’ shift from risky assets knocked equities across Europe, with Germany’s Dax, France’s CAC 40 and Spain’s Ibex all about 2 percent weaker.”
For quite some time, investors have appeared immune to geopolitical risks. Perhaps that is beginning to change.
Capital gains tax reform comes with a big price tag: $100 billion over 10 years.
A capital gain is any increase in the value of an asset, such as an investment, a home, land, etc., between its purchase and its sale. The amount of a gain is determined by subtracting the purchase price from the sale price.
Last week, the White House proposed capital gains be adjusted or ‘indexed’ for inflation before they are taxed. Princeton Professor Alan Blinder explained the idea in The Wall Street Journal:
“Why index gains? Suppose you own a stock for many years, during which time overall prices have doubled because of inflation. Over the holding period, the value of your stock also has doubled. When you sell, the proceeds have precisely the same purchasing power as the original purchase. There’s no gain, no loss. But under current tax law, you owe taxes on the phantom ‘gain.’ Worse, if your stock went up by less than the cumulative inflation, you’ll still get taxed despite your loss. This is unfair and dysfunctional.”
While the suggestion is appealing to many investors, it’s not without controversy. For example, the White House suggested the Treasury Department change the tax code without Congressional approval by modifying enforcement regulations. However, the legislative branch – Congress – is constitutionally responsible for tax law.
In addition, adjusting capital gains for inflation without doing the same for interest expense and depreciation may allow some taxpayers to be able to generate significant losses on paper. Current tax law includes provisions that limit this kind of tax strategy, but indexing capital gains would reopen the door, reported the Tax Policy Center.
Another consideration is the impact of the change on the deficit and the national debt. The Congressional Budget Office estimates suggest 2017 tax reform will increase “…the total projected deficit over the 2018-2028 period by about $1.9 trillion.” Adjusting capital gains for inflation could increase the shortfall by about $100 billion over a decade, reported Naomi Jagoda for The Hill.
Is it a sugar rush or something more sustainable?
Economic growth in the United States was strong during the second quarter. Gross domestic product (GDP), which is the value of all goods and services produced in the United States, grew by 4.1 percent. That’s the fastest growth in four years, reported the BBC.
The news was received with varying levels of enthusiasm. President Trump said the gain is “an economic turnaround of historic importance” and thinks the economy should continue to grow rapidly, reported Shawn Donnan in Financial Times.
Economists were less certain. They think second quarter’s GDP gains were underpinned by one-time factors. These included high levels of profitability attributable to last year’s corporate tax cuts and an increase in exports as U.S. producers and their buyers abroad tried to avoid upcoming tariffs, reported Financial Times.
Another consideration is the business cycle. The business cycle tracks the rise and fall of a country’s productivity over time. The U.S. appears to be in the latter stages of the current cycle. John Authers of Financial Times explained:
“…President Donald Trump’s self-congratulation yesterday was fully merited. Things are going according to plan. This business cycle looks ever more like a normal one, which is a fantastic and welcome development after an epochal crisis and then a decade of doldrums…The advent of a normal cycle is itself a problem because a normal cycle terminates with high interest rates and declining growth. The president has voiced his disapproval of these things, but they are the logical and sensible consequence of the economic developments that are now unfolding.”
In the United States, the Dow Jones Industrial Average and the Standard & Poor’s 500 Index moved higher while the NASDAQ Composite gave up some ground.
Last week, there was some good news and some notable news.
Here’s the good news: Corporate earnings have been strong. As of July 20, 17 percent of the companies in the Standard & Poor’s 500 Index had reported second quarter results. More than 85 percent of those companies reported positive earnings surprises, according to FactSet, which means they earned more than expected.
“It appears the lower tax rate is more than offsetting the impact of rising costs, resulting in a record-level net profit margin for the index for the second quarter,” explained FactSet.
Here’s the notable news: U.S. stock markets largely ignored a slew of domestic and global issues to finish up a basis point or two last week. (Performance was flat when you round to one place, as we do in the table.) Barron’s reported:
“President Donald Trump took on the Federal Reserve, telling an interviewer that he’s ‘not happy’ about rising interest rates, the kind of meddling we haven’t seen in a while. We also had the usual trade war concerns, as the president and his advisors talked about the need to take on what they consider China’s unfair trade practices. China’s yuan, meanwhile, tumbled in a way that was a little too reminiscent of August 2015, when its slide caused global markets to shudder. Those concerns, however, were offset by strong corporate earnings.”
The U.S. bond market has been less sanguine than the U.S. stock market. Debate has focused on the flattening yield curve. The yield curve reflects the difference in yield on U.S. Treasuries from short- to long-term. Normally, investors expect to earn higher yields when they lend their money for longer periods of time (e.g. invest in longer-term bonds).
At the end of last week, two-year U.S. Treasuries yielded 2.6 percent and 30-year Treasuries yielded 3.0 percent. Some say when short-term rates rise above long-term rates, inverting the yield curve, recession is ahead.
Investors are becoming more discriminating.
Trade tensions escalated as the U.S. administration expanded tariffs on Chinese goods last week. You wouldn’t have known by watching the performance of benchmark indices, though. Just four of the 25 national stock market indices tracked by Barron’s – Australia, Italy, Spain, and Mexico – moved lower.
However, if you look a little deeper into the performance of various market sectors, you discover an important fact: The market tide wasn’t lifting all stocks.
It has been said a rising tide lifts all boats. When translated into stock-market speak, the saying becomes, ‘A rising market tide lifts all stocks.’ In other words, when the market moves higher, stocks tend to move higher, too. That wasn’t the case last week.
Barron’s reported investors have become more selective:
“We went from a market where everything moved largely together to one where sector fundamentals began to matter more than where the S&P 500 was going...At the sector level, it’s apparent that no one has been ignoring tariffs. While the S&P 500 has gained 1.7 percent over the past month of trading, industrials and materials have dropped 2.5 percent, while financials have slumped 2.9 percent, hit by a double whammy of trade fears and a flattening yield curve. Utilities and consumer staples have outperformed, gaining 8.1 percent and 3.5 percent, respectively.”
Utilities and Consumer Staples are considered to be non-cyclical or defensive sectors of the market because they are not highly correlated with the business cycle.
Defensive companies tend to perform consistently whether a country’s economy is expanding or in recession. For example, a household’s need for power, soap, and food doesn’t disappear during a recession. As a result, the revenues, earnings, and cash flows of defensive companies remain relatively stable in various economic conditions.
In addition, the share prices of these companies tend to be less susceptible to changing economic conditions. Defensive stocks tend to outperform the broader market during periods of recession and underperform it during periods of expansion.
What a rollercoaster of a quarter!
When it comes to the American Association of Individual Investors (AAII) Sentiment Survey, respondents tend to be more bullish than bearish about U.S. stock markets. The survey’s historical averages are:
As the second quarter of 2018 began, investors were feeling less optimistic than usual. (About 36.6 percent were bearish and 31.9 percent bullish.) Their outlook was informed by a variety of factors, according to an early April article in The New York Times, which said:
“First there was the risk that the economy might be growing too fast, which could prompt central banks to hike interest rates sooner than expected. Then there was the risk of a trade war ignited by the White House imposing tariffs on certain products, an action that quickly prompted countries like China to erect trade barriers of their own. Next came the threat of a government crackdown on technology companies, after revelations of their misuse of customer data.”
As the quarter progressed, investor optimism increased on signs of economic strength. In early June, CNBC reported the economy appeared to be “operating close to full employment, with an unemployment rate at 3.8 percent, inflation still hovering at or below 2 percent, and business and consumer confidence strong.”
Robust corporate earnings helped spur optimism, too. FactSet Insight wrote, “The S&P 500 reported earnings growth of 25 percent for the first quarter – the highest growth since Q3 2010.” In mid-June, the AAII survey showed 44.8 percent of respondents were feeling bullish, 21.7 percent were bearish, and 33.5 percent were neutral.
As talk of tariffs and trade wars resumed, investor optimism plummeted. By the end of June, just 27.9 percent of respondents were bullish and more than 39 percent reported they were feeling bearish. AAII explained:
“Many – but not all – individual investors anticipate continued volatility and/or think that the current political backdrop could have a further impact on the stock market. Trade policy is influencing some individual investors’ sentiment as well. While many approve of the Federal Reserve’s plan to continue gradually raising interest rates, some AAII members are concerned about the impact that rising rates will have. Also influencing sentiment are valuations, tax cuts, earnings growth, and economic growth.”
Despite a downturn in bullishness, major U.S. stock indices moved higher last week.
There’s a bear in China – and it’s not a panda.
The Shanghai Stock Exchange (SSE) Composite Index, which reflects the performance of all shares that trade on the Shanghai Stock Exchange, dropped into bear market territory last week, reported CNBC. The Index has fallen more than 20 percent from its previous high. It appears some investors saw an opportunity and bought the dip since the SSE Index bounced higher last Friday, gaining more than 2 percent.
Slower economic growth and rising trade tensions were responsible for much of the red ink in China, reported Barron’s, but the Chinese government may be playing a role, too:
“What’s got global market watchers worried is that China’s stocks are sliding in tandem with its currency, the renminbi or yuan…That suggests China is using the exchange rate as a weapon. ‘The most effective way for China to retaliate [against] rising U.S. tariffs is to weaken the yuan,’ according to the July Bank Credit Analyst. That could roil financial markets, however. The dual declines in China’s equity market and currency are raising concerns of a repeat of 2015. Treasury strategists at NatWest Markets recall that the drop in the yuan that summer sparked severe equity market losses, including a 10.5 percent correction in the S&P 500.”
That may explain, in part, why U.S. Treasury bills were so popular last week, although it probably didn’t hurt the yield on short-term Treasuries was roughly equivalent to the dividends paid by the Standard & Poor’s 500 Index.
The coming weeks may deliver more excitement than Fourth of July fireworks.
What time is it?
The yield curve may be the pocket watch of economic indicators. It’s been around for a long time and it’s often right, but not always.
The yield curve is the difference between the interest paid on two-year government bonds and 10-year government bonds. In normal circumstances, an investor would expect to earn a higher rate of interest when lending money to a government for 10 years than when lending money for two years because there is more risk associated with lending for a longer period of time.
When the yield curve flattens or inverts, it suggests a shift in investors’ expectations. Financial Times explained:
“The slope made up of bond yields of various maturities has a record of predicting recessions that would make even the savviest econometrician turn pea-green with envy. It is not perfect, but the curve has become flat and inverted – when short-term bond yields are actually higher than long-term ones – ahead of most economic downturns in most major countries since the second world war.”
In the United States last week, the difference between yields on 2-year Treasuries (2.56) and 10-year Treasuries (2.90) flattened. The gap narrowed to 34 basis points (a basis point is one-hundredth of one percent). The change reflects higher short-term rates, courtesy of the Federal Reserve. It also suggests tariffs and trade issues have made bond investors more pessimistic about prospects for U.S. growth, reported The Wall Street Journal.
Globally, the yield curve is inverted. “The average yield of bonds in JPMorgan’s broadest Government Bond Index that mature in seven to 10 years last week slipped below the average yields of bonds maturing in one to three years for the first time since 2007…that indicates that investors have a pretty grim view of where the world economy and equity markets are heading,” reported Financial Times.
We’re keeping an eye on developments in the financial markets and will keep you informed.
Deal or no deal?
Last week opened with heightened trade tensions between the United States and its allies. It closed with the United States imposing new tariffs on $50 billion of Chinese goods. The Chinese declared it was the start of a trade war, reported Financial Times.
U.S. markets largely ignored the potential impact of trade wars on multiple fronts. Barron’s reported the Dow Jones Industrial Average, which includes companies that are vulnerable to tariffs, moved slightly lower. However, the Standard & Poor’s 500 Index shrugged off the possibility of trade wars, and the NASDAQ Composite gained more than 1 percent.
While Barron’s has written the largest risk to the U.S. stock market is the possibility of global trade wars, it appears many investors believe tariffs are a negotiating tactic. Barron’s reported:
“The market’s apparent indifference suggests it doesn’t see these tariffs as the reincarnation of Smoot-Hawley, but just the latest in President Trump’s negotiating tactics. Moving away from his denunciation of Kim Jong-un as “Little Rocket Man” inviting “fire and fury” by missile launches, Trump last week declared the threat from North Korea neutralized. Similarly, many professional investors view the bluster on tariffs as part of Trump’s negotiating tactics, rather than the start of an actual trade war.”
News that monetary policy is becoming less accommodating in certain regions of the world didn’t have much impact on markets either. Reuters reported the Federal Reserve raised its benchmark rate 0.25 percent last week. The European Central Bank is ending its bond-buying program and gave notice it expects to begin raising rates next summer. The Bank of Japan is still easing.
There was a lot of red ink in Asian emerging markets. China’s Shanghai Composite finished the week lower, as well. However, stock markets in Canada and Mexico finished the week higher.
Never before could the Group of 7 (G7) Summit have been mistaken for reality TV.
The generally dignified annual meeting of leaders from the United States, Canada, France, Germany, Italy, Japan, and the United Kingdom (along with the heads of the European Commission and European Council) was a lot more contentious than usual, reported Reuters.
Disagreements about trade were the reason for heightened tensions among world leaders. At the end of May, the United States extended tariffs on aluminum and steel imports to U.S. allies. They had previously been exempted. These countries “account for nearly two-thirds of the [United States’] $3.9 trillion annual merchandise trade,” reported The Washington Post.
Retaliation to U.S. sanctions was fast and furious. Mexico implemented “…a 20 percent tariff on U.S. pork legs and shoulders, apples, and potatoes and 20 to 25 percent duties on types of cheeses and bourbon,” reported Reuters.
Canada imposed $16.6 billion in tariffs on U.S exports of “…steel and aluminum in various forms, but also orange juice, maple syrup, whiskey, toilet paper, and a wide variety of other products,” says Reuters.
The European Union has a 10-page list of goods targeted for sanctions, including bourbon and motorcycles, reported The Washington Post. Complaints that U.S. tariffs are illegal also are being filed with the World Trade Organization.
Difficult relationships with allies are “expected to complicate U.S. efforts to confront China over trade practices that the administration regards as unfair,” reports The Washington Post.
Canadian, Mexican, and U.S. stock markets remained unfazed. Major indices in each country moved higher last week. Some American indices reached new highs. European markets fared less well. Markets may be bouncier this week as investors digest the costs and benefits of trade sanctions.