May 2019 Newsletter Part 1: The Trade War is Here

It's Dowman vs. Tariffman--and Mr. T Is Winning/Stocks & Consumers Losing

Dear Subscriber,

My entire team and I have spent more time on conference calls, Trump soothsayers, China research and talking with a slew of tech and China cognoscenti trying to unravel the real story behind the about-face in the "weeks to go" in the unilateral US/China trade negotiations.

The short version is partially what I predicted would happen: The Chinese came back to the final round with a 75 page "agreement" marked up with dozens of changes in the political and mercantilist structure of China that our President and his team think are "unfair" and not copacetic with the WTO agreement that China signed onto in 1993-1994.

Not anticipating this VERY normal Chinese approach, our "negotiators" had no counter offer and the Chinese took their ball and bat and went home. All the "we are so close" rhetoric was another round of feel-good market goosing bullshit--it was talking up the market aka "Dowman" speaking.  But Tariffman launched the commercial ballistic missile he evidently was anxious to launch as his "get back to the table" tactical move. Xi came back with a visit to one of China's main rare earth mining facilities (more on that in a moment) and then went into the "It's time for another Long March" speech which was a thinly veiled fuck you to Mr. Tariffman.

Here is just a part of the Reuters reporting on the final deal breakdown.

Beijing Reneging on Trade Promises? - From Reuters: 

The document was riddled with reversals by China that undermined core U.S. demands, the sources told Reuters. In each of the seven chapters of the draft trade deal, China had deleted its commitments to change laws to resolve core complaints that caused the United States to launch a trade war: theft of U.S. intellectual property and trade secrets; forced technology transfers; competition policy; access to financial services; and currency manipulation.

U.S. President Donald Trump responded in a tweet on Sunday vowing to raise tariffs on $200 billion worth of Chinese goods from 10 to 25 percent on Friday – timed to land in the middle of a scheduled visit by China’s Vice Premier Liu He to Washington to continue trade talks. The stripping of binding legal language from the draft struck directly at the highest priority of U.S. Trade Representative Robert Lighthizer - who views changes to Chinese laws as essential to verifying compliance after years of what U.S. officials have called empty reform promises.

Lighthizer has pushed hard for an enforcement regime more like those used for punitive economic sanctions – such as those imposed on North Korea or Iran – than a typical trade deal. “This undermines the core architecture of the deal,” said a Washington-based source with knowledge of the talks. Spokespeople for the White House, the U.S. Trade Representative and the U.S. Treasury Department did not immediately respond to requests for comment. Chinese Foreign Ministry spokesman Geng Shuang told a briefing on Wednesday that working out disagreements over trade was a “process of negotiation” and that China was not “avoiding problems”.
 
Lighthizer and U.S. Treasury Secretary Steven Mnuchin were taken aback at the extent of the changes in the draft. The two cabinet officials on Monday told reporters that Chinese backtracking had prompted Trump’s tariff order but did not provide details on the depth and breadth of the revisions. Liu last week told Lighthizer and Mnuchin that they “needed to trust China to fulfill its pledges through administrative and regulatory changes, two of the sources said. Both Mnuchin and Lighthizer considered that unacceptable, given China’s history of failing to fulfill reform pledges.
 
 One private-sector source briefed on the talks said the last round of negotiations had gone very poorly because “China got greedy”. “China reneged on a dozen things, if not more ... The talks were so bad that the real surprise is that it took Trump until Sunday to blow up,” the source said.
 
“After 20 years of having their way with the U.S., China still appears to be miscalculating with this administration.”  Investors and analysts questioned whether Trump’s tweet was a negotiating ploy to wring more concessions from China. The sources told Reuters the extent of the setbacks in the revised text were serious and that Trump’s response was not merely a negotiating strategy. 
 
Chinese negotiators said they couldn’t touch the laws, said one of the government sources, calling the changes “major.” Changing any law in China requires a unique set of processes that can’t be navigated quickly, said a Chinese official familiar with the talks. The official disputed the assertion that China was backtracking on its promises, adding that U.S. demands were becoming “harsher” and the path to a deal more “narrow” as the negotiations drag on. To avert escalation, some of the sources said, Liu would have to scrap China’s proposed text changes and agree to make new laws. China would also have to move further towards the U.S. position on other sticking points, such as demands for curbs on Chinese industrial subsidies and a streamlined approval process for genetically engineered U.S. crops.
 
Trump’s tweets left no room for backing down, and that was that."
 
Comment: Given that China was getting a relatively soft deal (with subsidies to key technologies sustained etc.), certainly versus what many in Congress would impose, it seems remarkable that Xi would take this risk. While there is an issue of FACE that I talked about in the last alert,  the claim that key laws on IP protection, etc. can’t simply be rewritten is disingenuous (recent history has shown the Chinese government does not need to wait for the annual NPC conference), and while some issues such as GM crops face real public resistance, that’s never stopped the CCP before from doing things against public resistance.

Net Net: I don't know how many large business transactions YOU have been part of, but this entire event was a complete and utter failure with ZERO accomplishments except for bad Chinese food (Note: After many many meals in China, I can tell you this--with the exception of Peking Duck--you best Chinese restaurant in your home town has better Chinese food than Chinese restaurants in China; it's the quality and freshness of ingredients). 

So--where do we go from here? Will Mr. Trump's other persona DowMan rush into to put the "Trump Put" under that Dow 30 (which as we all know is NOT the way to judge the health of the US stock market--it's the SP 500 and Nasdaq Composite). Will the Fed rush in with an emergency rate cut now that the 10-year bond has once again inverted in yield under the 2 year? 

TECHNICALLY SPEAKING

The market pullback is not yet back to the line in the sand 200-day moving average at 2750--but there is a lot of room to go before we get the WAY oversold bargain hunting on a sub 30 RSI

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The Nasdaq Composite is weaker but holding:

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The damage is in the semiconductor space for obvious reasons (and DO remember we sold ALL commodity semiconductors and equipment last summer because of the peak in Q3--AMD and Nvidia make their money in non-commoditized GPUs and Xilinx in customizable FPGA  chips. But the Sox Index is either one positive tweet away breaking down back to its December 2018 lows or extension of the 90-day blacklist exemption.

That is one ugly chart. 

Our Base Case Analysis & Advice

#1 The base case is now the Trump and XI egos are now in charge--and that is not good. For the U.S. $21 trillion economy, the full Federal Import tax rates aka tariffs on Chinese imports is not, in the grand scheme of things, going to spike inflation or be a big hit to anything. The US agriculture businesses are in very bad shape but the Trump administration is rushing to buy their loyalty with emergency funding and grants.

This new cold war is ALL about business confidence!! We already have Q2 turn down in capital spending in America and Europe--3 months by the end of May--not good!  Wall Street increasingly believes that the Trump administration is on auto-pilot with tariffs on another $300 billion in Chinese goods. And why not? No new talks are scheduled. China said through its Ministry of Commerce Wednesday that the U.S. should act with sincerity and change its “wrong actions.”″

What is different is where is DowMan? Normally if you had a day like this a couple of weeks ago, there would be somebody from the Trump administration coming out and saying how progress was being made… and it’s crickets today. This passive action tells me the extent of the tensions have jumped to Defcon 2 range and things most likely get worse before they can get better.

Action to Take: HOLD Risk Investments--AMD NVDA CHGG BE XLNX for the long holiday. 

Trading will be light tomorrow and Tuesday for the long holiday--markets could soar or fall and soar and fall again simply because of lack of liquidity.  BUT--NVDA AMD XLNX are on "the bubble" here and just because they have little Huawei exposure they do have 11-30% China exposure so they are not out of the crossfire. And with Apple being such a heavyweight in the S&P 500 and Nasdaq 100, if the Chinese get their nationalist boycott hate-on for Apple (which is likely--see Japanese cars in 2010, Korea in 2012 and 2015) the indexes will crumble.

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Here is total chip exposure in China

IF WE GET A SNIFF of an expansion of US chip sales restrictions, we are long gone and taking our 48% profits in 2X AMD and 14% in NVDA and 15% loss in Xylix (and we will short the SOX Index on a positive or flat day ASAP). AMD is the safest chip maker in the world right now--who knew?

Action to Take: BUY PFFA Under $26--Target $30 with 8%+ Monthly YIELD

We will get a full report out in the morning, but I want you to move some cash into PFFA-- its the rock of Gibraltar in a world turning upside down. When the market was down 453 points today--PFFA and its portfolio of preferred dividend paying stocks was down ZERO--that is what is smoothing out our portfolio with our $10K-a-Month Club securities; AMZA BDCL NEWT NRZ MORL MIC SMHB PFFA that are all 100% NOT RELATED TO CHINA in any way--100% All American income giants. You noticed in a 2% down day our 10K a month income plays went UP or moved 25-25 basis points!

Building Our Trump-Xi-Trade War Protection Portfolio
PFFA Enhanced Preferred ETF-Buy Under $26 with $28 Target + 8% Annual Yield
Investment Thesis: Take some volatility out of the trade war bombing runs while outperforming the S&P 500 (including yield) with less volatility.
I started out on Wall Street selling preferred shares of real and commodity-based public corporations—I know this space. With the risk-off flight to safety in 10-year bonds trade on fire (10-year bond yield is now inverted with 1-year treasuries for the second time this year--we are watching) preferred stocks now have a strong value-creating tailwind from the Fed's about-face on raising Fed fund interest rates and their rapidly advancing balance sheet run-off ending in September.

To help smooth out the bumpy ride we are GUARANTEED to see in our equity holdings until either Trump or Xi blinks on trade deal (and I can tell you this—if you are counting on Xi to blink you should sell ALL your stocks right now) –here is why I love this PFFA hybrid ETF

  1. Preferred shares are recession resilient relative to common stocks

  2. PFFA is a volatility killer (except in flash crashes where because of market mechanics and removal of bank liquidity from the markets thanks to new Dodd-Frank regulations)  EVERYTHING collapses—and we use our cash to BUY those market created mechanics like late December with MORL NRZ BDCL etc.)

  3. PFFA offers us a simple low-cost way to get the high monthly income and attractive total returns due to their prudent use of leverage and interest rate hedges.

  4. PFFA manages leverage risk by actively managing a broadly diversified portfolio of fixed-rate preferreds and using covered calls and the low volatility of this asset class vs. common stocks in general.

InfraCap, which manages our leveraged 15%+ monthly-distribution-paying MLP ETF (AMZA buy under $6 with $8 target and 15%+ yield) also manages PFFA which holds more than 100 preferred securities issued by U.S. companies with market caps of over $100 million.
Preferred shares combine features of both debt (in that they pay fixed dividends) and equity since they have no fixed maturity. As a result of the latter, they can sell at wide discounts to par value much more easily than debt does, since debt - in addition to being more conservative in structure - has a set maturity date and therefore trades according to a yield to maturity metric. Active preferred stock managers take advantage of these discounts—and PFFA management has proven itself in this regard.

I love preferred shares vs. straight corporate debt (like our SMHB in small-cap preferreds) because of their "cumulative" feature. Being on top of the debt stack with cumulative payment rights means that all preferred dividends (including unpaid ones) must be paid first before a dividend can be paid to common shareholders.

This means in an economic catastrophe (say China consumers boycott ALL US goods and services) and our preferred dividend is temporarily suspended, the company has to first pay all the missed payments back first before it could pay anything to its common shareholders.
PFFA’s strategy is to take advantage of the preferred bull case in a volatile equity climate plus the drumbeat of geopolitical trade wars by jacking up the underlying yield of its holdings by applying mostly hedged leverage to its portfolio. PFFA mitigates the leverage risk by

  1.  actively managing a broadly diversified portfolio that eliminates stocks with higher risk

  2. Selling covered calls to increase yield/lower portfolio cost basis on its equities with options

  3. The inherent defensive nature of preferred stock in general.

The PFFA chart says it all: When the equities markets break down (like on Monday or today), PFFA is solid as a rock; if there is another Flash Crash-like Dec 21-24th, there is nowhere to hide BUT the panic selling of a high dividend paying preferred security becomes THE buying opportunity of any market cycle.

In short, PFFA will, in my view, outperform common stocks in a bear market (not even including 8% ish dividends) while generating a very attractive and safe yield AND being non-volatile in an increasingly volatile equity market ex-flash crashes. PFFA is the definition of a “ballast position” in what I expect to be a very rocky summer and fall.

PS--PFFA preferred stocks already have lower risk as they are only ~25% correlated to the stock market as a whole--buy some "sleep at night" protection from more trade war insanity 

Part II Out Tuesday! Have a great long holiday weekend!

Toby