Unstoppable Force and the Immovable Object

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Electric Avenue

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Why are European car manufacturers against tariffs on Chinese imports? 

The European Union just slapped another layer of tariffs on Chinese electric vehicle (EV) manufacturers. It is a 5-year tariff on a sliding scale up to 35% in addition to the existing 10% import tariff. Despite their vulnerable position, Europe’s auto industry is pushing back on the action. German automakers dove headfirst into a failed strategy to develop diesel engines that sacrificed valuable battery research and development, and they are paying for it. Volkswagen just announced that it is closing three of its German factories.

The U.S. and Canada are already at 100% tariffs, which is a reason why we aren’t seeing a flood of Chinese EVs on our streets. However, European car makers, especially big German manufacturers, do not want to retreat behind any national interest in restricting the Chinese. They voted against tariffs because they are heavily invested in China and wish to stay involved. China is the biggest auto market, and more importantly, it is the frontier for advanced EV technology, so German manufacturers do not wish to risk Beijing closing the Chinese market to them. Just as German car manufacturers gave their government an ultimatum that they must stay involved in China’s EV hub, the German government may end up adopting that same uncompromising stance in discussions with the U.S. This schism between Germany and the U.S. administration will only widen during the next year over this issue of Chinese commerce.

The political problems between Germany and the U.S. over trade triggered the 1987 crash. While the word “crash” is not currently in our vocabulary, the potential for two powerful Western countries at loggerheads could become a major disequilibrium event.  

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Big vs. Small, with a Twist

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What do the years 1939, 1956, 1973, 1990, 2007, and 2024 have in common? For one thing, they are 17 years apart. For another, after the peak in October 1939, stocks sold off 43%; in August 1956, equities fell 22%; in October 1973, a bear market selloff of 46% to the 1974 lows; in July 1990, a 20% drop; and in October 2007, a cool 58% peak-to-trough drawdown in the S&P 500. Those years also marked economic cycle peaks, leading to recessions. There have been other notable drops in other years, such as 1987 and 2000, of course, but this 17-year cycle forecasting a peak right now is alarming because we are burdened with exceedingly high stock multiples, extreme concentration of the top ten largest stocks, stretched profit margins, and a cloudy geopolitical outlook.  

Thankfully, there are two smaller, albeit powerful, cycles that are bullish. From October lows into year end, there is typically a strong seasonal equity uptrend capped by the Santa Claus rally. Additionally, the 4-year Presidential cycle kicks off a rally into year-end starting after the election—especially if the incumbent loses, regardless of party.

In cycle analysis, the longer the cycle, the more powerful the effect, but also the less precise the timing. Therefore, we could see an advance into year-end as the shorter cycles take hold, but afterward, we expect valuation reality to set in, with a strong downward trend taking over. This 17-year cycle could be dismissed as a statistical quirk if not for strong parallels to 2007. Pave’s factor scoring across defensive stocks should rise if these risks materialize. Hence, we are on the lookout for any initial warnings.

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Are We Setting Up for Another Housing Crisis?

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The Federal National Mortgage Association (FNMA) may be nostalgic for the boom times of 17 years ago. FNMA just relaxed their lending standards and will now require a smaller 10% down payment than their current 20% requirement. For certain first-time home buyers, there is a program that drops it as low as a 3% down payment. The Federal Housing Finance Agency said the change was designed to allow market access to “more first-time home buyers, particularly low- and moderate-income first-time homebuyers.” While it is a gracious gesture, that sliver of a down payment is reminiscent of the easy mortgage lending policies that led to the housing crisis 17 years ago. Granted, there is a solid foundation with the current average mortgage rate comfortably fixed at 4% for existing home buyers and housing enjoying solid price trends. Today’s market is not as vulnerable as it was back in 2005-2008.

However, because the economy and the markets are driven at the margin, easing mortgage standards to this extent can create economic hazards. Moderate-income, heavily leveraged new homeowners entering an inflated housing market can be a disaster waiting to happen.

This is not an immediate warning sign; bank lending standards are still conservative in their lending to businesses and consumers. Our concern is this change from FNMA could be a turning point where we will see banks easing up credit just as the employment picture is becoming less stable. The large downward adjustments to the August and September employment data from Friday’s nonfarm payroll report illustrate the weakening trend in labor demand.

There now exists an important interplay between a weakening consumer, easing Federal mortgage standards, and commercial bank lending activity. That is our new focus. The next Fed Senior Loan Officer Opinion Survey for the quarter ending in October will be released on November 12 and will give us insight into any shift in consumer lending standards.

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What to Look for This Week (aside from the election)

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1. Thursday, November 7 at 2:00 p.m. E.S.T. the FOMC issues their rate decision statement. The fixed income markets are 99% confident about a 25-basis point rate cut at the meeting, despite some wondering if the Committee should take a pause. The market is expecting slightly above an 85% chance of another cut at the December 18 meeting, but Chairman Powell’s press conference at 2:30 following the statement could lower investors’ confidence.

2. Tuesday, November 5 at 11:00 a.m. E.S.T. October Institute for Supply Management Non-manufacturing Purchasing Managers Index. September’s headline number moved toward the top of a 2-year range as New Orders jumped up toward a very strong 60 reading, rising each month over the last three months. Prices also moved up to the same 59.4 reading as New Orders and have been rising since March’s low. The headline number is expected to pull back to 53.3 from 54.9, but our focus will be on New Orders and Prices.

3. Wednesday, November 6 at 10:00 a.m. E.S.T. the important but not widely followed New York Fed Global Supply Chain Pressure Index for October is released. For now, supply chain inflation pressures are tempered, but it may become an issue once again. August and September were the first consecutive positive readings since January 2023. The data series jumped in February 2020 before reaching unprecedented highs into Dec 2021 before going back into negative territory from February 2023-July 2024. A third positive reading in October could catch FOMC voter’s attention and increase pressure on slowing rate cuts for fear of a resurgence of supply pressures. 

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