January 22, 2019
L&S Risk Pulse™ Score
The composite economic picture is mixed or unclear, indicating confusion in global markets. Valuations are questionable and volatility must be monitored.
L&S Risk Pulse™ Insights – “A Trade War is Still a Trade War“
Good riddance. Sorry to be so brutally honest, but good riddance to 2018. It is hard to find investors who are looking back on last year longing for more.
One omen that should have been a more important guidepost last year was Trump’s announcement in March that the United States was applying tariffs on goods imported from China. There were, however, discussions that tried to portray this potential policy mistake as a trade “skirmish” or “battle” but not a full-fledged trade war. Semantics might help us feel better, but a trade war is still a trade war, and the market dove and soared based on perceived progress on trade negotiations and posturing by the Chinese or tweets from the President.
With worries over trade, it is not surprising that growth in China slowed dramatically. The most recent report shows Chinese growth as weak as it has been since the bottom of the Great Recession. It is impossible to know how much of the Chinese slowdown was due to the trade “skirmish,” but it seems coincidental that Chinese growth slowed as the months of the trade “battle” waged on. China is the second largest economy in the world and one of the fastest growing, and a slowing China is likely to have global repercussions.
Growth slowed across Europe, and some nations reported contracting growth. Negative growth was seen in Germany, Italy, Japan, Turkey, Saudi Arabia, and Argentina, with many other nations showing very lethargic progress. With global growth slowing, it is no wonder that foreign stock markets performed much more poorly than domestic markets. China, one of the worst performing markets, fell by more than 27% in 2018. Germany was down more than 20%, and many other markets were down more than 10%. The best performing markets were Brazil and India, although both were down for the year. There was simply no place to hide.
As if the trade “scuffle” was not enough, the policies of the Federal Reserve have been widely criticized as having a negative impact on the market. The Fed increased interest rates in December, its fourth rate hike of the year, and the ninth since rates started higher in December of 2015. Investors had come to the belief that slowing growth overseas would slow growth in the U.S., and that further rate hikes were no longer necessary here at home.
With the Fed unrelenting in their desire to raise interest rates, and with concerns over the trade “skirmish,” it is no surprise that stocks sold off in a violent correction starting in early October. From the late September highs, the S&P has fallen nearly 15%. That number actually camouflages the real carnage felt by investors. As of December 31st, the average stock in the S&P 500 was down nearly 25% from its 52-week high, and 59% of stocks in the index were down more than 20%, what we typically consider a bear market.
We have frequently relied on several indicators to help us determine whether the economy is likely to slide into a recession. While we have no outright signals, several of our indicators are within striking distance of that warning, and that is disconcerting. The yield curve is not inverted, but spreads are incredibly narrow. New single-family home sales have fallen by 24%. For those looking for a recession, it is certainly possible to find support for that conclusion.
On the other hand, there are ample signs that suggest a recession is not on the immediate horizon. The job report for December showed 312,000 new jobs created. This was much stronger than expected. Previous months were revised upward. While the unemployment rate did increase to 3.9% from 3.7%, the cause of that increase was a significant number of people who rejoined the workforce. This increase in the labor force participation rate reflects the desire for people who had withdrawn from the workforce to return, and this is a very good sign of confidence. It reflects wage growth and the shortage of available workers, and is the best reason for an increase in the unemployment rate.
Other indicators, such as consumer confidence and the percentage of banks that are tightening lending standards, do not convey the risks of an immediate recession. Further, it is important to remember that recession indicators typically give investors several months or even several quarters of notice prior to a recession. The notion that a we are on the cusp of a recession seems a bit difficult to defend. We recognize that several companies have guided analysts to expect slower growth, but slower growth is not negative growth.
While the risks of a recession may be higher than they were six or twelve months ago, it is hard to support the notion that the economy will imminently fall into a recession. It is also important to remember that this is not 2008 all over again. Banks are in much stronger financial shape than they were in 2006. While there are some valid concerns about corporate debt levels, those issues are unlikely to create the systemic problems that unfolded during the Great Recession.
Warren Buffet said “be fearful when others are greedy and greedy when others are fearful.” Stocks are down significantly from the September highs, and at some point it is going to be more fruitful to consider searching for attractive ideas. Down years are not that uncommon, but multiple down years in a row are fairly rare and have only occurred in the midst of severe recessions, and that is simply not the economic environment we are in.
Further, any progress on settling our trade ‘dispute” with China, or additional comments from the Fed that they will consider the data prior to raising interest rates any further would provide markets with a meaningful reason to stop going down. When the market stops considering all news as bad, the potential upside could be substantial.
From all of us at L&S Advisors, we wish you and your family a healthy and happy New Year.