“And you may ask yourself, ‘well, how did I get here?’” — Talking Heads, Once in a Lifetime
The Twitter-storm that was Friday knocked 2.6% off of the S&P 500 Index, sent bond yields lower with the US 10 and 2 year Treasury yields at 1.53% each, and took oil and copper down while boosting gold. This all happened as President Trump responded to China’s announcement of retaliatory tariffs on US$75 billion of US goods including soybeans, pork, cotton and crude oil – hitting the President squarely in his base. By the end of Friday the President announced – via Twitter – that he would increase the tariff to 30% on the existing US$250 in Chinese goods and increase the proposed tariffs to 15% from 10% on the additional US$300 billion in goods with the first round of products to be impacted on September 1ˢᵗ. The global economic risks just kicked up another notch.
It is important to remember that this didn’t just happen. This has been an evolution and accumulation of macro-economic risks over the course of the year. The reasons for the risk build-up have been many. In part, it is political policy. In part, perhaps it is simply that the current expansion may have run its course. And perhaps it is other factors not yet realized. Regardless of the reasons, we would be doing ourselves a favour to take a look back and see how much things have changed, and in some cases how they haven’t today vs six months ago, and consider what it might mean for the economy and markets to the end of 2019 and into 2020.
From the broader market perspective the differences are quite amazing. In just six months the US 10-year Treasury yield has fallen approximately 120 basis points, the 2-year Treasury yield has fallen approximately 100 basis points and the yield curve has flattened by approximately 20 basis points. All the while, the S&P 500 Index has nudged higher by 2% (factoring in Friday’s close)
The bond markets have been pricing in greater risk while the equity markets have remained somewhat complacent to the global economic environment. We would say the equity markets have also remained complacent to the earnings environment. We don’t believe investors are fully appreciating the change in the earnings growth rate from 14.6% in the fourth quarter of 2018 to 1.7% for the current quarter on a year-over-year basis, and more importantly where we are headed. We can only assume that increased trade tensions will lead to lower demand and manufacturing, and will only have a negative effect on the forward earnings outlook. Having the equity markets move higher on weaker earnings growth isn’t often the highest quality market gains. Call me old fashioned but I prefer the majority of my equity market gains to come because companies are generating higher profits.
Across a number of macro indicators the recent trend has been weaker: manufacturing, new orders, exports, copper prices, earnings, etc. From the manufacturing side globally, manufacturing activity peaked in December 2017 with the JPMorgan Global Purchasing Manager’s Index (PMI) reaching 54.5 (an index level above 50 indicates expansion). As of July the global PMI has fallen into contraction at 49.3. Another indicator of the health of the manufacturing economy that we pay attention to is the price of copper. It is the old adage of “Dr. Copper” and the red metal’s ability to foreshadow changes in the global economy. Over the last six months copper prices have fallen 14%. This would also coincide with what we are seeing in terms of the New Orders and Backlog of New Orders component of the Institute for Supply Management Purchasing Manager’s Index at 50.8 and 43.1 respectively. Business is slowing and given the trade uncertainty it may be a while yet before we see a bottom.
*as of July
**as of June
*** Higher in this regard is negative as the equity index and valuation have moved higher on deteriorating fundamentals i.e. weaker earnings growth.
Not everything is worse off today vs six months ago however. The US unemployment rate is 3.7%, incomes have been growing, and consumer confidence remains strong. The narrative regarding the economy has recently revolved around the fact that the US economy can stave off recession on the back of a stronger consumer. We agree. The US consumer, as measured by a number of indicators below, remains quite strong, and is the bright spot in an otherwise lackluster global economy. We would also suggest that the consumer can be influenced by the macro forces. And strong confidence today can give way to weakness that would fail to provide the backstop that the US economy needs. Historically a significant drop in confidence, as measured by the University of Michigan Consumer Sentiment Index, has led to a drop in consumption. Today however, consumption growth year-over-year is already trending near the 5-year low at 2.5% yoy. A shock to sentiment may send an already tepid consumption rate even lower. What might shatter consumer confidence you ask? Oh, say perhaps a trade war between the largest and second largest economies in the world being played out in the Twitter-verse.
What will the Fed consider in September? If the Fed only considers the health of the US consumer, the current low unemployment level and moderate level of inflation, then there is an argument that the Fed doesn’t cut at all in September. But, given the events of Friday we would suggest that no move by the Fed is highly unlikely. Rather, if the Fed balances the current positive consumer environment alongside the weakening global economic environment than a 25 bps cut seems the more realistic option if the choices are between 25 or 50. Even with the risks having escalated on Friday we struggle to see justification for a 50 bps cut this soon. We don’t believe it is as simple as the Fed needs to cut by 50 to offset the tariffs. Consideration should be given to whether monetary policy can do anything to improve an environment weakened by trade policy. To use an analogy, I would never ask my electrician to clean up my plumber’s mess. In this case, we see the Fed proceeding at a slower and measured pace.
Lastly, we ask ourselves what the equity markets will consider given this latest row between the two largest economies in the world. Our view through 2019 has been towards reducing equity risk especially if the equity market is giving us an opportunity to do so near all-time highs. The latest news and forward risks only reinforce that view. The equity markets have remained buoyant in an environment of increasing risks, weakening earnings and slower overall growth. As we head into the seasonally weaker months of September and October we believe the risks may be realized in more volatile equity markets. As such, we continue to remain cautious and favour a defensive posture with regards to portfolio positioning.
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates. Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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