Winter 2019/2020 Market & Economic Commentary
By: Jim Scheinberg – February 17, 2020
Well, the trade war is over…at least for now. By far the biggest story of the forth quarter, and perhaps 2019 as a whole, was the October 11th announcement that the Trump administration had reached a “Phase One” deal with China, essentially ceasing hostilities in the nearly two-year economic trench warfare which saw round after round of draconian trade tariffs passed between the two countries. From the moment the deal was announced, U.S. stock markets began a euphoric rally of over 10% in just the following three months, capping off a year that saw the S&P 500 climb a whopping 31.5%.
The trade war had been haunting the economy, disrupting supply chains and inflating component and consumer prices of Chinese manufactured goods (like iPhones and Roombas). For the last two years, market sentiment fluctuated with each of the saga’s news headlines, especially with President Trump’s tweets on the matter. The markets don’t like uncertainty, and the trade war created plenty of it.
The overhang of new and threatened tariffs and unchanged future uncertainty for importers and exporters of hundreds of billions of dollars of impacted goods, components, and commodities caused the manufacturing sector to retreat both in the U.S. and abroad. Some companies were forced to absorb tariff-led costs or pass increases along to consumers, or both. Either way, earnings and oftentimes sales were dampened. Some companies took pause, waiting for the war to abate (certainly shelving expansion plans and in some cases battening down the hatches). Others re-resourced manufacturing to other Asian manufacturing centers like Viet Nam. In all cases, the situation disrupted business as usual; unfortunate, as business was good prior to the trade war.
Seemingly, that’s all behind us now. Chief trade negotiator Robert Lighthizer has renegotiated NAFTA, creating a more U.S.-centric deal (USMCA) between our two largest trading partners, Canada (15%) and Mexico (15%), and has made meaningful progress with our third largest, China (13%), with the “Phase One” deal. CAFTA is still in place and working well with key trade partners in Central America. Bilateral agreements with many Asian partners are in place or imminent following our 2017 withdrawal from the Trans-Pacific Partnership. For now, all is quiet on the Far-Eastern front of the U.S. trade war, and full blow peace has been declared on our Northern and Southern economic boarders.
How the Markets Fared
As we all know, a strong Fourth Quarter lifted U.S. equities to new highs. The S&P 500 rose an additional 9%, bringing gains for 2019 well past the 30% mark. Growth names, already quite lofty in valuation, outpaced value stocks by another three percentage points during the quarter, outpacing them by over ten full percentage points for the year. Growth stocks finished the year with P/E ratios of 23.4x, which is 22% higher than their average. Value stocks were still slightly inflated at 14.8 times earnings, an 8.8% premium to long-term norms. Small Cap stocks performed fractionally better, but still failed to pace large cap names for the year. There, the year-end valuations were even more dramatic. Small Cap growth stocks were trading at a 44% premium to their normalized P/E ratios, whereas Small Cap value stocks look like a bargain at a 10% discount. Internationally, the news was also positive for equities. Developed markets posted gains slightly less dramatic for the quarter and the year as a whole. The 10%+ dispersion between value and growth manifested overseas, as well. Emerging market stocks came roaring back during the quarter, outpacing even U.S. large caps’ gains. For the year, however, EM stocks were the laggards, weighed down by global-trade uncertainties. Nonetheless, most EM indices netted nearly 20% gains for the year. Not bad for last place.
In the world of debt instruments, the quarter was far less dramatic. Faced with pressure to lower rates amid fears about future economic conditions weakening due to the then-ongoing trade dispute with China, the Federal Reserve lowered the Discount Rate by ¼ % during the quarter. Since then, forward-looking policy has appeared to be stable, at least for the coming year. At the December meeting, which took place after the Phase One trade deal with China was announced, the Fed left rates unchanged and Federal Reserve Chairman Powell subsequently stated, “As long as incoming information about the economy remains broadly consistent with this outlook, the current stance of monetary policy likely will remain appropriate.” Unlike instances in the past year, where the street thought the Fed to be too dovish in the face of worrisome economic prospects (due to the trade wars), the markets have now embraced this idled stance from the Fed. And that they should. If the economy isn’t too hot or too cold, interest rates should be just right.
With optimism spreading through the equity markets, high-quality fixed income sold off slightly as appetites for risk expanded (and correspondingly dropped for low-risk instruments). This caused the 10-Year Treasury yield to rise about ¼ % during the quarter. The end result was virtually no net gains in high quality intermediate bonds, as price declines offset their coupon payments. The same was true in developed market international bonds. Longer-term paper fared far worse, being more sensitive to interest rate movements. However, with growing economic optimism, esoteric fixed income such as high yield bonds and emerging market debt, saw modest gains, despite the small rise in interest rates.
A Very Merry Christmas Indeed!
Christmas was a big success this year, and not just for Amazon. MasterCard reported that Christmas sales were up a strong 3.4% year-over-year this year. This is not surprising given the bright and cheery mood of American consumers. The Consumer Confidence Index climbed to 131.6 in January from an upwardly revised 128.2 (from 126.5) in December. The Present Situation Index has been strong for years (now at 175.3 vs. 170.5 last month), but optimism about the future, as measured by the Expectations Index, increased to 102.5 from 100.0. These two figures both represent multigenerational highs.
Consumers have every right to be optimistic. The labor market continues to be optimal for those employed and those seeking jobs. The unemployment rate for January was 3.6%, indicating a very tight labor market. This helped drive wages up another 0.3%, resulting in a 3.1% increase from the same time last year. The January report was led by a spike in construction hiring, which in and of itself provides an indication of further stimulus to the economy from that sector.
The second major bolster to consumer confidence and subsequent behavior is the housing market, which is experiencing a resurgence. The National Association of Realtors reported that median existing-home prices were up 7.8% in 2019, and that prices rose in every region. Supply continues to be tight, at just 3.0 months, which is about half the normal rate. This indicates that prices should continue to be firm until more supply returns to the market, or demand eases off… neither of which is likely to occur anytime soon.
The third, and normally not as impactful of a contributor to consumer sentiment, is the soaring stock market. But these are not normal times. Whether through personal investments, or the 401(k) balances of American workers, when people open their statements (or more likely log-on to their custodian’s website) and see more money than ever, they feel more confident to spend. Nevertheless, it deserves note that Americans are not nearly as tipsy from all this optimism and wealth as they were during the last economic booms (the housing and dot-com bubbles). Households are still saving about 7.5% of their earnings, about triple the rate from 20 years ago. This savings rate and appreciation in home values, 401(k)s, etc. has resulted in Americans’ net worth reaching record levels that are over 60% higher than they were at the peak of the housing boom just 12 years ago. This is the third leg of the consumer confidence stool.
The other key area of our focus on the U.S. economy is business-to-business activity. There too we are seeing signs that optimism may be on the rise. The services-side of the U.S. economy has actually been remarkably firm, with the Institute of Supply Management (ISM) Non-Manufacturing Index staying above the key 50% level – indicating expansion – every month since the end of the financial crisis. The January reading climbed to 55.5% from 54.9% in December and 53.9% in November. The ISM Manufacturing Index had been struggling of late under the weight of the trade tariffs and policy uncertainty. After dipping below 50% in August and reaching a troubling low of 47.2% in December, the index jumped to 50.9% last month, with a surge of new orders. It seems that businesses were holding their collective breath until the Phase One trade deal with China was announced and are now breathing some much-needed oxygen back into the manufacturing sector.
The ISM reports that both the recent manufacturing and services reports correspond to an expectation of a 2.4% increase in real GDP for the coming year. (This would be a large upside surprise compared to the fourth-quarter Survey of Professional Forecasters expectation of 1.8%). Internationally, however, the jury is still out. Though the U.S.-China and USMCA trade deals are obvious short-term positives for those markets, Europe and Japan are still mired in malaise (expected by the IMF to grow at a paltry 1.3% and 0.7% in 2020, respectively). We will need more time to see if these markets improve on the coattails of normalization in U.S. and Chinese trade. If they do, U.S. growth could accelerate further. In contrast, if our international peers contract further, there is a chance the U.S. could be weighed down by their economic drag.
Importantly, the U.S. economy relies proportionately far less on trade than our most significant trading partners, which mitigates the effects of the Eurozone’s and Pac Rim’s trajectories to an extent, regardless of the direction they trend from here. This fact gives Mr. Lighthizer the upper hand in most ongoing trade negotiations with countries that are more dependent on global conditions (e.g. EU and Japan). Though we can’t be sure that the trade issue won’t reignite, future skirmishes are likely to be more industry-specific squabbles or leverage points for U.S. foreign policy initiatives, not all out global tariff nuclear war. That is, unless we get addicted to the game of trade warfare like we did in the 1920s and go to the mattresses again. (See our Fall 2017 Economic Commentary for a comparison). For now, U.S. GDP, which is hovering just above the 2% mark, appears to be on solid ground. Long gone are the prognostications for recession that were rampant when the yield-curve inverted last spring. The vast majority of pundits believe that this stable trend should continue or even accelerate in coming months.
However, we can’t take our eye off two looming issues that could shift business conditions as well as consumer and market sentiment meaningfully. First, spread of the still uncontained coronavirus could continue, disrupting global travel and related multinational-business in the least and blooming into a worldwide health crisis at the worst. Though there is no way to predict the future path of that storm, it deserves note that all major contagions of recent history (bird flu, SARS, mad cow, etc.) began with similar alarm, and all were tamped down before our worst fears materialized.
Second, and the far more likely to disrupt, is the 2020 election. Regardless of your political views, one must recognize that the two parties espouse meaningfully different economic policy directions. The opposing Democratic candidates, if elected, intend to implement economic plans of varying extremes. All represent a departure from the near-term simulative policies of our current administration. With current economic and labor conditions arguably at fifty-year highs, sentiment regarding the future prospects for stocks in the U.S. would likely cool in response to an increased likelihood of a Democratic victory. If one of the candidates with a more aggressive platform of wealth-redistribution were to emerge as the likely nominee, that cooling effect could turn frigid. With no clear front-runner in sight, we will have to look ahead to the results of the upcoming primaries for more guidance. One thing is for certain, the upcoming fight for the presidency will likely make the U.S.-China trade conflict seem like a little lovers’ quarrel by Pierspective.