The stock market rebounded Monday morning after last Friday’s wild ride. Investors are breathing a sigh of relief after President Trump made some constructive comments on the trade negotiations with China during a press conference at the G7 meeting in France. However, we can’t declare that we’re out of the woods just yet. The sharp sell-off in stocks last Friday was caused by a dramatic escalation of the trade war between the U.S. and China. Investors sought safe-haven assets such as Treasury bonds and gold. The Dow Jones Industrial Average declined 623 points, representing a loss of 2.4%. The S&P 500 fell 2.6% and the Nasdaq lost 3%. The Dow initially opened higher on Friday, despite Beijing’s announcement that it would raise tariffs by 5% and 10% on an additional $75 billion in U.S. goods in response to President Trump’s latest round of tariff increases. Investors seemed somewhat comforted, at least initially, by comments from Fed Chairman Jay Powell in his speech at an annual symposium in Jackson Hole, Wyoming. The comments were perceived by the market as slightly dovish with Powell signaling the Fed’s willingness to cut rates further to try to sustain the economic expansion. However, at the same time, Powell acknowledged that trade policy uncertainty was playing a role in the global slowdown and that there were no precedents to guide the Fed in its policy response. The market began to slide as President Trump took to Twitter in reaction to the Powell speech. Trump tweeted “As usual, the Fed did NOTHING!” This was a curious comment, suggesting that Trump apparently wasn’t aware that the meeting in Jackson Hole wasn’t a regular FOMC meeting and thus no decision on interest rates was expected. Trump went on to tweet, “My only question is, who is the bigger enemy, Jay Powel (sic) or Chairman Xi?” He continued the series of tweets with, “Our great American companies are ordered to immediately start looking for an alternative to China.” He followed that by tweeting late Friday afternoon that he would raise the tariffs on Chinese goods by an additional 5%. He then added, “We don’t need China and, frankly, would be far better off without them.” With that emphatic end note, I think it’s fair to say, if there were any remaining doubts, we’re now in a full-blown trade war with China.
What’s the count?
For those of you playing along at home, and having trouble keeping track, which is understandable, here’s where things currently stand: Tariffs already in place on $250 billion of Chinese goods are scheduled to increase from 25% to 30% on October 1. Tariffs planned for September 1 and December 15 on an additional $300 billion in goods will increase from 10% to 15%. With the ongoing tit-for-tat between the Chinese and Trump, and the escalating rhetoric, how bad could things get? Investors are clearly worried that there may be no end in sight.
Storm clouds gathering
“Don’t know why, there’s no sun up in the sky”
While much of the country is continuing to experience warm summer weather, including 90-degree temperatures in parts of Southern California, it hasn’t all been sunny and bright. Fall weather in the Northeast, severe thunderstorms and flooding across the plains, heavy rainfall and massive landslides in North Carolina, and Tropical Storm Dorian brewing off the Florida coast, would seem to be a sure sign of a pending shift in seasons. I’m reminded of the classic jazz song, Stormy Weather, first performed by Ethel Waters at the Cotton Club in Harlem in 1933, and since covered by such musical greats as Lena Horne, Duke Ellington, Billie Holiday, Charles Mingus, Frank Sinatra, Judy Garland, Ella Fitzgerald, Bing Crosby, Etta James, Joni Mitchell, Bob Dylan, and Ringo Starr. It’s a song of disappointment and longing: “stormy weather, since my man and I ain’t together, keeps raining all the time.” Just as the weather serves as a metaphor for the feelings of the singer, serious “storm clouds” gathering in the economy have caused investors to suddenly turn blue. And rightly so. Global growth is clearly slowing and with the escalating trade war, the risk of a recession is rising. Here are the latest examples of “stormy weather”:
- Inverted yield curve - The most closely-watched version of the yield curve (the yield on 10-year U.S. Treasury bonds less the yield on two-year Treasury notes) has inverted at various points in time recently (e.g., two-year notes are yielding more than 10-year bonds). Another version of the yield curve, the 10-year bond minus the three-month T-bill, the preferred version among economists and the one used in the New York Fed’s recession probability model, has also fluctuated between negative and positive lately. Historically, an inverted yield curve has been a fairly reliable indicator of a recession. In fact, an inverted yield curve has preceded every recession over the past 50 years. However, it hasn’t always been a reliable indicator. It has been susceptible to false positives. And, many economists and market observers point to technical reasons why the yield curve is inverted, such as strong demand for Treasuries from foreign investors who are attracted to the positive yields in the U.S. compared to negative yields in their home countries.
- Slowing growth around the world – While the global economy continues to expand overall, growth is slowing around the world. And, some economies have actually begun to contract. For example, Germany, the U.K., and Singapore posted negative GDP growth in the most recent quarter. The eurozone economy overall is barely growing, posting second quarter GDP growth of only 0.2%, down from 0.4% in the first quarter. Industrial production in the eurozone is contracting. China’s economy is growing at the slowest pace in three decades and retail sales and industrial production have been particularly weak recently. Brazil is already in a recession. Mexico narrowly missed going into a recession and growth remains weak. All told, nine countries (Germany, U.K., Italy, Mexico, Argentina, Brazil, Singapore, South Korea, and Russia) are either in a recession or on the verge of entering a recession.
- Manufacturing weakness – The Purchasing Manufacturer’s Index (PMI) is an indicator of manufacturing activity and a key recession indicator. While the PMI for the U.S. and the world remains above the threshold level of 50, indicating expansion, it has been deteriorating lately. The PMI for Germany, the U.K., Italy, Spain, Switzerland, and the 19-member eurozone is signaling a contraction (i.e., below the threshold level of 50). The PMI for China and Japan has slowed and the PMI for South Korea, Taiwan, and Hong Kong is indicating a contraction.
- Brexit – The increased likelihood of a “hard Brexit” (the U.K. exiting the European Union without an agreement) poses increased uncertainty for growth in both the U.K. and the European continent.
- Hong Kong protests – The Hong Kong protests and Beijing’s reaction – apart from their otherwise important political implications - add to global economic uncertainty in that they exacerbate the U.S.-China trade war.
- Global macro risks – Other global macro issues including North Korea, Iran, India/Pakistan, Russia, etc. represent further risks to the global economy (in addition to their larger implications).
Forecast: Cloudy with a chance of recession
All of these indicators, and several others we track, point to an increased risk of recession and therefore can’t be dismissed easily. Normally, in any given year of an expansion, there is some probability of a recession – typically hovering somewhere around 10-15%. The New York Fed recession probability tracker recently jumped to 32%, its highest level since the financial crisis in 2008. The New York Fed model has risen above 30% before every previous recession.
While storm clouds are gathering on the horizon, and the risk of recession has increased sharply, it’s important to remember that despite the sudden spike, the probability remains below 50%. And so, our base case scenario, which we laid out at the beginning of the year, which calls for a continuation of the economic expansion (albeit with slowing growth), low inflation, and a reduction in interest rates, remains in place as the most probable scenario. Many indicators continue to signal economic resiliency, including labor market indicators (e.g., jobless claims, the unemployment rate, etc.) and consumer spending. However, one of the key components of our base case scenario that has changed – and it’s a significant change – is the failure to reach a trade agreement. Not only has no agreement been reached, but the trade war has escalated, as evidenced by the heightened rhetoric and tit-for-tat moves made by both the Chinese and the Trump administration over the last few weeks. This escalation means the likelihood of an eventual agreement has been reduced. And since a resolution of the trade war is so integral to maintaining the global economic expansion, this is a significant change to the probability of our base case scenario. Accordingly, the likelihood of the negative alternative scenario we sketched out at the beginning of the year (i.e., a Fed policy mistake or the failure to reach a trade agreement resulting in an ongoing trade war for an indefinite period of time) has increased. Said differently, storm clouds are gathering and the risk of recession and thus a possible significant market decline has risen.
Packing sunscreen and an umbrella
We’ve been watching these storm clouds gather for some time and have already been taking action in response. As described in our previous Market Action Update in early August, The Hawks Take Upper Hand, we have a three-part strategy in place for dealing with pending storms like this. This strategy includes (a) diversification across multiple asset classes (creating a balanced, “all weather” portfolio), (b) deliberately playing “offense” and “defense” (owning offensive and defensive assets) simultaneously, and (c) utilizing a disciplined, valuation-based framework for tactical asset allocation (investing in what we believe to be assets that are undervalued relative to their “intrinsic value,” thereby creating a “margin of safety”). As we also described in our earlier piece, as the economic and market environment has changed over time, and the probability of our alternative scenario (e.g., a Fed policy mistake and/or an extension of the trade war) has increased – leading to an increased risk of recession - we have sought to further adjust our portfolio positioning. Specifically, we have been gradually shifting exposure from the “offensive” category to the “defensive” category over time. In terms of the weather metaphor, you can think of this as packing both sunscreen and an umbrella for a fall trip, since you don’t know exactly what the weather will be like. As you get closer to departure, and the weather forecast shows some storm clouds gathering, you take some of the sunscreen out of your bag (though you leave some in too), and add a raincoat next to your umbrella.
Examples of specific trades we have made (in our balanced portfolio strategies) include (a) the a sale of international small cap equity fund and the reinvestment of the proceeds in a more defensive global infrastructure fund, (b) the sale of an industrial REIT with the proceeds held in cash, and, just recently, (c) the sale of an international developed equity fund and redeployment of the proceeds in a gold Exchange Traded Fund (ETF).
Gold as a hedge against volatility
As mentioned above, we recently initiated a position in gold (in the form of an ETF) across our balanced asset allocation strategies. This is an unusual move for us that warrants an explanation since we’ve said in the past that we generally don’t invest in gold. Gold doesn’t generate earnings or cash flow and thus is difficult to value. However, in this environment, we think the unique properties of gold make it a compelling asset to own. Gold is a hedge against volatility, global macro uncertainty, the increasing risk of recession driven by the ongoing trade war, and a possible pullback in the stock market and other financial assets (including the U.S. dollar). Gold tends to be negatively correlated with stock market declines. We view the position as a hedge, providing partial protection against the possibility of our alternative scenario unfolding – like packing an umbrella with sunscreen.
Rest assured that we’re watching the weather carefully and are aware of the storm clouds gathering. While we can’t predict the weather perfectly, of course, we can endeavor to create an “all weather” portfolio (packing sunscreen and an umbrella). As more storm clouds gather (the trade war has escalated and the probability of recession has increased), we have shifted the mix of assets from fewer offensive assets to more defensive assets over time (taking some of the sunscreen out of our bag and adding a raincoat along with an umbrella). The clouds on the horizon could eventually pass and we’ll see sunny days again, but rest assured that we’re preparing for stormy weather.
As always, if you have any questions, please don’t hesitate to reach out to your wealth advisor.