Tradewinds, Headwinds or Bluster
2018 ended up being a roller coaster ride that few, if any, predicted. It began with excitement around how the United States tax cuts would spur domestic growth and, hopefully, spill over to the rest of the world. However, as the year progressed, the US-China trade issues became the governor on the market. Concerns of an all-out trade war spurring a global slow down sparked market volatility to the downside. The market rallied when it appeared that China and the US were close to an agreement. Unfortunately, by October, fears of a global recession re-emerged when China and the United States still did not have a trade deal. Fickle investors were not the cause of the volatility-the economic data supported the market’s behavior-accelerating growth early in the year, and a slowdown toward year end.
“Bull markets are born on pessimism, grow on skepticism, mature on optimism and die on euphoria.” – Sir John Templeton
The final outcome was a negative year for all U.S. equity indices. To compound matters, international equities did not provide any diversification benefits; they fared far worse than their U.S. counterparts. In the beginning of the year, domestic growth stocks, led by technology, dramatically out performed domestic value stocks. In a difficult fourth quarter for the entire market, value stocks out-performed growth stocks, but not by enough to offset the under performance in the first three quarters.
Why were the economic data and investor confidence so volatile during the year?
Our analysis indicates that uncertainty over trade policies distorted global economic activity. Our discussions with corporate management teams revealed an acceleration of purchasing orders in the first half of the year in order to avoid any increased costs associated with additional tariffs. Essentially, corporate management arbitraged potential tariff costs. Our belief is this pattern overstated growth early in the year only to understate it as the year progressed.
In addition to distorting order patterns, trade uncertainty likely decelerated corporate capital investment. It is impossible for corporations to make long-term investment decisions when trade/tariff policies are unknown. As such, we believe many corporations are taking a wait- and- see approach to future spending plans. For example, assume a manufacturer in the United States needs to expand capacity and is considering building a new plant. Based on historical labor rates, it is more economical for it to build in Mexico. Since building a plant is considered a long term investment, it would be a risky strategy to commit capital in this murky trade environment. Corporations taking a “sitting on their hands” approach can clearly slow global economic activity.
We continue to believe that the current trade issues will be resolved for two reasons. First, no one is “winning” with the status quo, and all will “lose” if the situation escalates into an all-out trade war. Contrary to the headlines, we have not yet entered into a true trade war. It’s not just the back and forth between countries, but the amount of trade affected that defines a trade war.1 The United States has not been in an all-out trade war since the Smoot Hawley Act of 19302.
Our second reason for optimism lies in the principal of fairness. Based on our current understanding, the United States is not requesting any preferential treatment-just the opposite-we are requesting a level playing field. Under the existing rules, US automobiles being sold in Europe face higher taxes than European autos sold in the United States. Chinese companies that wish to open facilities or buy companies in the United States are free to do so (with a few exceptions). The same cannot be said for U.S. companies, which for the most part, are not allowed to buy Chinese companies. United States companies can only do business in China through joint ventures with domestic companies. Prior to the European Union and China becoming the second and third largest economies in the world, respectively, these business practices were necessary; however updated and equitable trade rules are now required in today’s paradigm.
We believe that the United States economy will continue to grow at a moderate pace, and we will not experience a global recession. Typically, economies just don’t ‘run out of steam’ and slip into a recession. They usually enter a period of euphoria, and then face some type of shock (e.g. the housing crisis or the Asian debt crisis). While optimism may exist, it’s hard to argue that we are in a euphoric environment.
As previously mentioned, trade uncertainty is likely distorting current economic numbers. Utilizing potentially misleading data to extrapolate a market forecast is difficult at best, and we continue to seek true guideposts for the health of the economy. Two of the most reliable indicators of an impending recession are an inverted yield curve and the Purchasing Managers Index (PMI), dropping below 50, indicating a manufacturing contraction.
Exhibit 1 shows that while the yield curve has flattened, it has not inverted. There has been much discussion surrounding the inversion of certain maturities within the yield curve. We have not found any evidence to indicate that inversions at the lower end of the yield curve are reliable indicators of a recession. For example, during the bull market of 1995 – 2000 the lower end of the yield curve inverted quite often without a recession occurring. In other words, the entire yield curve needs to invert, not just a subset of it.
Exhibit 2 shows that while PMI has declined, it still remains above 50. In the past, softening PMI numbers have not been a good predictor of an economic recession; however a PMI below 46 seems to be the true tipping point.
While it is clear that global economic growth has slowed, it is premature to predict a global recession. Both the yield curve and PMI readings have decelerated, but neither indicates a looming recession. Additionally, we have not experienced a ‘shock to the system’ that typically precedes a recession.
Where could we be wrong? China and global debt
For years, some have called China a house of cards based on its rapid economic growth, high debt levels and unreliable economic data. Thus far, this view has been incorrect. Another fear is that the current trade issues might be the ‘straw that breaks the camel’s back’, causing China’s long track record of growth to crack. With China having the largest exporting economy in the world, it is true that trade disruptions could have an outsized effect. We are monitoring trade disruptions closely as we believe that any major changes to the Chinese economy will be felt globally.
Much of what has been written about debt since the Financial Crisis would imply debt levels have been reduced. While this might be the case for individuals and financial institutions, overall debt levels for corporations have risen to unprecedented levels. Even as individuals have reduced their indebtedness, sovereign government debt has also increased substantially (see Exhibit 3). Sovereign governments play by different rules and can default, devalue their currencies to lessen the value of their debt, and raise taxes to repay creditors. These options are not available to most other borrowers, nor are they truly options for developed economies (for example, the notion of Italy defaulting is unthinkable).
It is troubling that the United States and other governments are experiencing record budget deficits during the longest economic expansion in memory. In theory, governments will increase spending in an attempt to mitigate recession, and repay their debts with surpluses during expansions – a principal that has clearly gone out the window. The only time sovereign debt helps an economy grow is when it is used to build infrastructure or create growth programs to enhance the economy- think the New Deal. If surpluses are not used to reduce government deficits, then the government’s only option is to raise taxes. Increased tax burdens take spendable dollars out of the hands of individuals and corporations and are a drag on any economy.
Another concern surrounding large budget deficits is the cost of debt service as interest rates rise. For example, US government debt to GDP is about 1.0x, so a one percent rise in interest rates creates a 1.0 percent headwind to GDP growth. Until sovereign debt levels decrease, it is hard to imagine robust economic growth anytime soon. Also, a sovereign default would be a true shock to capital market confidence. While this is hard to imagine, it does constitute an outsized risk for investors.
As we discussed in our July 2018 letter, we continue to follow the leveraged loan market and Cov-Light loans, closely. As a reminder, Cov-Light loans refer to loans with minimal covenants. Covenants are rules that the borrower must follow in order to keep the money the lenders provided. These loans are made to companies with too much debt or poor credit. This market segment has been embraced by investors desperate for higher yields. Cov-Light loans tend to have less liquidity than conventional bonds and can experience periods of extreme illiquidity during times of market stress. While these loans represent a minority of the corporate debt market, they are used for private equity and real estate transactions. “Leveraged loans are already risky, but when they are structured with few covenants, they are even riskier. And we all remember how dangerous unfettered risk can be… don’t we?”3
We continue to remain constructive on equities in 2019. In the spirit of Winston Churchill, in an attempt to not let a crisis go to waste, we used 2018 to upgrade our portfolio holdings across all of our investment disciplines. During the second half, any company that had disappointing results was treated mercilessly by the markets. We were able to use this opportunity to add outstanding companies to our portfolios. These companies had been trading at rich valuations, but the market downturn in the fourth quarter drove them to more attractive levels. We continue to be cautious in the bond market, especially with longer dated maturities. Our caution is not based upon inflation fears, but more on the assumption that the Federal Reserve will continue to raise interest rates. We believe that bonds will earn their coupon at best or even lose principal if the Fed continues to raise rates.
As the quote from Sir John Templeton indicates, while we may have had a few periods of optimism during this bull market, we have yet to experience euphoria. We remain constructive for now. We will continue to evaluate future events that test our views and act accordingly.
As always we thank you for the trust and faith you place in us.
Scott B. Schermerhorn
Managing Partner and Chief Investment Officer
There can be no assurance that any of the securities referred to herein were produced for or remain in portfolios managed by Granite Investment Advisors. A complete list of all Granite Investment Advisors' recommendations within the preceding year is available upon request. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities described herein.