In the 1939 classic, The Wizard of Oz, three of our favorite characters (four if you include Toto) are nervously walking along the yellow brick road, anxiously anticipating what’s ahead. They of course, fear the threat of physical attacks from the likes of lions and tigers and bears, which is quite different from the fear of a crippling economy. However, I do not live in a jungle, nor do I work at a zoo so the fear of recession is quite relevant to me, my clients and those that I interact with every day. So, I figured that today we can discuss some of the more common topics that we are frequently asked about and to put these issues in context for portfolio construction.
Why Do We Experience Recessions?
Recessions are usually the cause of bear markets in the United States. We did technically experience one at the end of 2018, but that proved to be short-lived and not the result of a recession. In fact, we have had a sharp V-shaped recovery in the US stock markets as the unemployment rate recently fell to a historically low 3.6% and economic growth posted a strong +3.2% in the first quarter of 2019, despite a government shutdown. Nonetheless, we did see pronounced selling pressure that capitulated on Christmas Eve, caused from fears of a global slowdown and a Central Bank (FOMC) unwilling to loosen monetary policy. These were legitimate concerns at the time that were proved to be a buying opportunity for long-term investors that cashed in on those fears.
Before I focus the discussion tariffs, I’d like to spend some time on the importance of interest rates and how the Fed can actually trigger recessions. If you recall, before the markets tumbled late last year, FOMC Chairman Jerome Powell said the US was “a long way” to neutral on interest rates. This effectively hinted at much higher interest rates were to be expected and yields began rising to the highest levels seen in years. With the threat of a global slowdown/recession and a government shutdown happening at the same time, market volatility spiked and sent stocks sharply lower. It wasn’t until the Fed reversed course and halted interest rate increases that markets began to recover to where we are today. Needless to say, central banking policies have an extremely important impact not only on the economy, but for markets that have come to rely on them as a form of sugar high. The Fed’s current stance is to take a wait-and-see approach before resorting back to the slow and steady pace of hikes. The market is pricing in zero interest rate increases for the remainder of 2019 and is actually pricing in a higher likelihood of a rate cut before rate hike.
With the Fed playing nicely for now, it is important to watch other indicators that could flash warning signs of a future recession. I’ve talked in the past about 7 indicators that Credit Suisse monitors for deteriorating fundamentals which include the shape of the yield curve, inflation trends, job creation, credit performance, ISM manufacturing, earnings quality and the housing market. The majority of these indicators still point to future economic expansion. The ones that I continue to focus most on that have either turned negative or neutral include the shape of the yield curve, inflation and the housing market. Of these three, the shape of the yield curve is probably the one that I’m most concerned with. However, this does not mean a recession is imminent nor that markets are topping out. I would like to see the delta (difference) between the 2 year Treasury and 10 year Treasury to widen out from this historically low level of 0.2%. This would be a positive development for banks that at their core make money off of this gap.
Tariffs are such an interesting topic to discuss and think about because there are so many moving parts and of course the politics make for interesting TV. At their core, tariffs are used to protect a domestic industry by taxing imported goods. In this most recent example, it is being used as a negotiating tactic that only time will tell if it proves successful or not. It is important to keep the size of our imports in context as it relates to economic output.
Below, I have charted the size of the US gross domestic product (value of all finished goods and services produced in the US) over the trailing 10 years. US-GDP recently finished at a little over $21 trillion versus China at roughly $14 trillion. The US just imposed a 25% tax on around $200 billion of goods imported from China, up from 10%. China retaliated by raising tariffs on $60 billion of US goods that they import. Collectively, these imports amount to less than 1% of each country’s GDP. Even if additional rounds of tariffs were levied, the direct impact wouldn’t have a substantial impact on production of goods and services but it would impact certain companies, industries and consumers in different ways. For example, global corporations that have supply chains in China may feel the need to move operations. US farmers that export goods to China would feel the burden of those taxes. Also, consumers that purchase finished goods in the US may pay higher prices that the company passes on to the consumer. There is a definite impact felt across the board, but I think the biggest impact may be tougher to incorporate in financial models. This may be the consequence of reduced confidence (market sentiment) and lower investment (capital expenditures) from small businesses to CEO’s of major corporations.
I have also included the growth in our national debt over the same time period. This has always been one of our major long-term concerns that this country will need to address. And it is no small feat with the mounting obligations that need to be paid including social security and our rising health care expenses. We will explore this topic in the future but I wanted to address recent reports of China selling its massive holdings of US Treasury bonds. China owns a little more than $1 trillion of our debt, which is a significant sum of money. So what are the ramifications if they decided to dump $500 billion or more of treasuries on the open market as punishment for taxing their exports? At first, it would likely put marginal upward pressure on interest rates. This would probably only be temporary as other countries would gladly buy more of our bonds as the yields on US treasury bonds far exceed those from Europe and Japan. But ultimately, the likelihood of this coming to pass is low.
Our friends at Strategas, a wholly-owned subsidiary of Baird, recently published a report titled: “China threat to sell treasuries is a cold war scare tactic from a bygone era”. In this report, they listed 5 reasons why they are unlikely to sell treasuries:
If you sell treasuries, you have to buy something else with it
Impact on treasury yields will likely be minimal
Selling treasuries undermines the collateral that backs their financial and municipal system
Potential to cause liquidity squeeze in emerging markets
May help capitalize Japan’s remilitarization
The overarching theme here is that this is merely a scare tactic and would most likely hurt China more so than the intended impact to the US. There are many different scenarios and outcomes with this trade dispute with China. With the economy absorbing most of the headwinds from the past year, the possibility for this dragging out farther should be assumed. US markets would likely need to take a more significant punch than the 5% recent pullback to get both parties more interested in hammering out a deal. From a technical perspective, if the markets can hold these levels of support, then the resumption of the bull (not the lion or tiger or bear) will likely continue.
Questions about tariffs? We're here to chat!