Tariff Volatility Comes Off the Boil
Tariff escalations faded and the Fed lowered rates for the third time this year as domestic equity markets finished with their best year since 2013. The S&P 500 scored a 9.1% gain in the fourth quarter, capping off a 31.5% gain for 2019. International developed and emerging markets kept up for the quarter, up 9.0% and 11.6%, respectively, but once again lagged for the full year, up 22.1% and 17.6%, respectively. Fixed income returns were muted in the fourth quarter, up 0.4% for the Barclays Intermediate Government/Credit Index and 0.2% for the Barclays Aggregate Index, but posted much higher-than-expected returns for the entire year of 6.8% and 8.7%, respectively, as the Fed transitioned from a tightening stance to an easing stance as the year progressed.
We discussed at length in the last couple of letters that the tariff situation would have to stop escalating if Trump hoped to have an economic environment conducive to getting re-elected in 2020. We quote below from our third-quarter letter:
Barclays Intermediate Government/Credit
Internationally, activity appears to be bottoming after a tough 2019 that was buffeted by the tariff battle. Global PMIs bottomed earlier in Europe than they did in the United States and now appear to be back on the upswing, helped by the broad decrease in interest rates in 2019 around the world. Germany, the largest economy in Europe and the worst hit from the tariff battle, is improving after posting recessionary-like economic statistics for most of 2019. Britain, the second-largest economy in Europe, should have less volatility in 2020 as the recent vote there should lead to decisive action on Brexit and finally give industry the ability to make some long-overdue decisions on expansion in their European operations. Emerging markets should improve with China and may also get a boost from a weaker dollar in 2020. This should set up a much better global backdrop in 2020 that will benefit foreign markets and U.S. companies doing business there. We are not willing to make a call that international will outperform the United States this year, but we believe we should see much more broad-based participation from foreign markets this year than we have experienced in recent years.
Interest rates came down last year as world growth slowed and the tariff battle raged. With world growth expectations bottoming out, we also expect that interest rates will bottom and eventually work their way higher as growth progresses. We were surprised by the extent of the yield declines in 2019, but are staying with our short-duration strategy in our fixed income portfolios. Besides the Fed being on hold, money growth has been stronger recently (see Figure 4) and the Fed has been forced to increase its balance sheet (see Figure 5) to deal with the repo disruptions in the overnight markets. We are still uncertain if the repo situation is a result of technical glitches in the Fed's response mechanism, or if it is hiding a more systemic underlying problem in the funding markets. This is something that we will continue to monitor closely. In the meantime, liquidity is higher, which is a positive backdrop for financial markets.
We continue to believe that the Fed got too aggressive tightening rates in 2018 and that the three cuts in 2019 were a combination of corrective action in an admission of that mistake, as well as tariff-related economic weakness in 2019. The Fed has made it clear that it will take significant inflationary readings for it to reverse course and begin a new tightening campaign. It is much more likely we will see an additional rate cut before we see the next rate hike. On that subject, however, people should be careful what they wish for. Historical data shows that after the Fed eases three times, the market performs well above average if there is only one or no additional rate cuts. Five total cuts, or more, and those are scenarios that usually depict the end of a cycle and an imminent recession. The base case is no action in 2020, unless yield curves start to invert again. Inflation readings are currently very benign, in both broad terms and wage terms. Average hourly earnings have actually been decelerating recently (see Figure 2), even with a 3.5% unemployment rate. As we have discussed over the last two years, average hourly earnings growth approaching 4% has signaled the end of the business cycle the last three cycles. Today, not only are we not near 4%, but we are actually heading in the other direction. This plays into our long-running theme of this recovery lasting much longer than anticipated. Lack of inflation in wages is partly the result of continued slack in the employment markets through labor force participation rates. So, even at 3.5%, there has been a steady supply of people rejoining the labor force (see Figure 3), which has subdued wage gains. This is a "goldilocks" situation for the labor markets in the short run and should keep the Fed on the sidelines.
International Backdrop Improves After Being a Drag in 2020
One lingering negative for the United States as we enter the new year is the ongoing 737 Max saga for Boeing. Reading through quarterly research reports for industrial stocks, it never ceases to amaze how many different companies are impacted in the aerospace supply chain when Boeing has issues. While Boeing has stated that it has no planned layoffs, even though the return of the 737 Max has just been delayed again, we are starting to see some announcements from suppliers of layoffs as Boeing goes from a reduced production rate of 42 planes a month to zero. Unemployment claims have been at historically low levels for some time now (see Figure 6) and there is clearly room for those numbers to worsen a little without being overly alarmed. However, there is always a catalyst for claims deteriorating at the end of the cycle, and we will monitor this data closely to ensure that it does not start feeding on itself.
Employment remains a bright spot in the U.S. economy. Although the unemployment rate popped from 3.7% to 3.9% in December, it was for all the right reasons. New jobs created were 312,000 in December, but the number of people rejoining the labor force was 400,000. The number of initial unemployment claims relative to employment is at an all-time low (see figure #4). Participation rates are going up (see figure #5), and this is a primary dynamic explaining why there is not more wage infl ation with such a low unemployment rate. Consumers are generally in good shape as debt service levels have come down and wages have been increasing. Many middle-income consumers should get a nice surprise during tax season this year. With the increase in the standard deduction to $24,000 for a married couple and the doubling of the child tax credit, many sub-$100,000 earners will be getting much larger-than-normal refunds this year. We have been assuming that many people adjusted their withholding with their employer last February and have been receiving a little extra money each paycheck. Some recent surveys indicate that many people did not adjust their withholding and will therefore get a lump sum back at tax time. While there are many high-income people in high-tax states that will see higher tax bills due to the loss of state and local tax deductions, there are a larger number of people owing less, and thatcohort of the population will have a higher propensity to spend that new marginal dollar of after-tax income. Also, with oil dropping 35% in the fourth quarter, consumers should expect relief at the gas pump in the new year. Rising gasoline prices in 2018 offset a decent chunk of the tax cuts (see figure #6), but 2019 could show a double-barreled benefit.
International Continues to Lag
While we have been laser-focused on the two major policy risks in the United States, we need to ensure we are reading the tea leaves on other esoteric risks that are arising. Recently, there were some major dislocations in the repo market. We are far from experts on the machinations of Federal Reserve daily liquidity operations. For now, we are willing to accept the explanation that the dislocation in the repo market was caused by a confluence of large Treasury auctions paired with a much higher-than-expected level of tax payments coming out of the banking system in mid-September. However, we are aware that seemingly innocuous events that can be easily explained away at the time are often canaries in the coal mine for developing fractures that start in the financial system near the end of cycles. Our antennas are up.
Another extraneous risk factor reared its head recently with the attacks on the major Saudi Arabia refining facility and Iran being identified as the likely sponsor. Over the last 50 years, spiking oil prices have been a major contributor to recessions. It has been surprising how fleeting the response has been in the price of oil and the price of oil stocks since the attack. After an initial price spike on day one, both have given back all their gains. It is almost inconceivable that with such tight spare capacity worldwide, there is no fear built into current oil prices. Part of that may have to do with the fact that oil production in the United States has doubled in the last decade (see Figure 11) and U.S. shale has now become the de facto spare capacity in world oil supply. On a longer-term horizon, we wonder whether markets may have already started discounting the end of fossil fuel dependency. Either way, the response, from an already deeply oversold oil market, has been disappointing and may be the last nail in the coffin of keeping an energy weighting in portfolios.
We wrote in our year-end letter that we expected the market could have a decent year in 2019 with the market multiple expanding from a depressed 14.6 back to the 15-16 range and midsingle digit earnings growth. Well, we got a 13.6% return in the first quarter and the market looks poised to be up an additional 3% or so in April.
John Cultra, Partner, CFA
+1 312 364 8768
Michael Wertz, Partner, CFA
+1 312 364 5323
Sarah Mercurio, Partner, CFP®
+1 312 364 8141
Mark McKinley, Managing Director, CFA
+1 312 364 8211
Download printable version
Download Q3 2019
Download Q1 2019
Download Q4 2018
View our website
The opinions expressed in this report are not necessarily the same as William Blair & Company L.L.C.’s Equity Research department. This information should not be construed as a research report, as it is not sufficient enough to be used as the primary basis of investment decisions. This information has been prepared solely for informational purposes and is not intended to provide or should not be relied upon for accounting, legal, tax, or investment advice. We recommend consulting your attorney, tax advisor, investment, or other professional advisor about your particular situation. Investment advice and recommendations can be provided only after careful consideration of an investor’s objectives, guidelines, and restrictions. Any investment or strategy mentioned herein may not be suitable for every investor, including retirement strategies. The factual statements herein have been taken from sources we believe to be reliable, but accuracy, completeness, or interpretation cannot be guaranteed. Past performance is not necessarily an indication of future results. All views expressed are those of the author, and not necessarily those of William Blair & Company, L.L.C. “William Blair” is a registered trademark of William Blair & Company, L.L.C.
As we discussed earlier in the year, we expect there to be some divergence in international markets this year. As mentioned, China has instituted a number of easing measures over the last several quarters that have helped its economy and market inflect upwards. Obviously, having the second-largest economy in the world re-accelerating is important by itself. In the bigger picture, though, the emerging markets are likely to be big beneficiaries of China’s re-emergence. Last year, when China caught a cold, the emerging markets caught the flu. Most emerging markets have China as their largest trading partner, and that weighed heavily on results last year. We expect a turnaround in many of those markets in 2019. Europe, on the other hand, continues to slumber along. Brexit uncertainty has been a drag on both the British and the eurozone economies and markets, and now we have to wait another six months until we theoretically get resolution. France remains mired in the “yellow vest” protests that have caused President Emmanuel Macron to scale back a number of his reforms. Germany is the biggest economy in Europe, and we have recently seen a disturbing number of deteriorating economic statistics such as manufacturing orders (see Figure 8). We do not intend to increase allocations to Europe in 2019 since we believe we will continue to see better investing opportunities in the United States and emerging markets.
Fed On Hold in 2020
3 Mo. Avg. Y/Y%
Figure 8: German Manufacturing New Orders, Y/Y Pct Change
We have written several times about how the excesses in this cycle have been primarily outside the public equity markets. Specifically, cryptocurrencies and private equity have been highlighted. Our concerns in private equity center on the explosion in the number of private equity firms and their assets under management. Another concern has been the number of transactions that seem to involve private equity funds selling companies to each other instead of to an ultimate operating entity. We questioned whether we were getting true price discovery in these scenarios and what valuations would look like when these companies finally matriculated to the public markets.
Well, we are finally getting some of that price discovery, and we are not sure the private equity markets like what they are seeing. Uber and Lyft were both high-profile IPOs earlier this year of companies that do not have profitability anywhere in the near future. Both stocks have traded off significantly from their IPO prices and are currently trading at fresh lows. In the last couple of weeks, the bloom has come off the rose for WeWork, a former private equity darling that was due to come public recently but pulled the offering after valuations cratered from $45 billion to $15 billion and the CEO was fired. The private equity bubble seems to be in the initial stages of bursting, which may act as a preventive release-valve for the economy. As valuations are questioned in the private markets, the S&P 500 is trading at a reasonable valuation of 17.7 times this year’s earnings estimate of $168 and 17.0 times an initial 2020 estimate of $175.
As the tariff and Fed threats receded in the fourth quarter, equity markets priced in the reduction of uncertainty and the markets increased 9.1%. This was the mirror image of last year's fourth quarter. With the most obvious market threats gone, market volatility in 2020 is likely to be driven by concerns about the presidential election and geopolitical events, like the recent Iran imbroglio. We are 10 months away from the election and expect volatility associated with the Democratic primaries and the general election, as polls and opinions sway from one extreme to the other. We will pay close attention to outcomes that could produce specific legislation or regulation that could be harmful to the individual companies we own or the industries in which they operate. We plan to filter the general noise around the election. Speaking of filtering noise, we have received many questions on the impeachment situation. It is obviously dominating the news cycle. There appears to be virtually no chance that the Senate will vote to remove President Trump, so we do not believe it is worth our time and energy.
So, buckle up and be prepared for some turbulence this year. The ride may get bumpy, but we believe investors will ultimately be happy with the destination. We still believe we have two years or more remaining in this cycle, but are on guard for any signals that it could get truncated. Ten years into this cycle, asset values have appreciated considerably. Therefore, we expect we will have another relatively heavy capital gains year in 2020. We look forward to seeing everyone this year and we wish everyone a happy, healthy, and prosperous New Year!
Always on the Lookout for the Canaries in the Coal Mine That Could Signal the End of the Cycle
We do not believe that we are necessarily heading for a long-term resolution anytime soon, just that the escalation phase of the battle probably just ended. We still believe that Trump wants to win re-election badly, and he will need a good economy and markets to overcome his persistently bad approval ratings. Any escalation of the tariff battle from these levels would be anathema to his chances of winning in 2020. We believe he will be content to freeze tariffs where they are and will ultimately not end up engaging that last tranche of tariffs in December.
As we write this letter on January 15, Trump and China's Liu He have signed "Phase one" of the tariff agreement. We expect the rest of the year to be status quo on the tariff front as Trump focuses on strengthening the economy and re-election and as China focuses on stabilizing its economy and dealing with the Hong Kong situation. We expect that tariffs could again become a big issue after the election regardless of who wins. If Trump wins, knowing he is unshackled from future elections, he could take a very hard line on the next stage of negotiations and tariffs could definitely become a big issue again heading into 2021. If Trump loses, it is possible that the new Democratic president will want to quickly resolve this issue in order to focus his or her time and energy on the campaign agenda. So, the tariff issue should be dormant for the next three quarters, but could erupt again post-election.
Source: Cornerstone Macro
Figure 1: 10Yr-2Yr Yield Spread (bps)
10Yr-2Yr Yield Spread (bps)
Source: Cornerstone Macro
Source: Cornerstone Macro
Figure 3: U.S. Labor Force Participation Rate
Prime Workers (25-54 Years) Dec: 82.9%
Source: Cornerstone Macro
Figure 4: U.S. M2 4 Qtr. Avg. Y/Y% 2019: 4Q: 5.2%
Source: Cornerstone Macro
Figure 5: Federal Reserve Balance Sheet ($ Trillions)
Source: Cornerstone Macro
Figure 6: U.S. Initial Unemployment Claims
Jan 13 Wk. Avg. 11: 220
Figure 2: U.S. Average Hourly Earnings
3 Mo. Avg. Y/Y% Dec: 3.0%
Entering 2019, our two biggest risks were tariff uncertainty and Federal Reserve policy. Tariffs are now on the backburner and the Fed seems to have loosened rates just enough to unkink the short end of the yield curve and allow the 2-year/10-year Treasury spread to widen out to 35 basis points at year-end (see Figure 1) after flirting with zero for much of last year.