“None of the U.S. expansions of the past 40 years died in bed of old age; every one was murdered by the Federal Reserve.”
Rudi Dornbusch, MIT economist, 1997
This may be a rather graphic way of pointing out that economic expansions don’t just fade into recession without some outside help. Frequently that has come at the hands of monetary authorities through ill-timed interest rate moves. Since the collapse of trade talks with China in late May, investors, and more particularly the Federal Reserve, have focused on the ripple effects of the unfolding trade war. Both are fearing that these could be the trigger for a slow- down. Certainly, the math behind the impressive first quarter rally has changed significantly as the possible impacts of a burgeoning trade war are seeping into market psychology and corporate earnings. As a result, since reaching an all- time high of 2,945 on April 30th, and following 4 straight weeks of declines, the S&P 500 has now dropped 6.8% (6.3.19 close).(FACTSET)
The current economic expansion will be 10 years old in July, making it the longest expansion in U.S. history. We know that age itself doesn’t end a recovery. Instead, any number of factors can prove fatal to a cycle; An outside shock or event such as the 9/11 attacks or the 1973 oil embargo; excesses building up in the economy or financial system as they did in real estate markets in 2007-2009; or a mistake in monetary policy that overshoots interest rates and contracts liquidity at just the wrong time.
Reflecting the growing risks presented by the deteriorating tariff situation, investor’s risk appetite changed significantly over the last month, leading to the flight out of equities and into safe harbor treasury bonds. While the market dropped almost 7%, yields on 10- year Treasury bonds fell from 2.53% a month ago to 2.11%–a huge 16.6% move in the staid world of government bonds. Clearly the perceived risk levels of the global economy and markets have increased. As a result, the current environment does seem to check off more and more of the potential triggers for a slow-down.
First, we believe the evolving trade situation would qualify as an outside shock. At a minimum, the uncertainty as to the amount, duration and targets of seemingly random tariffs is undermining business confidence. This is a very serious concern because sustained increases in corporate capital investment to improve productivity are essential for a growing economy (the other being a growing population, which much of the developed world is clearly lacking). A major benefit of the significant reduction in corporate taxes should be a capital spending boom. So far that has not been the case.
On the consumer side, tariffs act as a tax on imported goods because they are primarily passed on by producers through higher prices. Tariffs therefore raise prices in the short term which can ultimately cut demand in the longer term. Personal consumption accounts for two thirds of the U.S. GDP, so any headwind on this front can slow growth and distort inflation numbers.
Against this increasingly treacherous background, the Federal Reserve has now signaled its commitment to combating the drag of tariffs. Its “wait and see” attitude toward the direction of interest rates has clearly been replaced by “do what it takes” to keep the economy stable. Chairman Powel’s comments yesterday were met by a surge in stocks and may well provide the boost of energy the markets and economy were looking for. It does appear the Fed’s hand may have been forced by the weight of expanding tariffs, since it is not immune from the steady drum beat of lowered expectations emanating from almost every forecasting front. Check rising potential for a monetary policy mistake?
And finally, among historical causes of a recession is a build- up of excesses. Some of the current potential bubbles have been on our list of concerns for some time. Specifically, the exponential growth in corporate debt levels during this expansion has been unprecedented. The deterioration in balance sheets has left even investment grade bonds at risk during a recession. Note the record percentage of BBB rated bonds within the investment grade category in the charts below. Of course, as the Federal deficit approaches a trillion dollars with no spending restraint in sight, excesses on the government side are also evident. We would also add the growing list of packaged investment products and computer- generated trading programs as other potentially destabilizing elements.
For better or worse, the markets are a discounting mechanism that has already priced in many of these concerns—thus the volatility in share prices since the market topped out early this spring. The tricky task for investors is to gauge what, exactly, current prices are discounting. Is there room for upside surprise? There certainly could be, if the trade situation improves, and the growth outlook stabilizes for another year or two. An aggressive Federal Reserve could also pump the economy by lowering interest rates. We’ve already seen how the prospect of lower rates changes the narrative for the stock market. And the U.S. consumer remains in a strong position, thanks to record employment numbers and improving wage growth. We are concerned, however, that valuation levels, on possibly overly optimistic earnings expectations, may not fully reflect the direction of earnings growth. At a minimum we would expect volatility to remain elevated until there is some light at the end of the trade war tunnel.
At the end of the day, the current turmoil surrounding the economy and politics is nothing the markets haven’t seen before. There are almost always geopolitical threats lurking in the valuation mix for capital markets. Investors have been mulling these same concerns for some time now. It is hard to believe that despite the drama of rallies and corrections over the last 18 months, the S&P 500 is right back to the same level it was in January, 2018. Radnor Capital’s investment philosophy aims to put the odds back in our clients favor by taking a long-term view and to be sensitive to valuations. Time is the one edge individuals have over institutions when it comes to reaching their investment goals. We could cite statistical studies supporting the long- term growth of various asset classes. Or, just look at your own statement and note the cumulative growth in specific stock positions. Those gains likely came after many years of holding high quality companies, while ignoring short term volatility and noise.
As always, we continue to focus on opportunities in individual stocks and add to positions opportunistically by using the market’s short- term gyrations to clients’ advantage.
Please give us a call if you have any questions or would like to discuss your portfolio in more detail. We also invite you to stop by and see our new offices at 38 West Ave. in Wayne.
- Radnor Capital Management, LLC (“RCM”) is a Registered Investment Advisor.
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