Never in my investment career can I recall political “happenings” carrying so much weight in daily market movements. Today’s markets are whipsawed by political slings and arrows, often in the form of tweets or breaking news reports. And “investors” increasingly are reacting impulsively to a reality that’s shifting minute-by-minute. Put differently, broad swathes of equities can flip from winners to losers in an incredibly short time period — perhaps in the wake of a single tweet.
We believe politics inordinately captures the market’s attention because it’s the only reason that a recession could ensue in the coming months. Absent a policy mistake, our research continues to show few fundamental reasons for the U.S. economy to fall into recession — at least from a traditional economic cycle perspective. Ultimately, easing or escalating political risk could be the x-factor that pushes us further into an economic expansion or slips us into a future recession.
We believed the economy was following a predictable path, like economic cycles of the past albeit at a slower pace. And even with the recent uptick in political noise, if you “listen” closely, you can still “hear” a normal economic cycle ticking in the background. Workers are collecting real wage gains, business investment is stirring (though slowing) and productivity has arrived to the party. This formula has been the secret sauce to the strength and longevity of previous economic cycles. However, these positive developments are increasingly at risk of being drowned out by heightened political uncertainty: Brexit, the U.S.-China trade war, and now impeachment proceedings to name a few. While our research points to expanding but tempered economic growth, we acknowledge that recession risks are rising.
Record Levels of Political Noise
Throughout my career, I have heard many investors haphazardly repeat the refrain that “this is a particularly uncertain time”. I tend to sarcastically respond that I have yet to live in a time of certainty. However, over the past few years, researchers have identified objective ways to measure “uncertainty” magnitudes. As you might expect, uncertainty readings are currently at extreme levels. Turns out, this is a particularly uncertain time.
The U.S. Economic Policy Uncertainty Index quantifies uncertainty by counting the number of articles in the 10 largest U.S newspapers that contain terms, such as uncertain or uncertainty, economic or economy and one or more of the following terms: Congress, legislation, White House, Federal Reserve, regulation, deficit. The article must contain terms in all three categories to be included. Reviewing this data back to its 1985 inception shows that the index hit its third highest level in August 2019, just below the all-time high set in January of this year. Indeed, the past 12 months have witnessed record uncertainty, with the U.S.-China trade war playing a central role.
As the below chart shows, rising uncertainty has historically been a byproduct of recessions. The question we must ask ourselves now: Will uncertainty be the catalyst for a recession? Will politics cause business owners and consumers to retrench spending so much that economic growth tips into the red? While we believe the answer is no, we admit that worrying evidence to the contrary is building. Over the past few months, we have witnessed a gradual weakening — but not yet recessing — of U.S. economic data. Indeed, what once was a global manufacturing problem (think the trade war’s acute impact on export-driven economies) is now washing up on U.S. shores.
During the quarter, U.S. manufacturing, as measured by the Institute for Supply Management (ISM) Manufacturing Index, fell into contraction. However, we note a review of history shows that the ISM Manufacturing Index has fallen into contraction on roughly 10 occasions in the past 40 years or so, with only four recessions following. One key differentiator between ISM readings that foretold recessions and those that didn’t is the actions of the Federal Reserve, which we currently believe is very supportive of continued economic growth. We also note the larger service sector of the U.S. economy has remained healthy, albeit with recent data indicating that uncertainty has begun seeping into this part of the economy as well.
We believe tariffs, absent escalations that affect all world trade, create artificial winners and losers at a company/country level but, overall, will not cause recession. Supporting this commentary, we point out that total U.S. trade with foreign countries is roughly the same as it was last year but with relative winners and losers. Indeed, places like Vietnam and Taiwan have benefited from China’s loss of U.S. exports.
We have previously opined that the Trump administration would avoid pushing too hard on the trade front and risk an economic recession. This remains our base case. Indeed, we believe the Trump administration has attempted to sequence trade negotiations over the past 12 to 18 months in order to keep “disruptions” manageable. China didn’t find itself firmly in the crosshairs until the USMCA was largely hashed out last October. The U.S. recently agreed to deals with Japan and South Korea. The U.S. is working through deals with its largest trade partners. Still, the recent flare in tensions has reinvigorated our concern that the administration may misjudge where the uncertainty edge resides, and unknowingly tip us into the economic abyss.
The U.S. and China recently agreed to a “phase one” deal, which alleviates some uncertainty concerns. We think the administration acknowledged growing economic weakness domestically, which may have been the impetus for striking a truce of sorts. However, a final deal is far from done and many of the main sticking points on both sides remain unresolved. And even if a China deal comes to fruition, Europe could be next in the crosshairs. Somewhat worryingly, in the past few months the Trump administration announced an initial volley of $7.5 billion of tariffs on European cheese, scotch and airplanes stemming from a long-running World Trade Organization dispute. We also remind that the Trump administration previously deferred a decision on European auto tariffs until November 2019. However, we don’t believe the U.S. will open a broader trade spat with Europe until there’s increased clarity on China.
At the end of the day, we continue to contend that the most important things to President Donald Trump are: 1) the economy 2) the markets and 3) getting re-elected. Our base case remains that if those things are at risk, the administration will pull back its trade war fervor. With the election just one year in the offing and economic growth stumbling, perhaps the past quarter marks the peak of trade war and political uncertainty.
The Uncertainty Cushioning Committee
We have long noted our belief that the Federal Reserve has an outsize role in ending traditional business cycles. Fed leaders put the final nail in the coffin of each business cycle by aggressively raising interest rates. Indeed, while most recall the harrowing Q4 2018 plunge as a time when U.S.-China trade tensions initially flared, we would remind that the market was also worried that the Fed and other centrals banks were busy tightening policy and threatening more rate hikes in 2019.
Based upon our calculations, we don’t believe the Fed pushed too far last year and the last few months have seen two interest rate cuts. The Fed is attempting to cushion the fallout from political uncertainty. While we are still experiencing some of the growth-sapping effects of last year’s rate hikes, they have largely filtered through the economy. Soon, the stimulative effects of lower cuts should be pulsing through the economy’s veins. And we are not in the camp that believes Fed rate cuts have no impact. Indeed, while parts of the economy have recently weakened, we note that housing has measurably strengthened over the past few months on the back of rate cuts.
Central bank rate cuts and stimulus are not confined to the U.S. but are a global phenomenon. As of this writing, there have been 45 central bank rate cuts and fiscal stimulus is ramping up in many economies. China, an economy where authorities were attempting to slow growth coming into 2018, has now opened the fiscal and monetary spigot. While tariffs are weighing on the Chinese economy, it appears stimulus efforts have brought stability.
The bottom line remains that we don’t believe the U.S. economy will tip into a recession, but the risks right now are certainly much higher than we prefer. The good news is that consumers appear to be in a very good place to weather an economic storm, as are the banks. If we do tip into a recession, we think it would be mild and dissipate quickly once companies have certainty about the new rules of trade or finish revamping their supply chains to adapt.
The Impact of Tweet Trading
During the quarter, total dollars invested in U.S. passive equity mutual and exchange traded funds (ETFs) surpassed dollars invested in active U.S. mutual funds ($4.271 trillion to $4.246 trillion), according to Morningstar. To clarify, this is only dollars invested in U.S. mutual funds and ETFs and does not include individually held stocks. When you bring this into the picture, total dollars invested in passive instruments is still small relative to active. But we note the explosive growth of passive vehicles and ETFs over the past few years.
This is not a commentary that passive vehicles are unattractive investments. Indeed, over the past few years, active managers have generally underperformed their respective benchmarks. However, we note that this, like most other things in markets, has historically proven to be cyclical. The bigger point is that Wall Street trading over the past few years has been driven, on a broad macro-index basis, by the twists, turns and what-ifs of the current political narrative.
The advent of ETFs has provided investors with easy access to vehicles that allow them to react to macro news. Broad swathes of stocks can be bought or sold with the click of one button. Research shows that stocks are now held by investors for minutes, not years. And the primary impetus for investor (re)actions over the past year has been trade war developments. We believe this has created market distortions that have grown alongside all the political uncertainty. Individual securities and entire asset classes are rising and falling based solely upon their perceived sensitivity or insensitivity to trade.
If the trade winds shift and the normal economic cycle begins ticking a bit louder again, we believe individual stock fundamentals may once again win out and patient, active security selection may put one in position to harvest gains. The key word here is patient, because that’s exactly what’s lacking in today’s hypersensitive world of tweet trading through passive instruments or a focus on what-have-you-done-for-me-lately performance chasing. One of the biggest lessons I have learned in my 25 years of industry experience is the biggest opportunities lie in areas where something is in short supply, and right now patience is rare.
We are neither suggesting investors abandon passive investing, nor are we suggesting that certain asset classes and styles are immune from headwinds associated with continued political uncertainty. However, we believe that concentrating a portfolio based upon an overall theme, such as stocks or asset classes resistant to trade tensions, will get investors caught up in a tweet trader’s mentality. Rather, investors should focus on asset allocation strategies that align with their risk tolerance and include diverse asset classes to potentially capture growth in a wide array of market conditions. Diversification is a hedge against uncertainty, while tweet trading smacks of certainty. And if our contention is right that this is peak uncertainty — it’s at a 34-year high, after all — then investors may want to begin contemplating the other side of the equation.
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance. To learn more, click here.