Lay of the Land

For this week’s Market Commentary, I am sending out an excerpt from the 3rd quarter edition of The Farr View.

The domestic economy continues to chug along, albeit at a slower pace compared to the tax-cut-induced strength we enjoyed in 2018 and the first quarter of 2019. However, there are some troublesome internal dynamics that could be cause for concern. Business investment and exports continue to be adversely affected by trade-related uncertainty, weak global growth, and a strengthening dollar.
The same factors have pushed the US manufacturing sector into contractionary territory, and the weakness may be spreading. Mark Zandi, Chief Economist at Moody’s Analytics, reckons that about 20% of the US economy is already in recession. In addition to manufacturing, Zandi says, the agriculture and shipping sectors are no longer growing. For now, it’s easy to scapegoat the trade war with China because the weakness appears to be concentrated in export-oriented sectors. But that might not be the whole story.

The big risk for the economy going forward is that the weakness in the manufacturing sector could spill over to the services sector, which covers a much larger swath of the US economy while also providing the vast majority of private sector jobs. Unfortunately, the data isn’t looking too good. The chart below shows data for two surveys produced by the Institute for Supply Management – the ISM Manufacturing Index, which covers manufacturing, and the ISM Non-Manufacturing Index, which covers services. It is easy to see that the Non-Manufacturing Index has been tracking the Manufacturing Index sharply lower in recent months. It is important to note, though, that the Non-Manufacturing Index is still above 50, which is the dividing line between expansion and contraction. I would also point out that the Non-Manufacturing Index never fell into contractionary territory during the late-2015, early-2016 slump in manufacturing. Will the services sector be so resilient this time around?

Without a doubt, the big question mark for the economy is whether or not the US consumer, one of the most reliable pillars of global economic growth, will begin to more directly feel the effects of weakness in other parts of the domestic and global economies. So far, there hasn’t been much evidence supporting this notion. The consumer continues to spend at a solid pace thanks to the healthy job market, solid income growth, and ready access to inexpensive credit. The sharp decline in interest rates in recent months has breathed life into the housing market following a period during which residential fixed investment contracted for six straight quarters. Higher home prices, along with a buoyant stock market, have also been supportive of consumer spending. Savings rates are quite healthy, and debt service ratios, which measure the consumer’s ability to make principal and interest payments on his debt, are at the best levels in decades (due largely to low interest rates). It will be important for these trends to continue given the sizeable drags on growth from other sectors.

But while the consumer’s ability to continue spending freely is not in doubt right now, his willingness to spend may be another matter. Willingness to spend will be determined by changes, either real or perceived, in the consumer’s financial circumstances. Hiring has slowed a bit from the breakneck 2018 pace, though some slowing is to be expected with the unemployment rate at a 50-year low. Wage growth appears to have slowed as well, but inflation has declined even more, and wage gains are likely to continue at a solid pace given the ultra-low unemployment rate. Stock-market volatility appears to have returned, and the constant news coverage of trade wars and political upheaval in Washington has taken somewhat of a toll on the consumer psyche as well. But at this time, it is hard to draw any conclusions from the various cross-currents. Gauges of consumer confidence have pulled back a bit in the past couple of months, with a particularly large drop in consumers’ expectations for the future. These decreases in confidence are well short of a crisis, but they warrant attention as we move into 2020.

There is also a lot riding on the trade talks with China. Some are clearly beginning to lose faith in the president’s hard-ball trade tactics. Others think this process is long overdue and will ultimately be additive to our economic growth potential. I can understand the arguments on both sides. But if I were a gambling man, which I’m not, I would bet that President Trump will ultimately come to the conclusion that perfect cannot be the enemy of good on this issue. In other words, political expediency would argue for a trade deal in advance of next year’s elections. This is especially true given that key election battleground states are suffering the worst effects of the trade war. A September 30th article by Laura Silva Laughlin in The Wall Street Journal read, “Regional economic indicators suggest that the financial health of the Midwest is waning, as trade tariffs start to take their toll on sectors from farming to manufacturing.” Of course, China knows full well that Trump is in a bind politically. The People’s Republic will surely use this to its advantage as the trade talks resume. Oh, and did I mention that the Trump administration just imposed retaliatory tariffs on the EU and that we still don’t have a trade agreement in place with Mexico and Canada?

All that said, we maintain that investors should not be rash and bow to their emotions when contemplating the gathering risks. The investment landscape has been rife with potential landmines since the bull market began in early 2009. Those who were spooked out (Halloween pun intended) at any point since then are likely feeling some regret. As hard as it can be at times, long-term investors are often best served by drowning out the noise. If we could, we would take our own advice.

This is not to say that playing a little defense is a bad game plan. A rudimentary analysis of the current bull market reveals that the gains have been heavily dependent on a handful mega-cap stocks, many of which fetch valuations that have become very hard to justify. At the same time, there are many high-quality companies that have been shunned precisely for their adherence to the principles of conservatism and management for the long term. The latter group seems to make a lot more sense right now.