After a roaring start to the new year (indeed the new decade) during which a fully diversified equity portfolio tacked on another 3+% to its 27+% gain for all of 2019, stocks ran into a ‘Chinese Wall’ around about January 20, giving up all of its gains and then some, ending with a 1.2% loss. The most-cited cause, for good reason, was the emergence of the coronavirus within mainland China, which has now exceeded the 2003 SARS virus in terms of widespread affliction. Never mind the humanitarian impact which is of course incredibly serious, but this is an investment letter, so therefore the focus will be on the perceived macro-economic impacts to global growth. At this writing, there appears to be no credible basis of predicting the progression, or its eventual containment, of the disease. Hence it will remain a wildcard with unforecastable volatility across all financial asset classes.

From a purely (and I stress the word ‘purely’) economic point of view, there are certainly worse times for such a potentially devastating event to occur, with the U.S. economy in arguably its strongest position ever in absolute terms (but not in growth – more below), and with a few more-than-just-glimmers of re-acceleration across Europe and Asia. Certainly global growth, even if the corona-virus concern all ended tomorrow, will have already been affected to some degree. One major Wall Street firm has already estimated an annualized 0.4% hit to Chinese GDP just in these ten days or so, although that seems low to me with 80% of China’s productive capacity still shuttered even after it has just returned from its elongated Lunar New Year holiday. China is such a big enough factor that some of this weakness will absolutely prove to have affected all other major economies. The longer this goes, the higher that degree will prove to be. But at least the world in macro-economic terms is dealing with it generally from a position of strength, not weakness.

New monetary policies from all major banks

Another major factor is the continued massively accommodative monetary policies from all major central banks, most notably of course our Federal Reserve, the European Central Bank, the Bank of Japan and the Peoples Bank of China. The PBOC injected a massive amount of cash into its financial system this morning, no doubt a factor in today’s early Wall Street recover rally. I have written at length lately about the financial markets’ collective near-giddiness as they happily translate the rising tide of new money available into ever-higher stock, bond and commodity prices. Yes, even bitcoin. Though the stock and commodity markets have sold off in response to the economic uncertainty created by the disease, all this newly-created liquidity isn’t going to be reversed anytime soon. For the moment anyway, within the markets much is clearly being shifted into bonds, as the yield on the benchmark U.S. Treasury 10-year has fallen from 1.92% on 12/31 to 1.55% a month later. More on this below.

So that’s all the ‘good news’ I can manufacture for the moment

There’s also another side to the overall story, the investment side. Though I suppose one can make some argument to the contrary based on underlying fundamental economic strength, I see this exogenous event hitting at the point of maximum market risk, i.e. when prices had already ascended to levels, as of the peak on January 22, that can only prove sustainable if everything across all spectrums goes not only well, but perfectly.[JL1] As I have written a number of times in this monthly space, I am nowhere near as sanguine about this prospect as the markets assert. Here’s why.

Last Thursday came the first (known as the ‘flash’ report, subject to later revisions) Commerce Department release of Q4’19 GDP growth (obviously well-pre-virus), showing a 2.1% annualized increase, a slight reduction from earlier in the year, leaving full-year 2019 growth at 2.3%. This was actually better than most economists had predicted as the calendar quarter started but, peeling off the layers from the surface report, there was quite a bit left to be desired.

First and foremost, consumption growth dropped like a stone, from 3.2% in Q3 and 4.6% in Q2, all the way to only 1.8%. With aggregate business investment in actual 1.5% contraction, this reduced the ‘private domestic sales’ annualized growth to only 1.4%. These reductions were offset by large growth in government spending and in the very-hard-to-decipher net trade accounts. Exports rose to 1.4% but imports crashed at an 8.7% rate, with the net-net positive contribution to GDP of a full 1.5%.* Add everything up and U.S. GDP actually had its weakest nominal growth since 2016.

Other data released with the GDP was also not particularly favorable

Even with core inflation contained to 1.3%, real (net of inflation) disposable income growth rose only 1.5% in the quarter. Yes, it’s up, but for the vast majority of households, the actual ‘feel’ of the increase would be negligible. Even in nominal terms – real plus inflation – there is such an income skew in favor of the higher income deciles that for the politically important ‘middle class’, there may have been no increase at all. This is of significant concern since the bottom 90% (by wealth class) operates at a negative 2% annual savings rate. Indeed, this may become an increasingly important political factor as November approaches.

Chicago Purchasing Managers Index

As this Update goes to press comes the January Chicago Purchasing Managers Index, regarded as the most robust regional manufacturing-oriented data series. No sugarcoating here – it crashed and burned, down to the level of 42.9 versus an expectation of 48.9, the weakest in five years and compared with a 50+-year average of 54.75. On the other hand, the national ISM reported this morning, wasn’t quite so negative, although its internal Employment Index continues to struggle.

What I see from market-based indicators

The dramatic drop in interest rates has taken the shape of the yield curve back to as close to ‘inversion’** as it’s been since early fall. You might remember that it actually did ‘invert’ briefly in August before returning to its normal positive slope when the Federal Reserve re-initiated its money printing endeavor.

Additionally, the yield on the so-called ‘long bond’, the U.S. Treasury 30-year, is back only fractionally above the 2% line, not far at all from the lowest-in-my-professional-(38+ years)-lifetime 1.90% level it also reached in August. This is not a favorable economic indicator – quite far from it…and this trend was well underway pre-virus.

Furthermore, two other market ‘tells’ are acting very poorly.

1. The spot price of copper (occasionally referred to as Dr. Copper because of a reputation as having a PhD in economic analysis) is now plumbing lows not seen since late 2016. In fact, its current eight-day losing streak is the longest on record.
2. Likewise, the Baltic Dry Index, which measures the cost of shipping goods around the world by ocean-going freighter, has fallen a full 79% from a September, 2019, peak to also a near 4-year low.

Of course, both can be subject to sudden upside reversals but in my opinion these moves must be respected.

Now let’s go strictly within the stock market

Beginning in mid-December (well-pre-virus) the character of the stock market changed completely. Even with all the macro-economic news seemingly getting better and better, the stocks of cyclical companies began to falter relative to mega-cap technology.

The high-octane ‘algos’ and ‘hedgies’ have piled into – and almost only into – a relative handful of stocks - FAANG+M – Facebook, Apple, Amazon, Netflix, Google and Microsoft. One can add Visa and MasterCard and the defense industry stocks too. Indeed, as we’ve seen from their Q4 earnings reports, their collective corporate performance has been awesome. But really, are there no other stocks whose future prospects are good enough to earn your dough? This certainly begs the question as to whether this intense concentration is too overly reminiscent of late-‘99/early-’00, a comparison I’ve made before, which ended in major tears. Virtually every major bulled-up pundit is screaming – “Don’t worry. It’s not 2000. It’s different this time”. Okay, maybe it is. But maybe it isn’t.

Political impact

Of course we can’t forget another elephant in the room – politics, more specifically the perceived odds of a progressive Democrat (Sanders/Warren) winning not just the nomination but also the general. Indeed these odds have increased lately. Since Wall Street is virtually certain of the incumbent’s re-election, and since (rightly or wrongly) this is regarded as the best possible outcome from purely an economic/markets standpoint, any small wiggle in the other direction would be, ergo, bad for stocks. It doesn’t mean it will be bad should that actually occur, but that’s the current conventional wisdom. So for the time being, any such ‘progress’ through the various electoral mileposts could have an impact. We get our first such milepost today in Iowa, followed closely by New Hampshire the next Tuesday.

Suffice to say, again, I’m content to maintain our equity weighting for our clients at slightly below longer term targets. Even so positioned, our portfolios were happy to bask in Wall Street’s reflected glory in 2019, giving up only a fractional amount of the return available. January ended up slightly to the downside and February is often (though not last year) one of the year’s weaker months. No matter what happens, these next 26 days certainly won’t be boring.

Let’s finish on a, shall we say, more whimsical note. With the Chiefs remarkable comeback victory last night, the 53-year-old Super Bowl indicator flashed a negative warning sign for 2020. It holds, with so far a 75% accuracy rate, that when a team from the original AFL wins, it portends a below-average year for stocks. Conversely, if an NFC team or an original NFL team now in the AFC (Steelers, Colts and Ravens) wins, that’s terrific. Admittedly, it hasn’t worked the past four years.

*Nothing like double-entry bookkeeping, where a reduction in a negative (imports) is actually accounted for as a positive. In my experience, when we reduce our demand for imports, it’s not because we’re spending more on domestic goods.

**Inversion occurs when the yield on shorter-term bonds/bills exceeds those on longer-term bonds. As I wrote back last summer, I regard this as the single best predictor of future negative economic activity as, all else equal, this provides a true disincentive to spend/invest. That said, I concede that the overwhelming monetary ease underway by our Federal Reserve may have reduced its predictive utility.