Westlake PWM Insights

Quarterly Missive

We’ve always said bull markets never die of old age.  The present cycle - ten years old as-of March – is already the longest in U.S history, but its age is unlikely to be its undoing.  Bull markets traditionally die because of excess leverage or overconfidence, or sometimes because of external catalysts such as Fed policy…or perhaps government fiscal policy that works its way into the system and stalls economic growth. 

We believe the risks that we may be entering the early stages of change are now elevated.

To be right up front, we are not doom and gloomers who believe the sky is falling.  However we do believe that conditions have sufficiently changed to cause us some moderate concern and warrant our full attention. 

Hear us out:  the last several years have been punctuated by deregulation, tax cuts, accelerating GDP growth and impressive corporate profits growth.  The U.S. economy and financial markets have been good to us, without question.  With interest rates low and accommodative, capital spending has been robust; with low unemployment and negligible inflation, consumer confidence has seen some of the highest readings of the last ten years1.   However with trade rhetoric ramping up over the last several months, many of these positives are now at risk of unwinding.

By now we’ve all read the articles detailing the increase in tariffs from 10% to 25% on $200 billion of Chinese imports to the U.S. and we’ve read about the risk of additional possible tariffs to come.  We’ve read the public statements that seem to undermine real progress in the negotiations, and we’ve all shared concern over the uncertainty they’ve presented.  Of course our first challenge is to try to gauge the direct economic impact from the imposition of tariffs and protectionist trade policies.  The analysis that makes most sense to us suggests we can expect a 0.1% hit to GDP for every two months the tariffs are in place2.  For an economy growing around 3% annually, that doesn’t seem like much.  But that’s not what concerns us.  The tensions impacting the markets today are less about the tariffs themselves and more about the uncertainty surrounding where everything is headed. 

As of this writing, the expectation for a breakthrough when Presidents Trump and Xi meet in Japan later this month are dimming.  China won’t change the way it subsidizes state-owned companies and the U.S rightfully won’t back down from issues such as China’s pirating of intellectual property.  There are no further talks on the calendar, and even if Trump and Xi have a terrific June meeting it would take months beyond that to hammer out a deal.  To be fair, we still expect an agreement, and the financial markets are still discounting such, but perhaps not until 2020….or when elevating levels of discomfort cause one side or the other to break…or when President Trump realizes that his re-election efforts hinge on Iowa’s or Missouri’s electoral votes.  Until then, mounting uncertainty may wreak havoc on capital spending plans and the business investment needed to sustain and grow GDP.  We’re already seeing signs that capital expenditures are slowing - capital goods orders were up only 1.3% in April, the lowest year-over-year monthly reading since the President took office.

We’re also seeing initial signs of impact to the consumer as well.  The closely-watched University of Michigan consumer sentiment index fell from May’s initial estimate of 102.4 to a final reading of 100 because, according to the University’s economist, consumer confidence “significantly eroded in the last two weeks of May.”3  Two-thirds of U.S. GDP is represented by consumer spending and is the fuel that keeps the economy humming.  Substantial slowing in this metric will likely have a spillover effect that will be felt by all.

Beyond China there is now Mexico, where President Trump appears to be using the threat of tariffs to stem the flow of migrants from Central America.  We won’t argue with the need for smart immigration policy, but using tariffs to promote policy objectives beyond foreign trade is concerning.  From a business perspective, it makes it wildly challenging to plan and invest.  If tariffs on Mexican imports are actually imposed, what’s next…and how will businesses efficiently allocate capital amidst growing political uncertainty?  These questions are beginning to weigh on investors, and until they’re sorted out, we should expect a bumpy ride.

To be fair, none of the economists or market strategists we follow are suggesting a recession is imminent.  But the consensus nevertheless is calling for slowing economic growth, perhaps from the current rate of 3.2% down to 2.0% or so4.  While this is nowhere near catastrophic, it is an adjustment that may test our patience as investors’ expectations are collectively reset for this new reality.

In summary, the economy remains on good footing.  All traditional measures of U.S. economic health – GDP growth, unemployment, inflation, and corporate profits growth - are sound.  However external catalysts in the form of government policy are creeping into the picture and are, in our view, beginning to threaten the durability of the economic recovery and bull market in equities.  Because we aim to remain true to our strategic asset allocation models, we are tightening up and focusing to ensure our clients’ portfolios are consistent with their long-range objectives and tolerances for risk.  It is important to remember the reason why we steadfastly remain committed to our process for managing wealth.  Simply stated, asset allocation and portfolio diversification help.  Over the last 30 days, as volatility has increased, stocks (as measured by the S&P 500) have pulled back 4.4% while bonds (as measured by the Barclay’s Aggregate Bond Index) are up 1.4%.  Some commodities and alternative investment classes have performed even better.5 Bonds and alternatives have done exactly what they are supposed to do: mitigate equity market volatility.  This is why we do what we do, and why we will remain wholly committed to our process.

As always, we remain truly grateful for the continued trust and confidence you have placed in us and we wish you, your family and friends a wonderful summer season ahead.

1University of Michigan Consumer Sentiment
2The Bahnsen Group, May 17, 2019
3The Wall Street Journal, May 31, 2019
4First Trust Advisors LP
5Wells Fargo Investment Institute

S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value. Bloomberg Barclays U.S. Aggregate Bond Index: Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based measure of the investment grade, US dollar-denominated, fixed-rate taxable bond market.

The opinions expressed in this e-mail are those of the author(s) and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The e-mail has been prepared for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Investing involves risk including the possible loss of principal. Any index referenced is presented to provide you with an understanding of its historic long-term performance and is not presented to illustrate the performance of any security. Investors cannot directly purchase any index. Past performance is not a guarantee of future results and there is no guarantee that any forward looking statements made in this communication will be attained.