A Smarter Way to Invest Market Summary 2-5-20

MARKET SUMMARY

Provided By: Adam Blocki, CFA, CFP® – Senior Portfolio Manager

Aside from two brief hiccups in the second half of the month, January saw most major equity indexes continue their march higher. Unfortunately, those two brief periods saw the S&P 500 fall 2.5% on January 24th and 27th and 1.8% on January 31st, effectively wiping out gains seen the other 18 trading days of the month. In total, the Large Cap index was essentially flat for the month. The Mid Cap 400 (-2.6%) and Small Cap 600 (-4.1%) fared worse with the Dow Jones Industrial Average (-1.0%), MSCI EAFE Developed Markets (-2.1%), and MSCI Emerging Markets (-4.7%) Indexes all joining in on the losses. The lone gainer among major indexes was the NASDAQ Composite which posted an increase of 2.0% on the strength of the Technology and Communication Services sectors. The drag on equities was mainly due to the outbreak and rapid dissemination of coronavirus in China. While it has spread faster than the SARS virus in 2003, it has fortunately proven to be less deadly so far [1]. The fear for equities is the impact it will have on corporate revenues as whole cities are shutting down and travel restrictions are put into effect to try and prevent further contagion.

Fixed income (IEF, 3.5%) and gold (GLD, 4.5%) prices rose on the fears, but commodities (DJP, -8.6%) took a hit not only from the prospect of decrease Chinese demand due to coronavirus but also from the increased tensions with Iran after airstrikes early in the month. The hit to commodities was reflected in both the Materials (XLB, -6.2%) and Energy (XLE, -11.0%) sectors. Overall, price changes among sectors were mixed with 5 of 11 sector ETFs posting gains for the month. While Materials and Energy were the biggest losers by a wide margin, Utilities (XLU, 6.8%) and Technology (XLK, 4.0%) helped to blunt some of the overall impact to indexes. With most indexes falling while safe-haven sectors such as treasuries, gold, and utilities rose, it’s safe to say January was a risk-off month.

One of the most discussed topics in this newsletter since 2018 has been the trade war with China and January saw a milestone reached on that front. On January 15th, delegates from the U.S. and China met in Washington to sign phase one of the bilateral deal [2]. The agreement reduces some tariffs and leaves others in place as a way to hold China to the promises it has agreed to. These tariffs would be reduced in the future if China purchases an additional $200 billion of U.S. goods and services as well as addressing issues tied to its currency, intellectual property practices, and the trade imbalance between the two countries.

Critics of the deal point out that it focuses too narrowly on the trade deficit and fails to address bigger issues such government subsidies for industrial and state-owned companies; the fate of Huawei and the development of future 5G networks; geopolitical concerns regarding Taiwan, Hong Kong, and the South China Sea; and the use of detention camps for Uighur Muslims. The White House hinted that some of these topics would be addressed in a phase two deal, for which no timeline was given.

A skeptical observer might be tempted to say that progress so far has been mostly political theatrics. This is supported by the fact that the scheduled reduction of tariffs is aligned with the 2020 Presidential election, the lack of specific progress to the key items mentioned above, and the fact that the future purchases by the Chinese outlined in the deal reportedly focus on goods and services that are key to the economies of regions that helped President Trump win in 2016. If, however, this is a stepping stone towards more concrete fixes in a phase two agreement then it would be hard to question the efficacy of the trade war on the whole.

As it currently stands, the aforementioned critics have questioned whether the economic pain experienced by specific sectors of the domestic economy thus far has been worth it without the major changes originally hoped for. Luckily, data on current trade through November was released this month and seemed to offer an answer. On the surface, the indication was that the President has been achieving his goal of reducing the U.S. trade deficit [3]. Compared to the same period in 2018, the deficit shrank by 0.7%. If sustained through December, this would mark the first annual reduction during Trump’s tenure in office. A deeper dive into the numbers shows that the biggest contributor to the drop was the reduction of the petroleum deficit by $35 billion while the deficit outside of petroleum (including manufacturing) actually increased by $20 billion. This is significant because the President has been a vocal critic of free trade due to its effects on U.S. manufacturing jobs being sent overseas. Even though the deficit shrank, domestic manufacturing did not see the benefit.

A second factor that contributed to the overall drop was a decrease in imports. Since imports in excess of exports are what create a deficit in the first place, a reduction in imports without a similar reduction in exports will lead to a smaller deficit. The concern is that falling imports are typically a signal of weakening domestic demand for foreign goods. This decrease in imports would also artificially juice the headline GDP figure (same level of exports minus fewer imports equals a smaller negative number for net exports which leads to higher overall GDP). Since most economists agree that the result is more of an accounting quirk than a true boost to the economy, this might actually be a negative sign despite its positive impact on GDP.

A separate topic of discussion with regards to the deal is the ways in which it differs from most other trade agreements that have been put in force since WWII [4]. Trade agreements in recent decades have typically set forth the rules that each party must abide by and from there, market forces determine what the optimal flow of goods will be. The phase one agreement with China instead commits China to buying a pre-determined amount of specific U.S. goods and services that has been referred to as “Socialist-style central planning”. White House officials insist this was by design so that it wouldn’t be subject to Congressional approval but it does risk setting a dangerous precedent.

Since FDR, the U.S. has typically led the charge on free, rules-based, international trade. It helped to launch the General Agreement on Tariffs and Trade in 1947 and subsequently the World Trade Organization. The argument in favor of such pursuits was that global trade provides access to new products and lowers prices around the world as countries are able to specialize in the areas that they are uniquely adept at. There have always been critics that point out labor practices, environmental issues, and national security; but on the whole, humanity seemed to benefit from lower prices in developed countries and growing economies in emerging markets.

The story has shifted in the last decade. Trade in goods and services as a share of global GDP has been flat, and when removing services from the equation, has actually fallen since 2010. Now the U.S., formerly the lead figure in the globalization push, is led by a President more concerned with national interests, pursuing one-off trade deals with individual partners, and reintroducing tariffs as a bargaining chip.

We have already discussed the ways in which the U.S.-China deal lays out specific terms and quotas for purchases, but the U.S.-Mexico-Canada Agreement also set forth similar terms dictated by the signees instead of the markets. In its current form, these deals would seem to benefit the U.S. since we are involved in the deals and are looking out for our own best interests when negotiating them.

The problem is that these one off-pacts with fixed quotas don’t necessarily consider the nations not included in them. If Europe is harmed by our interactions with Mexico and Canada, normally that would be addressed by submitting a complaint to the WTO. The WTO nations then determine who broke what rules and settle on a remedy. The system isn’t perfect, as has been demonstrated by the ways in which China at times flouted the rules, but for the most part, countries have abided by the framework. What may prove to be the fatal flaw is that the WTO doesn’t necessarily have enforcement powers of its own and has been weakened by the recent lack of support from the U.S. Once the WTO arrangement begins to crumble, other nations could begin to pursue their own one-off deals with trade partners that would also have little concern for the nations not party to the deal.

From our current seat as the largest global economy with immense bargaining power, the U.S. would seem to have little to lose from this new paradigm in the short-run, but other countries might not be so lucky. However, there will come a day when the U.S. is no longer the world’s largest economy and no longer has the dominant position. What happens in a scenario where we are no longer on top and the rules regarding fair trade have been thrown out is anyone’s guess.​

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