November in Review: Is All Well That Ends Well?


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 0.6% in the month of November.  The NWM Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

The NWM Bond Fund returned -0.1% in November and is +1.4% year-to-date, compared to the FTSE TMX Canada Universe Bond Index which was +1.0% for the month, and -0.1% year-to-date. East Coast Investment Grade Fund II at 22% of the Fund was -1.4% in a month where Canadian investment grade credit spreads widened. We expect ample capacity for East Coast to generate higher yield income from wider credit spreads that will outweigh any losses that occurred during the widening.

NWM High Yield Bond Fund returned -0.6% in November and is +2.9% year-to-date. All of our component managers had a negative return in November, aside from the long/short manager Apollo Credit Strategies which was +0.6%. Picton Mahoney Income Opportunities Fund was the largest negative monthly contributor at -2.0%. The NWM High Yield Bond Fund began investing with Apollo in January 2018, and we are increasing the allocation to Apollo Credit Strategies in December.

The NWM Global Bond Fund returned +1.3% for the month.  The NWM Global Bond Fund benefited from relative stability in emerging markets fixed income, USD$ strength vs CAD (~53% of Fund is in USD$) and positive U.S. duration exposure. Individual Fund returns (CDN$) in descending order: Templeton Global Bond (~+1.8%), PIMCO Monthly Income (~+1.4%) and Manulife Strategic Income Fund (~+0.2%). Templeton’s performance was mainly driven by Asia ex-Japan currency exposure. Both PIMCO and Manulife’s returns were relatively flat in local currency terms due to the widening of credit spreads in both the U.S. High yield and U.S. Investment grade credits markets, offset by U.S. duration exposure (U.S. 10 year decreased from 3.14% to 2.99%).

The Mortgage Pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3% and +0.4% respectively last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.2% for the NWM Primary Mortgage Fund and 5.8% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund had 12.9% cash at month end, while the NWM Balanced Mortgage Fund had 19.1%.

The NWM Preferred Share Fund returned -7.7% for the month while the BMO Laddered Preferred Share Index ETF returned -7.2%. The negative pressure on preferred shares is due to broader concerns on risk-off markets coupled with retail based ETF selling pressure. ETF’s account for about 10% of assets in the entire universe and on a block basis, there have been days where ETF’s have presented 85% of volume.  With no one making a bid, selling pressures have hit the market unabated.  The sell-off is different from 2015 / 2016 when the five year Government of Canada yields flirted with 0.5%, today they are at 2.1%. The sell-off has unfortunately punished high quality issues with more liquidity. Given wider credit spreads and the sell-off in equity markets, a weakening of preferred shares was warranted but the severity is overdone relative to the movement of stocks and bonds. We are incrementally selling high reset bank issues, which have held in, and are purchasing mid resets which have sold off significantly and will continue to do so while opportunities present themselves.

Canadian Equities recovered slightly in November with the S&P/TSX +1.4%. The NWM Canadian Equity Income Fund was +1.2%.  Industrials and Health Care were positive contributing sectors. We had negative contribution from Communications Services which had a strong month and we were underweight (BCE +11.8%, Quebecor +11.3%, Telus +5.8%) and our only exposure is in Shaw. Consumer Discretionary was also a negative contributor. We added a position in ATS Automation and sold Gildan Activewear. Top contributors to performance were Great Canadian Gaming, Air Canada, and Medical Facilities. Top detractors were Spin Master, Sleep Country, and Whitecap Resources.

The NWM Canadian Tactical High Income Fund returned -2.7% in the month, which was relatively worse than the S&P/TSX’s+1.4% return.  The NWM Canadian Tactical High Income Fund was underweight most of the top performing sectors (Communication Services, Utilities and Info Tech) and had negative stock selection (Cineplex & Sleep Country) within the industrial & communication services sectors.  During the month we added Bank of Nova Scotia via short Put options and we continued to sell down our long position in KP Tissue.  The NWM Canadian Tactical High Income Fund remains defensively positioned with companies generating higher free-cash-flow and lower leverage relative to the market.

The NWM Global Equity Fund returned +3.0% vs +2.6% for the MSCI ACWI (all in CDN$).    The NWM Global Equity Fund outperformed the benchmark due to region –overweight Asia, and sector –underweight IT and Energy, which more than offset headwinds from being underweight in the U.S. and overweight in Europe and in Small-cap. Performance of our managers in descending order was: BMO Asian Growth & Income +4.4%, driven by exposure to Asian Financial Services ; CWorldwide: +4.0% helped by positions in HDFC and Visa; ValueInvest +3.8% benefitting from US Pharma and Staples exposures; and Edgepoint Global: +3.4%, driven by stock selection in mid-cap U.S. Industrials.  Headwinds to performance were: NWM EAFE Quant +1.4%, which is an International strategy so it didn’t benefit from strong U.S. equities; and Lazard Global Small Cap +1.1%, which experienced drags from being underweight Healthcare and the U.S., and stock selection in Asia.

The NWM U.S. Equity Income Fund returned +2.6% while the S&P500 returned +2.0%.  Relative performance was driven by Newell; Materials names Westrock and Sherwin-Williams; as well as Consumer Staples name Procter & Gamble.  Drags included Activision, refiner Valero, and semiconductor company NVidia.  Cyclical sectors such as Materials, Industrials, Discretionary and Financials recovered some lost ground after a challenging October, which helped our performance.   While no new names were added, we sold Aptiv due to concerns the Auto-parts maker will continue to get hurt from slowing auto sales.   We also added to some names on weakness, including growth names Activision and NVDA, refiner VLO, as well as insurance company AIG.

The NWM U.S. Tactical High Income Fund’s performance was +0.3% vs +2.0% for the S&P 500.  The Fund’s underperformance was mostly due to being underweight Healthcare and negative relative stock selection within consumer discretionary space. Option volatility decreased during the month, but still remains elevated relative to the past couple of years. We added Costco back into the portfolio via short Puts as this high quality name sold off close to 9% since the beginning of November.  The portfolio remains defensively positioned with a lower valuation multiple, higher free-cash-flow and lower leverage relative to the S&P 500.

The NWM Real Estate Fund was +0.9% for the month of November vs. the iShares (XRE) +2%. The publicly traded REITs were strong for the month and outperformed the broader TSX market, which was +1.4%.  CIBC research has made the case the 10 year Treasury yields should be a key focus of REIT investors. The Government of Canada 10 year rates declined from 2.49% at the end of October, to 2.27% at the end of November. 10 yields now sit at 2.08% (December 6th). This has provided a tailwind to the REIT sector. The fund is currently weighted 24% publicly traded REITs and 76% LPs, which exhibit lower volatility (quarterly appraisals and NAV updates). No changes to the portfolio were made in November.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of November 30th, October performance for SPIRE Real Estate LPwas -0.1%, SPIRE U.S. LP +1.0% (in US$’s), and SPIRE Value Add LP +1.5%.

The NWM Alternative Strategies Fund returned -0.5% in November (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.6% to returns as the Canadian dollar continued to weaken. In local currency terms, Winton returned +2.2%, Millennium -2.8%, Apollo Offshore Credit Strategies Fund Ltd +0.7%, Verition International Multi-Strategy Fund Ltd -3.1%, RPIA Debt Opportunities -1.1%, and Polar Multi-Strategy Fund -1.1% for the month. The drawdowns in both Millennium and Verition mainly came from their quantitative based strategies where statistical arbitrage, quantitative based fundamental equities, index rebalancing and other systematic strategies all suffered losses during the month. While other strategies were mainly flat to slightly positive, they were not able to offset these losses.

The NWM Precious Metals Fund returned -3.9% for the month under performing underlying gold stocks in the S&P/TSX Composite index which returned 2.6% while gold bullion rose 1.5% in Canadian dollar terms. Junior and Intermediate precious metals and mineral names generally fared worse for the month as Guyana, Semafo, and Alamos all suffered losses of more than 15% for the month.

 

November in Review

Most global equity markets ended the month of November in positive territory, but it took a herculean rally at the end of the month to erase what was shaping up to be another bad month for stocks.  The S&P/TSX was up 1.4% while the S&P 500 gained 2.0%, or 3.2% in Canadian dollar terms.  While one could conclude that “all’s well that ends well”, we’re not convinced investors have seen the last of the extreme volatility exhibited in the markets over the past couple of months.  According to the American Association of Individual Investors, bears out-number the bulls by over 20%, mirroring the negative outlook of professional market timers as evidenced by plunging average equity weighting in the Hulbert Stock Newsletter Sentiment Index.  Some prominent hedge fund managers, like Carl Icahn and Paul Singer, have been warning of market doom for a number of years.  Up until recently, most believed they were wrong.  Now perhaps they can claim to have just been early?

U.S. Federal Reserve and Trade Wars concern the market.

There are two main issues concerning the market.  One, the possibility the U.S. Federal Reserve is about to commit a policy mistake by continuing to raise interest rates into a slowing economy, thus driving the U.S. into recession.  Second, the trade war between China and the U.S. will worsen and result in higher inflation and slower global growth.  We think concerns of the former are overdone, though we concede risks have increased.  As for the second, we have no idea.  It’s a battle of wits and endurance between Presidents (Trump & Xi), whose outcome is uncertain and alarming, never a good thing for the capital markets.  President Trump recently commented to the Wall Street Journal “the Fed right now is a bigger problem than China”, but this is just Trump attempting to manipulate the Fed.  The President himself is likely a bigger threat than either, but that is a discussion for another day.

This month, we will look at both the Fed and the China/US trade in more detail, before sharing  some thoughts about what their impact on the capital markets might be in the months ahead.

The U.S. Federal Reserve has been pretty transparent in its intention to raise overnight interest rates back to a neutral level, a level that neither spurs nor restricts economic growth.  Fed Chairman Jerome Powell has currently pegged “neutral” as falling somewhere between 2.5% and 3.5%, which means another five or six hikes is possible before monetary policy becomes restrictive.  The market generally believes “neutral” is much lower and is hoping the Federal Reserve slows it’s present tightening pace, ending 2019 with overnight rates below 3%.  Another 25 basis point hike in December is a near given, but limiting next year’s hikes to just one or two 25 basis point increases would appear where the market believes the Fed will end up.

 

The recent market volatility will likely make the Fed slow down even more.

In late November, Chairman Powell appeared to be bowing to the wishes of both President Trump and the market when he remarked the Fed’s series of rate increases had brought policy to “just below” the range of estimates of neutral.  Now this could be interpreted a couple of different ways.  Given the Federal Funds rate is currently set at 2.25% (Fed Funds is expressed as a range, with an upper and lower bound.  The lower bound is currently 2.0% and the upper bound is 2.25%), after December’s anticipated increase, the overnight rates could effectively be at “neutral” if the lower end of the 2.5% to 3.5% range is determined to “neutral”.  Alternatively, the Fed could be required to hike an additional four times in 2019 if the upper end of 3.5% is ultimately determined to be neutral.  Chairman Powell has been very open about the fact that they don’t know exactly where “neutral” is, recently comparing the Fed’s strategy to walking into a living room when the lights suddenly go out.  “What do you do?  You slow down and maybe go a little less quickly, and feel your way more”.

Before LTCM (Long Term Capital Management) imploded in late 1998 requiring a Fed sponsored bail out, changes in the fed funds rate appeared to move independently to that of stock prices.  After LTCM, they appear highly correlated to market volatility, with corrections in stock prices being met with more accommodative monetary policy.  In fairness, declining stock prices has a similar impact on the economy as tightening monetary policy, as does widening credit spreads and a stronger dollar.

The combination of all four working in the same direction has caused financial conditions to tighten quicker than perhaps the Fed had been anticipating.  Also, while it looks like the Fed has increased rates 2.25% since the current tightening cycle began in late 2015, keep in mind when rates were reduced to zero during the financial crisis, the Fed used other monetary policy tools, like quantitative easing, to stimulate the economy.  Including the impact of these other tools, the Atlanta Federal Reserve estimates the effective fed funds rates actually bottomed out at minus 3%, meaning the current tightening cycle has been closer to 5.25%.  Bond guru Jeffrey Gundlach, recently used the Atlanta Fed’s research to conclude the Fed’s decision to unwind quantitative easing and reduce the size of its balance sheet by about $600 billion is equivalent to three interest rate hikes, or 75 basis points.  The point being, maybe the Fed has done enough?

This is the conclusion the market appears to be coming to and is evident by action in the bond market.  One of the best early recession indicators for the economy is the shape of the yield curve.  When short term bond yields are higher than longer term bond yields, a recession normally follows one to two years later.

In early December, two year Treasury yields rose above five year yields, inverting the short end of the year curve for the first time since well before the financial crisis.  While most strategists view the relationship between the two and ten year yields, which is still positive, as the key recession indicator, the 2/5’s inversion was taken as a negative harbinger by traders, who reacted by selling risk assets.  Year end positioning by banks having to raise higher-quality capital by buying Treasury’s in order to meet regulatory requirement is rumored to have helped cause the inversion.  Macro research shop Strategas also recently pointed out the demand for five year Treasury bonds (higher demand means a higher price and lower yield) could be a result of large institutional investors buying credit default hedges on some large investment grade corporate debt positions, like General Electric.  It’s a bit technical (meaning it’s beyond our level of expertise), but five year Treasury bonds are used as part of the offsetting hedge used to construct and layoff the risk of these instruments.  Both of these allude to the fact that changes in market structure could be the cause of the inversion, thus diminishing its predictive ability in signaling economic recessions.  Still, the fact remains that longer term yields have been falling while shorter term rates have been relatively unchanged over the past month as even the 2/10’s yield curve has flattened.  This would suggest the continued flattening of the yield curve is due to investors becoming more worried economic growth is slowing than reflecting on the impact of central bank tightening (which would result in shorter term rates increasing).

Two things investors need to keep in mind.  

First, the longer end of the yield curve, namely the two year versus ten year yields, or the 30 day versus ten year yields, haven’t yet invested.   They have flattened and are getting close to inverting, but a flat yield curve has not historically been bad for the markets.  Second, even when the yield curve finally inverts, markets can continue to rally for the next year or two, which makes sense because an inverted yield curve typically occurs because the economy is in the process of overheating.  The one word of caution we might offer with this cycle, however, is the focus the yield curve appears to be getting, which could push forward a market correction in anticipation of a future recession.  How do we know when this has become a problem?  Cynically speaking, when taxi drivers start commenting how they have shorted the S&P 500 because the yield curve is about to invert, perhaps the usefulness of this indicator has run its course.

If this were to happen and the usefulness of the yield curve becomes eroded, it doesn’t necessarily mean we will be forced to join Fed Chairman Powell in his dark living room, bumping into furniture, there will always be other indicators to watch.  One we continue to keep our eye on is credit spreads, namely the amount of yield in excess of the risk free Treasury rate corporate borrowers are forced to pay.  When monetary conditions become tighter, the price of money increases.  Also, when lenders become more concerned with how late in the economic cycle we are, they become a lot more discriminant with whom they lend money to.  In other words, return of capital becomes more important than return on capital.  Credit spreads have started to widen, both investment grade and high yield, but the declines have been mainly company and sector specific rather than a more general asset mix shift out of the asset class.

In the investment grade space, the balance sheet of industrial conglomerate GE has come under scrutiny, as has California utility PG&E, with potential wild fire liability weighing on investor minds.  In high yield, energy companies make up about 15% of non-investment grade issuers, and the recent decline in oil prices has caused lenders to become more cautious.  We would become more concerned about the recent sell off in credit spreads if it was less issuer specific and if the selling preceded a correction in the equity market rather than appearing to just follow along.  This is not to say we aren’t concerned about debt markets, especially once a correction occurs.  In the next downturn, recovery rates may disappoint given lax lending terms borrowers were able to negotiate this cycle and investors should invest allocate capital accordingly.  As an early warning signal for the markets and the economy however, credit spreads are still not flashing red.

Even within the equity market itself, we think investors have jumped the gun and started to position for a recession before the economy has actually started to roll over.  We see this with the recent move toward defensive stocks, the correction in both the housing and technology sector, as well as the recent decline in energy stocks.  Since September, any sector that had been doing well appears to be under pressure as investors shift away from momentum and growth and start to allocate capital into traditionally defensive low volatility sectors like healthcare and utilities.

 

Higher prices, lower inventory, and increased mortgage rates have made it harder for home buyers to buy new homes.

In addition, while tax reform introduced in late 2017 may have helped lower personal taxes, it has also made it less attractive for home owners to take out large mortgages and residents in high tax states to buy more expensive homes.  (The doubling of the standard deduction reduces the incentive for taxpayers to claim itemized deductions like mortgage interest on their income taxes.  Because state and local tax deductions are capped at $10,000, items like property taxes in high tax states will be limited). Declining new and existing home sales is a concern.  The housing sector has historically been a leading indicator for the economy and a decline in residential investment has proceeded the past five recessions.  Fortunately, the housing sector is not the force it once was for the U.S. economy and hasn’t recovered to pre-financial crisis levels.  While it is true housing is an interest rate sensitive sector and higher interest rates will impact affordability, construction never really recovered from the financial crisis and is still below projected demand based on population growth and household formation.  Also, while higher interest rates will negatively impact affordability, higher wage growth and a strong job market should help offset some of the negative impact from higher mortgage rates.  As for housing related stocks, many are already discounting a recession that hasn’t yet happened.  The housing sector could represent more of an opportunity for investors right now rather than warning a recessionary near.

It’s a similar story for technology stocks.  A general market shift out of momentum likely accounts for most of the decline in the sector given most analysts still believe earnings growth in the sector should still outperform the broader market.  Perhaps expectations and valuations had gotten a little ahead of themselves, but we don’t think investors have been selling in anticipation of a decline in economic growth.  One area where we have some concern, however, is the growing scrutiny some technology monopolies have come under from an anti-trust perspective, Google (now called Alphabet), Facebook and Amazon in particular.  It’s a complex area, especially given the traditional anti-trust benchmark for abuse is higher consumer prices, and technology companies such as Amazon have been major drivers of lower consumer prices. The control and market share these leaders have managed to garner, however, has led many to worry that innovation is being stifled as competition is quickly eliminated or purchased by larger competitors.

A battle against technology titans rages in Europe.  

It has been said all major wars start in Europe, and the battle against the technology titans could be no exception. Germany’s antitrust regulator recently opened an investigation into Amazon while the European Commission fined Google $5 billion this year for favoring its own applications on Android devices, on top of the $2.7 billion it fined the company last year for giving its shopping service an advantage in search results.  Perhaps the most interesting development has taken place in the UK, where a digital tax on large technology firms is being planned for 2020.  U.S. based tech firms generate billions in revenue overseas and collect valuable data, which up until now has largely escaped the grasps of foreign tax collectors. In as much as the big technology monopolies have managed to fly under the radar screen, we would suggest the jig is up and increased public scrutiny over their business models could become a headwind for valuations moving forward.  This doesn’t mean they still can’t be fabulous investments, however.  There aren’t many industries where companies of this size can deliver the double digit growth rates, even if the economy does slow.  Not all will go up, but we don’t think the current correction in the technology sector is a sign the economy is about to contract.

 

Mixed messages from the energy sector.

The message the energy sector is sending about the direction of the economy is less clear cut.  Energy, and oil in particular, is considered to be cyclical, meaning it does well when the economy does well, and poorly when growth slows.  Based on this, a decline in the price of crude oil could be taken as a sign the global economy is weakening.   A closer analysis of events leading up to the decline might suggest otherwise.  Global oil prices (Brent Crude) soared past $85 a barrel in early October on news the U.S. was planning to re-introduce economic sanctions on Iran, which RBC Capital markets estimated could reduce the global supply of oil by between 1.3 million to 1.7 million barrels a day by Q1 2019.

In order to maintain a stable market, and bowing to political pressure from the United States, Saudi Arabia and friends agreed to increase production to help make up for the short fall.  When the U.S. blinked and gave exemptions to eight countries to continue buying Iranian crude for at least six more months, the world was suddenly awash in oil.  At the same time the physical market was adjusting to a constantly changing geopolitical environment, the financial market was quickly shifting its outlook and positioning.  In July, traders positioned to take advantage of higher oil prices outnumber bearish traders by 26 to 1.  By the end of October, the ratio had fallen to only 4 to 1, thus helping drive Brent crude prices dramatically lower.

In general, computerized trading using algorithms to buy and sell based on trading patterns rather than fundamental factors have increased volatility in the energy sector. Adding to the drama unfolding on the international stage, logistical issues getting oil to market in the domestic market helped drive WTI (West Texas Intermediate, which is mainly U.S. production) and WCS (Western Canadian Select, mainly Canadian production) to large price discounts compared to international crude (Brent).  With OPEC and Russia agreeing to cut crude production in early December, Brent crude began moving higher, taking WTI crude with it.  The government of Alberta’s decision to mandate production cuts did the same for Western Canadian Select.  The supply of oil is causing the price volatility in oil, internationally because of Iran, and domestically due to logistics.  Because of this, we don’t think the decline in the price of oil is a negative indicator for economic growth.

Even if economic growth was slowing, lower oil prices have historically helped strengthen the economy because lower oil prices and the resulting lower gasoline prices help increase consumer disposable income.  But here is where things start to get tricky.  Lower oil prices are good for consumers, but now that the U.S. is actually a net exporter of energy, lower oil prices might not be  positive for the economy as a whole.  The energy sector, and oil in particular, has been a major driver of investment and capital spending growth in the U.S. and it’s estimated U.S. shale oil producers need about $50 a barrel in order to profitably drill new wells.  As for energy stocks themselves, given the volatility in crude, it shouldn’t be a surprise that oil stocks would perform poorly, but historically this has only been the case if oil was falling due to declining demand.  Like the market in general, energy stocks have historically done quite well near the end of an economic cycle where interest rates and inflation move higher.  According to financial research company CFRA, only the technology sector has provided higher monthly total returns when 10 year Treasury yields are rising. What hurts energy stocks is a global economic downturn and a strong dollar, where oil prices would come under pressure due to falling demand.  Because the decline in oil has been due mainly to supply related issues, we don’t think investors should view its decline as a negative signal for economic growth,  or at least not entirely.

There is some concern that global growth has slowed, which could be partially responsible for the decline in the price of oil.  While 2018 started off with the prospect of converging global growth, with the Euro-zone, Japan, and China all seeing their GDP growth turn higher, all three have subsequently seen their manufacturing sectors lose momentum and economic growth stall.

Fortunately in the U.S., strong new job growth has helped keep consumer confidence high, which for an economy in which consumption comprises nearly 70% of GDP, means economic growth has a pretty strong base from which to expand.  Interest rate sensitive sectors like housing and autos have weakened, but consumer spending in general remains the bedrock of the U.S. economy.  The economists at UBS Securities recently analyzed data from the last 120 recessions that have occurred over the past 40 years across 40 different countries in order to determine how economies behave leading up to a recession.  They have concluded recent behavior and data in the U.S. has been “completely incongruous” with any recession that has taken place since 1980.  Even in Japan and the Eurozone, UBS believes the data is more representative of a sharp global slowdown, than a recession.  J.P Morgan concurs, with their proprietary impending recession alarm system built on high frequency economic data putting only a 21% probability on a recession in the next 12 months.

 

Capital Spending needs to take over some of the heavy lifting if the economic cycle is to be extended.  

This was the hope when U.S. tax reform was passed in late 2017.  In the first half of this year, capital spending looked to be following the script, with business investment increasing at a double digit pace.  In the second half of the year, however, capital investment has decelerated, and a declining percentage of Chief Financial Officers are predicting higher spending over the next 12 months.  This is a concern, because capital spending increases productivity, and productivity enables  the economy to continue growing without overheating.  Some of this decline in business investment was due to the aforementioned lower oil prices and declining investment in the oil patch.  Higher credit spreads are also a headwind for capital spending and the two have historically been highly correlated.  If it’s harder and more expensive to borrow money, the expected return threshold needed to green light the project will be higher.

 

Trade wars continue to worry the markets.

Apart from wider credit spreads and lower capital spending in the energy sector, the other reason companies may be hesitant to spend money is uncertainty around the brewing trade war between China and the US, which also happens to be the second major issue worrying the market last month.  Stocks rallied in early December after the U.S. and China agreed to a cease fire over tariffs with the U.S. agreeing to hold off increasing tariffs from 10% to 25% on $200 billion of Chinese imports for 90 days, or so.  During this time, it is hoped the two sides will be able to reach some common ground, particularly on divisive issues like intellectual property.  But don’t expect market volatility to dissipate in the meantime.  The preliminary agreement between the President Trump and China’s President, Xi Jinping, was very vague and contained no substantive details (a common Trump feature).  Soon after the meeting Trump tweeted optimism for a deal, but warned if talks failed he was “Tariff Man”.  The President was all smiles when meeting with Chinese President Xi, who he has a “very strong and personal relationship”, but he is playing hard ball.  Trump’s choice as lead U.S. negotiator is Robert Lighthizer, a known China hardliner, fresh off the NAFTA negotiations (now known as USMCA) and ready for the next battle.  China would have preferred to deal with Treasury Secretary Steven Mnuchin.  And just to add a little extra spice to the affair, the U.S. recently asked Canada to detain Huawei’s chief financial officer for alleged violation of Iranian sanctions.  Huawei is one of the largest telecommunications equipment companies in the world and the CFO just happens to be the founder’s daughter.  A coincidence totally unrelated to the trade negotiations? Hardball folks.  There are a number of different scenarios in which the negotiations war could play out, not all of them bad.  The key is determining who has the upper hand.

From China’s perspective, waiting to engage the Americans until after the midterm elections was a calculated bet a weakened Trump would be more eager to sign a deal.  While the Republican’s did lose the House, Trump did what he needed to do in the midterms to  keep control of the Senate and maintain support in some key battlefield States like Ohio and Florida.  Even in districts most impacted by China’s tariffs on soy, Republican’s largely held their ground.  Advantage Trump.

From an economic perspective, however, global manufacturing indices have turned lower as uncertainly over global supply chains start to weigh on business confidence.  Perhaps even more concerning would be the impact on capital spending, which as mentioned above, is key to extending the business cycle.  President Trump is fully aware of the negative impact a prolonged trade war could have, and a recession leading up to the 2020 Presidential election is his worst case scenario.  The fact that Chinese equities have recently started to outperform U.S. equities could be taken as a sign that China has more leverage than Trump previously believed. Advantage Xi.

Two very different leaders, and two very different negotiating styles.  The “Art of the Deal” versus “The Art of War”.  President Trump aims big and goes in strong using maximum leverage.  President Xi, on the other hand, aims to understand his adversary and is prepared to endure more pain.  So far Trump’s leverage has failed to convince the Chinese to make meaningful concessions, while Xi has misjudged Trump’s willingness to make a deal and the degree to which political opinion in the U.S. had shifted against China and its trade practices.  That leaves us tied at 2-2, in case you were keeping score.  The world will be watching how these two battle in 2019, as will the Federal Reserve.  Both President Trump and the Federal Reserve understand the present risk to markets in 2019.

In this environment, 2019 could prove to be a much more profitable year for investors.

The S&P 500 has historically performed well after midterm elections, likely because Presidents tend to advocate pro-growth policies in order to brighten their prospects for re-election, but 2018 has been a tough year for investors with most asset classes  on pace to end the year in the red.  What’s happening in the market, however, doesn’t appear to be reflective of what’s happening in the real economy.  The bond market, technology stocks, the housing sector, and oil all appear to be trading like the economy is already in recession, which the numbers just don’t support.  Yes, the Eurozone, Japan and Chinese economies have slowed, but they are not contracting.  If monetary policy cooperates and a trade war is averted, markets should begin to discount economic fundamentals that are just not that bad.

Good bye year of the dog, hello year of the pig?

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