While the late 2018 Downturn was More Than a "Garden Variety" Correction, the Anticipated Recovery Looks to Have Begun; and, it is Annual Review Time

Jan 04, 2019 | Nick Scholte


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Corrections happen, but the damage they inflict is transitory and can be recovered. As always, the main enemy is recession, and the three most recent Chairpeople of the U.S. Federal Reserve unanimously agree that a recession is not imminent.

To my clients:

My apologies in advance – this will be a longer than usual update this week. Also, a reminder that Brenda will be contacting you soon to arrange for our annual review. Please give some thought as to dates and times that may work for you.

It was an up week for North American stock markets with the Canadian TSX up 1.4%; the U.S. Dow Jones Index up 1.6%; and the U.S. S&P 500 up 1.8%. This comes on the heels of a Christmas week (for which I did not write a weekly update) that was also up to the tune of 2.1% on the TSX; 2.7% on the U.S. Dow Jones Index; and 2.9% on the U.S. S&P 500 Index. Overall, call the two week increase roughly 4%.

Despite the overall two week upturn for markets, clients who paid attention to the markets over this stretch (and I sincerely hope that was very few of you!) will know that volatility reigned supreme. Up and down days vacillated wildly, and at least one record was set (a one day 1,000+ point increase in the Dow Jones Index). In my view, many of these histrionics were simply a case of volatility begetting more volatility. In other words, it was a self-perpetuating cycle to some extent. That said, there were developments this week – specifically today and yesterday – that I think stand out and deserve some attention.

Let’s begin with yesterday. First, the ISM Manufacturing Index came in at 54.1. In the grand scheme of things, and on its own, a 54.1 reading is decent (anything above 50 represents expansion, and expansionary readings tend to slowly oscillate between 50 and 60 over the course of most expansions… anything above 60 is considered exceptional, but also unsustainable). BUT, the deceleration in this metric from the prior month’s reading of 59.4 was unusually sharp. The ISM Manufacturing Index is an important monthly metric (I always write about it each month) and such a slowdown has my attention and should absolutely be paid attention to. However, RBC is of the view that the slowdown may be transitory and due to industry specific factors – most notably component supply shortages in the technology sector. Nonetheless, moving forward this index will be monitored closely for signs of sustained deterioration.

Yet as stark as the drop in the ISM Manufacturing Index was, it was not the big news of yesterday. A revenue warning by Apple Inc. was the big news. In fact, the revenue warning actually came after the market close on Wednesday, but investors were unable to react until the markets reopened yesterday morning. Leading up to yesterday’s market opening, owing to Apple’s news, futures contracts on the various exchanges were off about 2% for most of the intervening evening. Given that the U.S. markets finished the Thursday down around 2.8%, this is how I can assert that the warning from Apple was the bigger of the two market moving events. This was the first revenue warning from Apple in about 15 years and, according to a letter from Apple’s CEO Tim Cook, much of the revenue shortfall was attributable to slacking Chinese demand. So, of course, this begets the question: is China’s economy in trouble? And, if so, what does this portend for the global economy? While it is impossible to answer these questions with certainty, I’d suggest that anecdotal evidence is mounting that, at the very least, China’s economy is slowing. Perhaps not to the degree that Apple’s warning might suggest [I’ll not get into the minutiae of the release, but suffice it to say that other factors such as mis-priced (read: too expensive) iPhones as well as possible retaliatory behavior from Chinese consumers in the wake of the arrest of the Huawei CFO in Vancouver last month may also be playing a role], but slowing regardless. The grander concern is, of course, that the tariff spat between the U.S. and China is beginning to have a tangible effect – on China especially.

The preceding two developments were from yesterday - but today saw a trifecta of very positive developments. Beginning with China, it was announced that face-to-face trade negotiations would begin next Monday. Previously, there had been a handful of telephone conversations in the wake of the 90-day tariff moratorium agreed to in Argentina last month, but nothing face-to-face and no particular momentum was evident. Actual sit-down meetings suggest that there may indeed be some impetus to get a deal done. It very well could be the case that China’s economy is slowing (see the Apple note above) and there is motivation from President Xi to resolve the trade issues for the sake of his domestic economy. However, I will reiterate a point I made a few weeks ago – President Xi almost certainly will not agree to a deal that makes him appear weak to his population. If, and when, a trade deal is reached, it must include elements that will be perceived as victories by the Chinese. But regardless of motivations and optics, a light is brightening at the end of the trade tunnel and a resolution would be very good indeed for the continuation of the current global expansion.

The second positive development was a blockbuster U.S. Employment Report. At 312,000 new jobs created for the month of December, the report easily beat the consensus expectation for 178,000 new jobs, and also far exceeded even the highest prediction of individual economists. Further, all of the sub-components were also strong, with the lone seeming exception being that the unemployment rate ticked up from 3.7% to 3.9%. But even here, this lone seeming blemish was, in fact, a positive as the move up in the unemployment rate simply reflected the fact that many more workers had decided to re-enter the workforce to seek one of the many jobs available in the U.S. (for what it is worth, there are more jobs available in the U.S. than the pool of available workers – the problem lies in a mismatch of both skills and geographic availability of workers/jobs).

In a very superficial way, one might be inclined to say that today’s job data offset yesterday’s poor Manufacturing reading, and today’s announcement of face-to-face trade meetings between the U.S. and China offset yesterday’s market woes owing to the Apple revenue warning (again, I acknowledge this to be a highly superficial analogy). But also on tap today was a fascinating round-table discussion with current Federal Reserve Chairman Jerome Powell, and former Chairpersons Janet Yellen and Ben Bernanke (I actually came in extra early to the office today so I could dispense with my morning routine prior to watching the discussion begin at 7:15). In the opening moments of this discussion, Chairman Powell hit all the points that the markets wanted to hear, namely (I’ll be paraphrasing here):

1) The U.S. economy is in very good shape in the here and now

2) The economic growth outlook for 2019, while slower than 2018, nonetheless is expected to be greater than post 2008 average

3) Owing to the above, the Federal reserve continues to anticipate two more rate hikes in 2019

4) But, despite its outlook, the Federal Reserve will be data dependent, flexible, and willing to change its course if conditions warrant

5) Likewise, the Federal Reserve will be willing to change course with respect to the unwind of its balance sheet (basically the reversal of the quantitative easing program it embarked upon in the wake of the 2008 financial crisis)

6) The Federal Reserve is cognizant that the market outlook has deteriorated and that, to some extent, deteriorating market sentiment might create a feedback loop that impacts the broader economy

Of the above, points number 1, 2 and 3 were not new, and continue to reflect the confident Fed outlook for the U.S. economy. However, points 4, 5, and 6 were entirely new and provided great reassurance to investors that the Federal Reserve was not on full “automatic pilot” with respect to rate increases and broader monetary policy and would not blindly steer the U.S. economy off the proverbial cliff. Quite frankly, the content, tone, and delivery of the message was fully on point and I suspect may be a turning point to the corrective episode we have been experiencing the past two months in the markets. Yet, even beyond the message of current Chairman Powell, former Chairpersons Yellen and Bernanke also offered interesting and supportive views of the economy. Yellen in particular noted that she does NOT believe that expansions die of old age, and those pointing to the near 10-year duration of the current expansion as reason for its demise are off-base (this is somewhat in keeping with my assertions over the past handful of years that this expansion may go on much longer than most think possible because of the shallower upward trajectory of the growth path…. in other words, slower for longer growth). For his part, Bernanke indicated that he saw U.S. economic growth through not only 2019, but 2020 also.

In sum, all of the above leads me to reassert that the stressful market downturn of the past two months should continue to be viewed as a correction, and not the opening salvos of a more ominous bear market and recession. Corrections happen. But the damage they inflict is transitory and can be recovered. While this correction has been somewhat more than a “garden variety” correction, it’s is not particularly unusual either – at least not with respect to equity (i.e. stock) markets. What is more unusual is that outside of cash and GIC’s, there was little place to hide from the correction. Over 90% of all asset classes suffered losses in 2018 (stocks, bonds, commodities, gold etc.). This is the first time this has occurred in a century.

That’s it for this week. Happy New Year 2019! Hopefully it is better than 2018. All the best,

Nick

Nick Scholte, CIM, FCSI

Vice-President & Portfolio Manager
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
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