Multiple Significant Developments This Week Result in a Tricky Environment With Cross-Winds Blowing

Sep 07, 2019 | Nick Scholte


But recession remains the lesser likelihood and, for reasons explained herein, a U.S./China trade resolution might come sooner than the popular narrative suggests

To my clients:

It was an up week for North American stock markets with the Canadian TSX finishing up 0.6%; the U.S. Dow Jones Index finishing up 1.5%; and the U.S. S&P 500 finishing up 1.8%.

This first week of September has been chock full of notable developments that might potentially impact my future portfolio positioning for clients. For now, however, client equity positioning stands at a slight overweight to the long-term targets set in each client’s own individual Investment Policy Statement. As a result of three successive ~ 5% reductions (totaling a 15% equity reduction overall) between October 2018 and August 2019, current positioning is down from the significant overweight equities stance maintained for several years prior. I apologize in advance, but this will be a lengthy update this week. Now to the developments…

While it is the first week of a new month, and with it comes the three most important recurring U.S. economic indicators upon which I always comment - the monthly U.S. Employment Report, the ISM Manufacturing Index, and the ISM Non-Manufacturing (aka “Services”) Index – I’ll instead begin this week’s update with three very significant international developments:

  • A détente in the U.S./China trade negotiations
  • A soothing of tensions in Hong Kong as the territory’s CEO, Carrie Lam, withdrew 3-month old proposed legislation allowing for the extradition of citizens who are wanted in territories outside of Hong Kong – most worryingly, and the impetus for the initial unrest, China
  • A bill has been passed (awaiting official royal assent on Monday) in the UK preventing Prime Minister Boris Johnson from taking the UK out of the European Union on October 31st without a deal

Beginning with the U.S./China trade “war” (which it certainly became over the summer), there was a very notable turn for the better this week, in that face-to-face meetings between the U.S. and China are back on, with an “early October” date in Washington set. While the mainstream business press appears to be downplaying the significance of the development (and who knows, they may prove to be right), myself I noted that the verbiage coming from the Chinese was very much more forceful and positive than in the past.

Specifically, I note a statement from China’s Ministry of Commerce saying both sides will hold consultations in mid-September in preparations for “meaningful progress (direct quote in parentheses with my underlining to emphasize the overall message) in the ministerial-level talks in October. According to Taoran Notes, a widely followed blog run by a state-owned Chinese newspaper called Economic Daily, the expression “meaningful progress” has not been used since the talks broke down in May. As I have always maintained in these weekly updates, I think both sides are well motivated to get a deal done, and I believe one will get done – the issue will be how comprehensive any deal turns out to be.

The preceding said, I now turn to comments from Bank of America Chief Currency Strategist David Woo. He was interviewed on Bloomberg TV earlier this week, and he made comments which, quite frankly, the interviewer clearly did not know how to respond to because the comments did not fit with the popular narrative. Yet it is hard to argue with Mr. Woo’s logic, and it further reinforces my belief that a trade deal will get done. Mr. Woo’s hypothesis is as follows: IF China’s strategy to combat U.S. tariffs is to devalue its currency, this strategy will not be effective, and the U.S. most definitely has the upper hand. An example will demonstrate his logic:

Suppose China devalues its currency by 10% to offset the impact of 10% tariffs put in place by the U.S. What happens in this scenario? Well, the U.S. collects 10% in tariffs (call it $50 billion), which benefits U.S. government coffers. Purchasers in the U.S. are neutral because they are buying Chinese goods that have been devalued by 10% with the cheaper price offset by the tariffs. In the meantime, Chinese consumers now have less international purchasing power because their currency is now worth 10% less than it once was. Should the scenario play out exactly as described (admittedly, unlikely), the net effect is that there is a wealth transfer of $50 billion from Chinese consumers to the U.S. government, while U.S. consumers remain neutral.

Obviously, the above scenario only plays out if China uses currency devaluation as its weapon of choice in the trade war. While there are other tools at its disposal, it is also worth pointing out that China is far more dependent on exports to the U.S. than the U.S. is dependent upon exports to China. Consequently, China would also face an uphill battle on the tariff front. So two of the most widely cited economic tools at China’s disposal both favour the U.S. Of course, referencing my comments from last week, China’s “ace in the hole” is its perceived ability to play the “long game” given that a) it does not face the political realities of the four-year election cycle; and b) the likelihood that its population might be more accepting of hardships in the name of the “national good” than that of the U.S. As always, time will tell, but to my mind the rhetorical tone changed this week, perhaps as a concession to the rationales laid out here.

Moving on, and for the sake of brevity, I’ll note that the withdrawal of the Hong Kong extradition bill and the actions of the UK parliament to prevent Boris Johnson from forcing through a no-deal Brexit have both tempered looming geo-political concerns. As I and RBC have long maintained, geo-political worries rarely result in lasting economic or market fallout, although in the short-term they certainly can play havoc. Nearly always it is best to ignore geopolitical concerns and ride out the turmoil. Of course, from time to time there are exceptions, and a Chinese military incursion into Hong Kong may certainly have met this threshold. Thankfully, this risk now appears materially reduced. Regarding Brexit, I’ll not dwell too much on that front, but I’d harken back to my phone calls to clients three years ago (when the “Leave” vote won the June 2016 referendum) and reiterate that once the dust settles, the direct impact of Brexit upon North American economic performance would amount to just fractions of a percent, and that it would be unwise to react in a knee-jerk defensive manner in portfolios to a no-deal Brexit - should it ever come. I maintain this view.  Of courser, this week's developments have materially diminished the odds of such an outcome.

Turning to the economic news of the week, at a reading of 49.1, the ISM Manufacturing Index fell into contractionary territory for the first time since 2016, when it had multiple monthly contractionary readings. There was also a contractionary reading in 2013. The point being that there have been other contractionary readings in this important indicator during this economic cycle, and the previous iterations did not themselves, result in, or portend, recession. Remember, excessive equity (stock) exposure during times of recession is the main condition we are trying to avoid. Certainly, the ISM Manufacturing Index slipping into contraction must be noted and tracked closely for further deterioration, because indeed it is an important economic measure (which is why I always comment upon it every month). And, when added to the general slowing of worldwide economic activity (itself significantly due to U.S./China trade tensions), it is all the more noteworthy. But it is not enough in itself to lead to further equity reductions in portfolios, particularly given my comments upon the U.S./China trade situation above.

Conversely, at a reading of 56.4, the ISM Non-Manufacturing Index (representing 70% to 90% of U.S. economic activity depending upon which data set one believes) came in significantly better than expectations and the prior month’s reading. In fact, a stand-alone reading of 56.4 is indicative of a well performing economy (with readings of 60 and above being both exceptional and non-sustainable). Like the Manufacturing Index above, this is just a one-month reading, and stands in contrast to the deteriorating trend seen the past several months. So while a pleasant “surprise”, it too should be monitored to see if this marks a sustainable turn in the metric, or a one-month deviation from a soon-to-return trend.

And finally, today saw the release of the monthly U.S. Employment Report. At 130,000 new jobs created, it missed expectations for a reading of 160,000 new jobs, and marked a slowdown from last month’s reading of 159,000. That said, I’m going to harken back to the one or two years in the immediate aftermath of the 2008 recession when, in these weekly updates, I’d often note that the “devil could be found in the details”. This time around, the devil is of the benevolent kind. The reason being is that the average number of hours worked per week for each of the 160 million strong U.S. workforce increased by 0.1 hours for the month. 0.1 hours spread amongst a workforce of 160 million people is equivalent to 400,000 new full-time jobs. Added to 130,000 reported new jobs and the implied total is over half a million.

Now, I will acknowledge that there is some cherry-picking happening here in that a) it’s conceivable that the increase of 0.1 hours per week was, in fact, rounded up from something closer to 0.05 hours which would reduce the implied additional jobs by around 200,000; and b) the hours worked had flown under the radar this past year as it had been declining in much the same way as it increased this month. Regardless, the Employment Report was probably better than the headline suggests, while at the same time the headline is likely weak enough (especially when combined with all else that has been written in this overly long update) to induce the U.S. Federal Reserve to cut rates at its next meeting later this month.

Phew, do I still have everybody? Again, my apologies for the long update. Bottom Line: a reasonable number of defensive measures have already been effected in client portfolios since last October, and client equity weightings are close to neutral when compared to the long-term strategic weightings specified in each client’s own Investment Policy Statement. That said, the outlook continues to demand close scrutiny. There are a number of cross-blowing winds at play, and it is admittedly a tricky juncture for both the economy and the markets. But, overall, I and RBC continue to think that recession does NOT loom. Stay the course.

That’s it for this week. All the best,


Nick Scholte, CIM, FCSI

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