— 2019 Q4 UPDATE —

EQUITY MARKETS

Statistics:

BROAD MARKET ANALYSIS

Entering the fourth quarter of 2019, the S&P 500 was fresh off of the first negative returning quarter of the year.  The negative returns and increased volatility were a derivative of investors linearly extrapolating the potential effects of a negative yield curve combined with the potential for US-China trade war escalation.  However, investors were clearly discounting the potential positives from inflation being below the Federal Reserve (Fed)’s target of 2%, which is one of the Fed’s target mandates.  When the inflation rate is below 2%, the Fed will be inclined to lower interest rates in order to add liquidity to the economy in order to jumpstart supply from financial institutions and spark consumer demand.  The combination of increased supply from financial institutions and increased consumer demand increases the inflation rate and adds growth to the economy.  Investors who understood this dynamic between inflation and the Fed would likely not have been as inclined to exit the markets after a negative returning quarter.  Many investors who stayed in the markets during the fourth quarter were rewarded with the second highest returning quarter of 2019. 

Being in the longest bull market in U.S. history can actually have an unsettling effect on market participants’ mindsets.  People are constantly wondering when the rug is going to get pulled out from under their feet because there is something unsettling about the markets consistently hitting new all-time highs.  This natural human emotion can cause investors to be skittish about leaving their money in the markets long term.  However, there are fundamental reasons why the market has been performing so well for such a long period of time. 

Normally, when there is an extended bull run inflation gets above the Fed’s target mandate of 2% and the Fed has to raise interest rates which dries up liquidity and credit in the markets.  This lack of liquidity and credit produces lower business investment and slows consumer demand.  This dynamic is one of the main features of the typical business cycle.  However, this market cycle, like all market cycles before it, is different than previous ones because the economy is fundamentally different.  The Phillips Curve, which is the negative correlation between unemployment and inflation and has been a well-known staple in economic theory, has broken down in this market cycle.  Ironically, this breakdown of economic theory can actually take partial responsibility for extending the bull market because the Fed has not had to put the brakes on an “overheating” economy.  With the Fed providing tailwinds to the market in our low inflationary environment, it makes sense the business cycle has been extremely muted and elongated. 

   Source: Federal Reserve Bank of St. Louis

The fourth quarter was a perfect example of how the Fed’s actions helped to extend the bull run.  With the existential fears swarming the market at the end of the third quarter between the negative yield curve and the U.S. China trade war, the Fed was able to cut interest rates 3 straight times in the second half of 2019 which reverted the yield curve back into positive territory.  This shifting in the yield curve caused a positive feedback loop where investors stopped being fearful of the negative yield curve which caused them to help steepen the curve even further because they went from risk-off to risk-on assets.

         Source: Federal Reserve Bank of St. Louis

Overall, the fourth quarter was a net positive for market psychology because it showed the resilience of this bull run.  However, there are other fundamental factors that changed during the fourth quarter such as the Purchasing Manufacturing Managers Index (PMI) going into negative territory, USMCA (United States-Mexico-Canada Agreement) being revised, and the U.S. China trade war agreeing the part 1 of a deal.

PURCHASING MANAGERS INDEX (PMI) 

Even though the yield curve and inflation are vital for understanding the current and future state of the economy, they cannot be looked at in a vacuum.  One of the most powerful economic indicators for understanding the current stage of the business cycle is the “United States ISM Purchasing Managers Index” or as it is commonly known as, the PMI.  The PMI can come in many different forms, but one of the most commonly used forms of the indicator is to look directly at the manufacturing sector.  According to Trading Economics, “The Manufacturing ISM Report on Business is based on data compiled from purchasing and supply executives nationwide.  Survey responses reflect the change, if any, in the current month compared to the previous month.  A PMI reading above 50 percent indicates that the manufacturing economy is generally expanding; below 50 percent indicates that it is generally declining.”  This is a key indicator for monitoring the economy because it gives us a glimpse into how senior executives are viewing the economy.  How they view the economy actually has a real impact on economic activity because these executives are deciding how much to stock their inventories, whether to add additional investment, and how many workers they should employ.  If these executives believe that business conditions are deteriorating, even if the fundamental data says otherwise, their decisions can cause a self-fulfilling prophecy.

The manufacturing PMI currently shows that we are in a manufacturing recession with a score of 47.2, the lowest since June 2009, which is another event that promoted fear in market participants.  Astute readers will ask the question, if the PMI is so important and it is currently showing the manufacturing sector in a technical recession, then why has the overall economy avoided falling into a recession?  One of the main reasons is that the economy relies less on the manufacturing sector today than it did in the past for GDP growth. 

Source: Trading Economics

A better PMI to look at is the composite indicator which according to Trading Economics, “The PMI Output Index tracks business trends across both manufacturing and service sectors (60 percent from the manufacturing sector and 40 percent from the services sector). The index is based on data collected from a representative panel of over 1,000 companies and follows variables such as sales, new orders, employment, inventories and prices. A reading above 50 indicates expansion in business activity while below 50 points to contraction.” While it may be helpful to dissect the economy by looking directly at individual PMI’s, such as the manufacturing PMI, an investor can get a much better understanding at the overall confidence from the aggregation of companies in different industries.  As of December 2019, the composite PMI rose to a 5 month high of 52.2 which says that senior executives across the country still believe that the economy is still expanding. 

Overall, different sectors have different outlooks on the economy and that can be useful when investing in individual sectors or if an investor is trying to understand weaknesses in particular areas of the economy.  However, you cannot get the full story by looking at an individual sector and that is why it important to look at the composite indicator which is weighted by GDP contribution.  Understanding which indicators are the most important to look at can help investors avoid making rash decisions when news headlines are scaring the public into believing that a recession is imminent. 
 

UNITED STATES COMPOSITE PMI 

Source: Trading Economics

USMCA (US-Mexico-Canada Agreement) vs. NAFTA (North American Free Trade Agreement)

On September 20^th, 2018, NAFTA was renegotiated by the U.S., Canada, and Mexico and it is now called the USMCA.  It was revised in the fourth quarter of 2019, on December 10^th and it is important to understand because it will slightly alter the way trade works in North America.  To properly understand the USMCA, we first must understand what NAFTA was and why it was important.

History of NAFTA: NAFTA was created 25 years ago (signed into law on January 1, 1994) and it was the first time that two developed nations signed a trade agreement with an emerging market country.  However, the idea started in 1980 with President Ronald Reagan, where he wanted to unify North American markets in order for them to better compete with the EU.  It took 3 presidents to actually get the deal finalized.  NAFTA removed tariffs and increased investment opportunities between US-Canada-Mexico.  It has long been known by economists that reducing trade barriers increases investment, lowers costs of goods, and promotes growth.  This trade deal was done for all of those purposes.

Pros and Cons of NAFTA: As with any agreement, there were both pros and cons that came along with NAFTA.  Some of the pros of NAFTA were that it increased trade and economic growth for all three countries, imported oil from both Canada and Mexico prevented higher gas prices, and grocery prices were lower than they would have been without the agreement.  Some cons of NAFTA were the deal sent many U.S. manufacturing jobs to Mexico, U.S. manufacturing workers’ had their wages depressed because of the lower cost of labor provided by Mexico, and Mexican workers suffered exploitation in its maquiladora programs.  The Trump administration felt that the costs outweighed the benefits, therefore, the USMCA was agreed upon and recently advised.

6 main differences between NAFTA and the USMCA.

• Auto manufacturing boost: USMCA requires 75% of a vehicles parts to be made in one of the three countries versus the previous 62.5% rule.
• Strengthened labor laws: This is a bit ambiguous but it gives stronger enforcement language in the laws to better protect workers.
• Dairy farmers get more market access: The Canadian market will be more open to importing dairy, poultry and eggs from the U.S. and the U.S. will import more dairy, peanut products, and sugar from Canada.
• Updating NAFTA for the digital era: Brings new benefits for the technology sector that deals with digital trade.
• Environmental protections: Provides $600 million to address environmental problems in the regions and also makes regulations easier to maneuver because you no longer need to prove an environmental violation directly affects trade for there to be an environmental issue addressed. Whereas, in NAFTA, you had the burden of proof before you could claim an environmental violation.
• Congress keeps control over biologic drugs: There was a provision that was negotiated away by Democratic law makers that would have required the three countries to provide at least 10 years of exclusivity for biologics. The U.S. currently provides 12 years, Canada provides 8 years, and Mexico provides 5 years.  Since this provision was shot down, there is potential that U.S. Pharmaceutical companies could be at intellectual property risk with the agreement.

Overall, the differences between NAFTA and the USMCA are not groundbreaking but they are relevant when looking at the flow of capital and trade between the three countries.  The most important difference for investors to look out for between NAFTA and USMCA is that the USMCA brings the NAFTA agreement into the digital age, which will inevitably help technology companies.

U.S. - CHINA TRADE WAR 

Statistics:

U.S. Tariffs: US$550 billion worth of Chinese products

China Tariffs: US$185 billion worth of U.S. goods

Source: China Briefing               

The U.S.-China trade war was a frightening topic in the third quarter for investors because it the uncertainty that was intrinsically linked to the topic induced severe headwinds on consumer spending and business investment.  These structural headwinds were relieved in part by some significant improvements in the negotiations in the fourth quarter.

Timeline (according to China Briefing):

• November 1^st: the US and Chinese negotiators agreed on trade points in principle.
• November 7^th-8^th: US and China spoke about rolling the tariffs back.
• December 13^th: The US and China agree to ‘phase one deal’ just before the next tariff hike.
• December 13^th: China released second set of U.S. products to be excluded from additional tariffs.

Each one of these announcements gave adrenaline shocks to the equity markets in the fourth quarter because it reduced some of the linear extrapolations that investors were making on how severe the trade was going to become.  If the U.S.-China trade war comes to a complete resolution then likely business investment will increase and consumer spending will increase as well which will promote real GDP growth.  The anticipation of these positives events happening boosted the equity markets in the fourth quarter but they provide some downside risk going forward because these positive events are currently priced in.  If the trade negotiations break down in a negative way again, we believe there will undoubtedly be a sell off in the equity markets as the uncertainty and negative linear extrapolation of events will become priced in again. 

Conclusion:

Overall, there are many moving pieces when it comes to financial markets and it is important to separate the signal from the noise.  Anyone who was reading news headlines in the third quarter probably would have been convinced the market was going into a recession because they would not have understood the fundamental signals of what was truly driving the markets during those times.  Unfortunately, those investors would likely  have missed a healthy rebound in the fourth quarter.  This complex phenomenon is why you should speak to your financial advisor to make sure you have a proper financial plan in place in order to withstand the good times and complex times in the marketplace.

Sources:

https://tradingeconomics.com/united-states/business-confidence

https://tradingeconomics.com/united-states/composite-pmi

https://fred.stlouisfed.org/

https://www.china-briefing.com/news/the-us-china-trade-war-a-timeline/

https://www.cnn.com/2019/12/10/politics/nafta-us-mexico-canada-trade-deal-differences/index.html

_{The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  Asset allocation does not guarantee a profit or protect against loss.  The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) is the central banking system of the United States. The Federal Reserve System controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy.  Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market.  Moderate inflation is a common result of economic growth.  A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession.  Gross Domestic Product (GDP) is a measure of output from U.S factories and related consumption in the United States.  It does not include products made by U.S. companies in foreign markets.}

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