Stocks sold off in the last half hour on Friday bringing a very volatile week to a close. For the week, the major averages were all down, but gains mid-week muted the overall impact with losses generally totaling less than 1%.
This morning, demonstrators in Hong Kong have massed inside the airport effectively shutting it down. While the protests began about 10 weeks ago to protest attempts by Mainland China to pass laws allowing extradition of certain residents accused of crimes to the mainland, it is harder today to see what the precise goals of the protestors are after China suspended any attempt to pass such laws. Granted, suspension isn’t the same as actually taking the issue off the table entirely. If nothing else, the ongoing protests, which continue to be large, suggest both a distrust of the Chinese government to abide by its treaty with Great Britain to allow generally self-rule for 50 years, and a build-up of resentment to the Chinese government at the same time. While protestors complain that police reaction to the protests has become more violent, so far there have been no deaths and injuries have been minimal. That could change should China decide to bring in the military to crush the demonstrations bringing back memories of the Tiananmen Square of 1989.
It appears far too early to make that leap from Tiananmen Square to the events of today. No one, including the Chinese government, wants to see anything that resembles those events. The Chinese government hopes that once schools reopen for fall semester, the size of the protests will shrink. So far, the protests have been dominated by youth and while support appears wide, it may not be universal. Residents of Hong Kong want to protect their freedom but want to avoid a strong military response. That’s a fine line to traverse and clearly shows in financial markets via heightened nervousness.
While the odds of an overwhelming military response may still be low, clearly risks have become more elevated in recent days and weeks. The White House has, to date, stayed out of the conflict, but rhetoric from our State Department is starting to get a bit stronger. None of this can help ease the path in trade negotiations between China and the U.S. Whereas six weeks ago, there was optimism that some first-step agreement between the two countries might come before the end of this year, today a majority no longer expects anything meaningful before next year’s Presidential election. President Trump has already promised 10% tariffs on the remaining $300 billion of Chinese exports to the U.S. China has declared it will no longer buy U.S. agricultural goods and we responded in kind by not allowing licenses for U.S. companies to do business with Chinese telecom giant Huawei. It remains unclear how far each nation will go to increase pressure in the absence of progress in trade negotiations.
Clearly, for years, China has promised good behavior and then acted in a bad manner. It isn’t just trade. Bold steps to increase its influence in the South China Sea, for instance, is another example. The question, of course, is whether increased pressure from the U.S. will be enough to move China in the direction of better behavior before next year’s elections. Obviously, steps we have taken to date have hurt. No one believes China is growing its economy at a 6.2% annual rate as stated in the nation’s latest GDP release, but all believe it is still growing. In some ways, given that Chinese leadership isn’t bound by election cycles, it can take a longer view. But a slower growing economy could have adverse consequences of note, some very long term in nature.
China is a big exporting nation. Over the past two decades, it has also become the dominant contract manufacturer to the world, making either generic products that can be exported at cheap prices or making higher priced goods to order (e.g. Apple phones) designed by others. China has yet to develop a suite of high quality, self-designed products for export such as Toyota cars or Samsung TV sets. As China has grown, its labor costs have risen. Today, there are cheaper places to have goods made in Asia where labor costs are lower than in China. But finding non-Chinese vendors who can meet commodity or quality standards isn’t easy and takes time. In that regard, especially with the heightened instability of the China/U.S. relationship, American and other foreign manufacturers are accelerating repositioning their supply chains away from China to other Asian nations. Once gone, manufacturers are unlikely to return very quickly. By playing the long game, China therefore, risks permanent economic losses.
All this plays into the worldwide deflation story as well. China has become the world’s incremental supplier and, because it sells its goods for less than most competitors, it has been the primary deflationary force. As supply chains leave China, the internal appetite for Chinese manufactured steel, for instance, will be less, meaning even more steel will be dumped on world markets. The same can be said for all sorts of generic products from pants to TV sets. No wonder long term bond rates and inflation expectations are headed in the direction of zero.
The evils of deflation are that if a consumer likes something, he can afford to wait until the product is really needed, knowing prices will fall in the interim. Non-luxury apparel is cheaper today than it was 10 years ago, but apparel sales are weak. Autos are cheaper. Yet auto sales are also stagnant. Price isn’t the only reason, but it is a contributing factor.
China isn’t the only place around the world where disruptive forces are active. Protests are increasing in Russia over a stagnant economy and worsening living conditions. Iran is obviously feeling the pressure of economic sanctions. Its oil exports are a fraction of what they were a year ago. Venezuela is rapidly becoming a non-entity, economically, on the world stage. Yet despite the absence of two major producers worldwide, oil prices are lower today than they were a year ago. Brexit will happen in just a few months and Britain still has no exit plan beyond a sharp separation from the EU certain to cause serious disruption. Germany and Italy face political turmoil.
It’s no wonder the stock market isn’t more worried than it is. Despite all the events I just mentioned, U.S. growth continues and the U.S. consumer remains willing to spend. Employment remains strong and maybe the best leading economic indicator, weekly jobless claims, remains near record low levels. Corporations are reticent investors in capital projects around the world but still spend to support domestic growth and improve productivity. The low interest rates, at least for now, support stock prices. The 10-year Treasury yield is now below 1.7%. That is below the yield of the S&P 500 once again. Whenever that has occurred in the past, stocks have been better relative values than bonds. Why would I want to buy a long-term Procter & Gamble bond yielding about 2% or less when I can buy the stock of the same company that pays over 2.5% and has raised its dividend for 63 consecutive years? Granted I accept more short term volatility risk, but the gap between the yields on bonds and stocks will continue to widen as the company raises future dividends.
The risks for equity investors today are that a combination of overseas weakness, escalating tariffs, and possible disruptions like, for instance, a worsening of the China protests, lead our economy into a recession that could cause earnings to fall faster than any rise in P/E ratios associated with lower interest rates. Worse, if deflation infects all economies, years of economic stagnation could follow.
How does one protect from these possibilities?
1. Stay true to your asset allocation. Stocks are still up over 15% this year. That may require some rebalancing. Letting your equity allocation creep down a bit may give you more protection at the expense of losing opportunity gains should markets regain footing and march to new highs.
2. Own companies with solid growth prospects even when the economy grows more slowly.
3. Stay away from companies dependent on capital markets financing to support current operations.
4. Own stocks that both pay good dividends (above the yield on 10-year Treasuries) and will increase those dividends annually even if there is a mild recession.
5. Stay agile and don’t overreact.
6. Remember that every action evokes a reaction. Too often predictions are made that (1) bad news occurs and, at the same time, (2) there is no offsetting response. A slowing economy, for instance, pushes central banks to lower rates to stimulate future growth.
With all the unknowns in place, this is a hard market to predict. Volatility is generally high in times like these. But, like last week, volatility doesn’t necessarily mean sharp gains or losses. We are not in a recession and none seems imminent. Low interest rates are a positive for equity valuations. So far, Hong Kong bears watching but isn’t explosive. But that could change quickly. Stay nimble.
Today, actor Casey Affleck is 44. Jazz guitarist Pat Metheny turns 65.
James M. Meyer, CFA 610-260-2220