Fire Capital Market Update - 3Q 2019

CIRCA 2019: NOISE & VOLATILITY

We often wonder what it was like to manage money prior to the internet. The pure breadth and speed of information flow nowadays gives us the ability to do what we do as a small independent investment management shop. Twenty years ago, access to information about companies and foreign countries was a competitive advantage for the big financial institutions. That advantage no longer exists. The considerable challenge we face today as investors has little to do with access to information. It’s all about sorting through an overabundance of information, while trying to decipher fact from fiction, and signal from noise.

A few months ago, we introduced our general thoughts about the health of the global economy in our first ever quarterly Market Update titled “Winter is Coming”. The general premise was that there were enough observable signs in the financial markets to conclude that caution is warranted and that we may be operating in a challenging investment environment for the foreseeable future.

Shortly after our Market Update was published, a meaningful spike in market volatility ensued due to a perceived breakdown in U.S. — China trade talks, which was accompanied by a deepening inversion of the U.S. Treasury yield curve. These new developments provided the Federal Reserve a concrete and obvious reason to step in and cut interest rates for the first time since 2008.

“Times like these remind us why portfolios need to be diversified. It’s a good time to take a step back and appreciate what we don’t know.”

This quarter’s Market Update focuses on recent developments that provide even more credibility to our concerns about the global economy. While we are not ready to call for a full-on recession or stock market meltdown, we believe the end of the business cycle may be near, but not without a few caveats.

NOT SO FUNDAMENTALS

There have been 8 market corrections (i.e. a 10% drop or more) in the S&P 500 since the end of the 2008 Financial Crisis. In hindsight, each correction presented an incredible opportunity to buy high quality stocks at a discount. Our approach to assessing opportunity versus risk during times of market stress is to rely on the fundamentals of both the macro-economy and individual companies. Throughout this past cycle, we’ve been able to point to positive data points such as an improving labor market, accommodative monetary policy, and a resilient U.S. consumer, amongst other things. When we look at the economic fundamentals today, the picture isn’t as clear.

Our main focus continues to be on the health of the U.S. consumer. In 2018, the U.S. consumer was the biggest contributor to global economic growth — accounting for 17% of World GDP. The next biggest contributor was the entire country of China accounting for 16% of World GDP. Recent job data shows that the pace of hiring is slowing and consumer confidence, while still high, has begun to dip as well. The psychological effects of the U.S.-China trade war may be creeping into consumer confidence, as it has already with business and CEO confidence surveys.

There are a lot of economic indicators that provide insight into the health of the economy. Some are better than others. The Institute for Supply Management’s (ISM) U.S. manufacturing purchasing managers’ index (PMI) is considered to be a good leading indicator as it aggregates sentiment across 19 industries related to the manufacturing sector. Important information such as new orders and inventory build is captured to provide investors a directional sense of future economic activity. The latest PMI reading of 47.8 — the lowest reading since June 2009 — gives us reason to be concerned. A weak ISM PMI reading alone isn’t enough to sound the alarm, but when combined with other deteriorating indicators it becomes a story worth monitoring.

A SLIPPERY SLOPE

If you already forgot about last month’s attack on Saudi Arabia’s oil refineries nobody would blame you. It was easy to simply chalk it up as just another headline born out of ongoing tensions in the Middle East. Afterall, markets barely budged on the news despite oil prices temporarily shooting up nearly 20% as 5.7 million barrels a day — over half of the nation’s daily output — was taken offline. To put this into perspective, last month’s oil supply disruption was the largest in recorded history.

In the not so distant past, an event like this may have sent the world into a recession. The 1973 Oil Embargo is a comparable historical example. At that time, the United States had grown increasingly dependent on foreign oil. During the 1973 Arab-Israeli War, Arab members of the Organization of Petroleum Exporting Countries (OPEC) decided to retaliate against the U.S. for supporting the Israeli military by banning petroleum exports to certain countries and cutting production. This caused oil prices to skyrocket, adding pressure to an already weak global economy that eventually led to a recession.

The good news is that the world has evolved since 1973. The U.S. has become the largest oil producer in the world and most developed nations maintain significant strategic oil reserves. Saudi oil production came back online much faster than expected and the threat of a direct military retaliation, while still a risk, decreases as each day passes. It may be premature to dream of a world that runs on sustainable sources of energy, but it’s hard not to wonder what other benefits a fossil free world could bring other than reduced carbon emissions.

A PEACH THAT ISN’T SWEET

As if there weren’t enough market risks to consider, why not add a potential presidential impeachment to the mix? Our expectation is that the political drama involved with impeaching the President of the United States will undoubtedly add to market uncertainty. Some may argue that the risk of impeachment has been evident since the Mueller Report was released, but if that was the case investors didn’t take notice. At that time the odds of a potential impeachment jumped from 10% to 20% according to most betting sources. More recently, the odds of impeachment jumped to over 40% after the House formally announced they would open an impeachment inquiry.

Considering that the possibility of impeachment is real (but still unlikely), we decided to look back at how the markets responded to similar past events. The two most obvious and relevant data points relate to former Presidents Clinton and Nixon.

As history would indicate, the long-term impact on the economy could be relatively minor, but the short-term impact on the financial markets is uncertain. S&P 500 returns were mixed in the year following the resolution of each impeachment inquiry (Clinton +28% & Nixon -33%), but both were proceeded by significant draw-downs in the weeks leading up to the actual inquiry. The point is that the financial markets generally express uncertainty in the form of heightened volatility. It would be unreasonable to believe that this time will be any different.

THE FINANCIAL SYSTEM IS UNHEALTHY

Perhaps most concerning are recent developments related to the financial system. Here are a few related issues we’re following:

• Central Bank Stimulus — The Federal Reserve, European Central Bank, and Bank of Japan will need to signal more stimulus in the form of rate cuts and asset purchases. The effectiveness of these policies with regards to stimulating economic growth are up for debate as the main beneficiaries thus far has been the equity markets.
• Negative Rates — Over $15 trillion dollars of global sovereign debt is now yielding negative. For reference, that figure was only $6 trillion a year ago. Weird.
• U.S. Repo Market — This is complicated. The Fed had to step in and inject hundreds of billions of dollars into the financial system because liquidity in the overnight bank lending market (i.e. repo market) began to fail. In our view, this is a precursor to QE4 — a restart of the Fed’s bond buying program that ended in 2014.
• U.S. Treasury Demand — The U.S. budget deficit increased to $1 trillion in August — the highest in 7 years. If demand for the treasuries were to fall, the U.S. could be faced with some really tough decisions.

STILL ROOM TO RUN…WE THINK

The financial markets are forward looking. The stock market is a real time information weighing machine that adjusts asset prices as things change. Despite our less than inspiring outlook for the global economy, we believe there are two important potential events that could add fuel to a market that has basically been flat over the past 18 months. Neither of these potential market catalysts are guaranteed to happen, but we believe there is a strong probability that at least one materializes in the next 6 months.

1. Central Bank Stimulus — There was a time not so long ago when “bad news” related to the economy was actually considered “good news” by investors. Essentially poor economic data forced the central banks to keep monetary policy accommodative, which helped to propel markets to all-time highs. We expect the Federal Reserve will need to do more than cut rates. A renewed U.S. asset purchasing program to boost liquidity would likely buy the stock market time despite a worsening economic backdrop.

2. U.S.-China Trade — It’s hard to quantify the impact the U.S.-China trade war has had on economic growth, but it’s clear that both the U.S. and Chinese economies have slowed down. It is impossible to assess what the tipping point is for both the U.S. and China but deteriorating global financial conditions may accelerate some type of deal. It’s very possible that a lite deal gets announced where the bigger issues get kicked down the road. Given how sensitive the market has been to this subject, we believe any relief could translate into positive market outperformance. With the U.S. now seriously turning their attention to the European Union, it’s not out of the question that something happens sooner than most believe.

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