May was a challenging month for equity investors. In the US, the S&P 500 fell 6.35% while the Russell 2000 declined 7.78%. Outside the US, developed markets were also down 4.80% and emerging markets dropped 7.26%. Bond market investors had a pretty good month with the US Aggregate Total Return Index rising 1.78% as rates fell. Base rates for borrowers fell but spreads(how much a borrower pays over a US Treasury Bond) for riskier borrowers widened, leaving high yield bonds with a loss of 1.19%.
Talking heads attributed the general weakness in equity markets to two main factors: a prospective trade war and a technology “cold war” with China, and fears about the slope/shape of the yield curve.
We recently expressed our thoughts on the yield curve, you can find them here. In this update we share thoughts and comments on the prospects for and implications of a trade war with China.
We think a trade war would have an impact on the overall US economy, but we believe the effect would be manageable and potentially offset by other factors if need-be, such as a preemptive rate cut by the Federal Reserve or some sort of fiscal stimulus. There would winners and losers in the US to be sure, and while we expect those potentially hurt by the negotiations to be vocal in defending their interests, the aggregate impact may not be too severe. We tend to import low value-add, cheap goods and while there could be some short-term disruption, supply chains could and would adjust through some combination of on-shoring or finding other places to make low-value goods. The US has a large, dynamic, diversified economy and given enough time to adjust it could operate as a closed economy if it needed to.
We would expect the effects in China to be a bit more pronounced and a lengthy trade war to potentially have a more lasting impact there. China is more dependent on trade and, due to the high leverage in its system, it is relying on mid to high single digit growth in order to keep its economy on track. US companies taking preemptive measures,something any good fiduciary looking out for shareholders or an owner/operator with a rational self-interest should be doing right now, by on-shoring or moving production to other low-cost labor economies that are friendlier with the current administration would have a more lasting impact on China, since a fair amount of that business would relocate elsewhere. It should be noted that short term effects are more acute and noticeable, long term effects seem to be manageable.
At the end of May, the administration turned its attention to Mexico and threatened tariffs on all imports. We view the impact to the US economy as similar, but the impact to Mexico to be far more damaging. A little data and context may be helpful here. According to the World Bank, over 75% of Mexico’s GDP is trade related (both imports & exports) vs. a little over 20% for the US and over 37% for China. Exports to the US represent about 30% of Mexico GDP vs. less than 5% for China. According to the BEA,in 2018 US exports to China and Mexico represent less than 1% and 2% of US GDP, respectively.
The trade war is a political dispute as much as it is an economic one, maybe more so, with considerations on both the foreign and domestic side for US actors. The 2020 Presidential election is ramping up and that makes the game theory multi-dimensional and even more complex. While we think some deal ultimately gets struck, the when and what of it seem up in the air.
To get back to the market today, it helps to put May’s setback in a broader context. 2019’s start was incredibly robust, one of the strongest ever and the recent decline leaves investors about where they were mid-February with the S&P 500 still up more than 10% on the year. That said, we view pullbacks and volatility as a healthy and normal feature of markets. It reminds investors that markets are risky and chastens them. We think the volatility is the price of admission to those seeking higher returns in equity markets. We remind clients that over time investors have been compensated for that risk, just not all the time.
We at Accretive were pleased with the way our portfolios held up in a difficult May environment, particularly our strategies that utilize individual equities. We construct portfolios contemplating both strong and difficult markets, in May we got a difficult one and it was good to see our portfolios behave the way we expected them to relative to their benchmarks. If you have any questions about how your Accretive portfolio held up or would like a review of an outside portfolio, please do not hesitate to reach out to us.
Economic Data Sources:
www.wits.worldbank.org
https://www.bea.gov/system/files/2019-03/trad-geo-time-series-0119.xlsx
