Q1 letter: A Song of Spring

Dear Friends,

Spring is in the air. Subir’s younger daughter won’t step outside without checking to see what plants and trees have flowered. It is a special joy to be reminded of the resilience of life and the cycle of the seasons.

Back in the more quotidian world of markets, Q1 saw US equities rally sharply, recovering from the lows seen in December. Stocks remain below the highs of last summer. Part of this can be explained as a relief rally after a tough Q4. Year-end consumer spending was not as bad as feared. The government shutdown did eventually end and everyone apart from contractors was paid for time lost. Of course, time is a non-renewable resource and several weeks of human effort were lost.

A more influential factor spurring the rebound was the Federal Reserve reversing policy in early January, telegraphing a pause in interest rate hikes. The Fed appears to have been spooked by a confluence of factors including: the shutdown, Brexit, the Q4 correction, deterioration in hiring, and a softening of real-estate prices in several markets. Going into the year-end, we’d expected two rate hikes in 2019. It is now far less likely that this will happen. In our view, this weakens the Fed’s ability to act if we do enter another recession.

There is some speculation that the Fed’s back-tracking was a response to pressure from the White House. If that were the case, it would be a cause for concern. It’s clear to all concerned that the president would like to see an accommodating, low-interest rate policy heading into the 2020 election cycle. In that respect, this White House is no different from any other first-term administration. However, the nature of the President’s statements is somewhat unprecedented. The Fed is largely independent of the government and such attacks do present another test to our institutions. However, most market participants have been ignoring rhetoric coming out of the White House. As long as the Fed governors don’t let this affect policy, and chairman Powell can brush off the president’s frequent bromides, the White House’s statements are likely to have no impact on the market.

Looking beyond our shores, we still see an unsettled environment. The United Kingdom continues to lurch towards a break with the EU, without any firm plan in place. In our view, the UK’s exit from the EU system will have a significant economic impact, but it is unlikely to be extreme. We do not ascribe to the doomsday Brexit scenarios.

Further afield in Asia, we still see unsettled questions around trade with China impacting real economic activity. Companies continue to shift production out of China and into other South Asian countries. We believe these trade spats portend a major shift away from the post-war order. For over 70 years, we have seen free, global trade as the reigning orthodoxy for relations between nations. This is now being replaced by a more mercantilist stance in both the EU and US. The US response to the rise of Huawei and other 5G Chinese manufacturers underscores this. In Japan, the details of Charles Ghosn’s arrest suggest that Japanese officials moved out of fear a top-3 Japanese automaker would be absorbed into Renault.

If we are honest with ourselves, we will admit that various European countries, and Japan have always had a mercantilist trade policy supporting national champions. The US less so for most of the 20th century (outside of energy policy). That is clearly no longer the case, at least under this administration.

There are several reasons for this shift, the most significant is the clear rise of China under a semi-managed system. The development of an information-based services economy and the disruption of manufacturing industries through outsourcing is also part of the explanation. These momentous changes taken together have brought into question the 20th century orthodoxy of free-trade in goods/services as the only route to prosperity. Many in developed countries challenge these assumptions by pointing to declining living standards among the general population. They can also point to examples like China, which continues to keep much of its domestic economy closed and props up state-owned national champions. All this creates a more unpredictable investment climate, where we now have to consider the political links of major companies alongside their purely commercial prospects.

From an investment perspective, we continue to advise investors to maintain cautious allocations. Though markets have recovered from their December lows, the past 15 months have seen increased volatility and we expect that to continue going forward. As we enter the spring, we will remain watchful for long-term opportunities that arise from any further correction.

Regards,

Subir Grewal, CFA, CFP Louis Berger