November 2018 Letter
Late Cycle Trade War Ructions
Market volatility has returned in the Fall of 2018. While there have been a few strong days of upside for equities, the downside has won the day since the end of August, with all major indices down over that period. While this causes concern, it is important to remember that market corrections are healthy. The trouble for investors is that there is a lot of noise in the market from the political “Trade War” discussions between the two great economic powers – the U.S. and China.
This has already been a very long market cycle. It is the longest economic expansion since the 1850’s. Long and strong market cycles are dangerous because “animal spirits” are inevitably awakened, excess credit is extended for dubious assets at extended prices, and this is unsustainable. A reset becomes necessary. The painful asset deflation that ensues is healthy in laying the groundwork for a beginning of a new cycle.
It is true that cycles do not die of old age. But there are conditions we can look for as to whether a downturn is near. 1) Unemployment is low across all major economies, i.e. resources are tight – check. 2) Profits are elevated for corporations – check. 3) Credit is being extended at record levels on loose terms. Non-financial Investment Grade Credit with the lowest rating of BBB recently increased to 48% of the market versus 25% in the 1990’s - check. And most crucially – 4) central banks are responding to the all the aforementioned conditions by tightening monetary policy – check. The usual litmus test for whether the economy can keep charging comfortably ahead despite the rising interest rates is the yield curve (see below). If it goes flat or becomes inverted, the economy looks to be running out of steam. And this is where we appear to be. We will know that the correction is actually ready to begin once High Yield Corporate bond spreads have risen to high levels relative to U.S. Government bonds. This hasn’t occurred yet. So while we are close to a significant market correction or possibly a recession, we are not there yet.
Understandably, investors are concerned. But the real “elephant in the room” is the uncertainty caused by the back and forth between the U.S. and China. In the last few months, the correlation between the Chinese and U.S. stock markets has increased to roughly 2x the level of the last five years. The U.S. is in the best position to talk tough in the discussions, given it’s large and flexible economy. China has more reasons to be concerned in the short run. They have already extended significant stimulus within their economy since the Global Financial Crisis. Many of their institutions are over levered, as Chinese Corporate Debt was 163% of GDP in mid-2017, according to the Bank for International Settlements. This financial leverage causes alarm for many institutions, and has been driving China to attempt to coax the economy to lower leverage without damaging growth. The confidence hit that is now coming from the “Trade War” discussions do not therefore come at an opportune time, and they will likely cause deleverage and other internal reform agenda items move to the back burner. This damage in China is very real, and is evident in recent auto production figures (November 2018 production declined 18.9% yoy).
Global equity investors have cause for concern because there is no recent historical record to use for extrapolating the damage to economic growth from a politically generated breakdown in the movement of goods and services. Add to this the signals from the Yield Curve and other late cycle indicators, and it is enough to keep markets volatile. We believe that global equity investors will remain cautious. We do not believe that now is the time to position for a late cycle bull market. “Grasping pennies in front of a bulldozer” has never been a sound strategy. We are confident that well diversified global portfolios comprised of companies trading at meaningful discounts to long term value represent the best way to protect and grow value going forward.
International All-Cap Value returned -0.06% (gross basis) in November 2018 versus 1.68% for the benchmark. Year to date performance was -11.69% (gross) versus -10.01% for the benchmark.
Global Small Cap Value returned -0.42% (gross) in August 2018 versus 1.43% for the benchmark. Year to date performance was -10.73% versus -6.52% for the benchmark.
 Source: National Bureau of Economic Research
 Source: PIMCO, “Investment Grade Credit: Be Actively Aware of BBB Bonds”, January 2018
 Source: Factset data
 Source: CAAM
 Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)