Value Investing

A Recession by 2020?

The current situation with the proposed tariffs between China and the US is somewhere in between a trade war and negotiation tactics. We’ll call it a “trade battle” because we don’t know what the end game of this war of words and proposals will lead to. Both sides are dependent on one another; since their interests align, the battle should end amicably, but sometimes negotiations get out of hand and policymakers act irrationally. We’re not going to delve into politics, but we’re sure you can think of an example of irrational politicians. The key contentions President Trump has with the current dynamic are that he feels China doesn’t respect American firms’ intellectual property and he’s worried the trade deficit is causing the US to lose industries and jobs to China.

It’s highly risky to make bets on how politicians will act, but it is critical to follow the story because your bets on other situations will be affected by it. For instance, one casualty of the recent US actions as part of President Trump’s tariffs on China and sanctions on Russia has been the price of aluminum rallying.

Aluminum Price

The U.S. economy will potentially face higher interest rates and inflation if the tariffs remain in place and some production moves back to America. Tariffs increase costs for overseas products and US production has higher costs, such as more expensive labor.

The labor market should be close to achieving full employment in the next 1-2 years.

Labor Market Not Full

These tariffs could amplify the effect of the full labor market causing accelerated wage growth. President Trump needs to balance the urge for bringing back American jobs with the understanding that trade brings about specialization which improves the quality of life for everyone as goods become cheaper and production becomes more efficient. Criticism of the new tariffs needs to avoid assuming the prior situation was perfectly fair because the weak Chinese currency ensures it wasn’t. This bias mostly arises because the recent tariff announcements have coincided with the correction in stocks.

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Inflation Expected To Increase Anyway

As we mentioned, the tariffs could bring about inflation. After the tariffs were announced on steel and aluminum there was panic buying in these commodities causing near term prices to increase and inventory shortages. That’s short term action, but the reason demand had a knee jerk reaction higher is because of the expectation that prices will increase once the tariffs are enacted. Increased inflation and higher commodity prices could be coming anyway even if the U.S. and China end this battle amicably without any tariffs. Commodities, which irrespective of the recent surges in price due to sanctions and trade wars, tend to be counter cyclical investments, outperforming as the business cycle concludes (stage we are in now) and heads into a recession, something we have discussed in Is Gold A Good Investment.

The year over year growth in core CPI is correlated with the small business survey which asks firms if they are raising prices. The survey is pushed ahead by 15 months because it acts as a leading indicator. The survey shows that small businesses are raising prices therefore implying that the core CPI will be increasing in the next 15 months. Obviously, an improvement in the leading indicators isn’t necessarily a bad thing, but when growth exceeds the output gap which is where we are right now, inflation starts to heat up thus causing the Fed to hike rates which stalls growth. Rate hikes that go too far lead to a recession.

Recession Incoming By 2020?

Forecasts for rate hikes and cuts give us an idea where the economy is headed. If rate cuts are expected, it implies the economy is about to experience weakness, potentially a recession. The overnight index swap (OIS) which can be used as a proxy for the Fed funds rate is expected to decline from 2020 to 2023. This implies rate cuts after Q1 2020. Expecting rate cuts through an inversion of the forward OIS curve implies a potential recession in 2020. Most of the rate hikes for this cycle will be over by the end of 2018. Usually a recession occurs after the Fed funds rate stops going up. If inflation accelerates, the Fed will be forced to hike rates more than expected. While further rate hikes mean the tightening cycle isn’t over, these hikes would hurt economic growth and tighten financial conditions.

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The late business cycle growth combined with the “trade battle” has increased uncertainty leading to more volatility in equities and higher commodity prices. The weakness in some economic indicators and the Fed’s hawkish policy are also contributing to the recent correction in equities. The tariffs could lead to increased inflation which is already on pace to accelerate if you look at the NFIB survey and the leading indicators, while the forward OIS curve signals these changes will lead to a potential recession in 2020. It is important to always have a plan for any scenario, whether positive or negative, when it comes to investing in order to avoid acting on emotions. In addition, as important as having an investment strategy, a portfolio in late business cycle should be different from a portfolio when the economy is just coming out of a recession.

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