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Climbing the Wall of Worry

by Catherine Trinder Miller, June 10, 2019


“Climbing the Wall of Worry is the financial markets' periodic tendency to surmount a host of negative factors and keep ascending.”
‐ Old Wall Street Proverb

At the heart of the bull and bear debate since late last year has been a trend of slowing economic growth, fueling recessionary concerns and financial market volatility. Yet, the market has climbed this wall of worry year-to-date, ascending to new heights. In assessing investment opportunities and risks from here, we must employ second-level thinking, considering not only what might happen, but the probability that it will happen. Legendary rock climber, Alex Honnold, beautifully embodies the power of second level thinking.

In the most gripping scenes of the movie Free Solo, Alex attempts to conquer the largest vertical rock face on the globe, Yosemite’s El Capitan, without a rope. At Pitch 23, the crux of his ascent, he must painstakingly decide to traverse Boulder Problem or Teflon Corner. Alex describes Teflon Corner as a ninety-degree sheet of glass, ultra-slippery, going on to say, “…it fills me with terror.” And even for Alex, Boulder Problem is a “near impossible” ten-foot section requiring an intricate sequence of thumb holds and meticulous footwork culminating in a “karate kick” that feels like falling into the other wall. It is only by assessing multiple paths and the potential outcomes and perils of each that Alex finally picks one promising the highest probability of success. Alex’s ability to process numerous potential outcomes, thinking many steps ahead, while calculating probabilities in real-time, is remarkable. It’s the ultimate game of chess. Yet at stake is more than merely winning or losing. At stake is Alex’s life.

Alex Honnold’s nerves of steel and extraordinary patience as he ascends El Capitan remind us of the importance of these tenets in investing. The stakes are high and the future is uncertain. Alex had a clear plan to achieve his ultimate goal. The importance of a plan cannot be understated in investing, and like Alex, your plan should contemplate multiple possible paths to achieving clearly defined goals. The probability of success increases drastically if you diversify your investments in manner consistent with achieving the outcomes most important to you. Adherence to this plan provides security during inevitable bouts of market volatility and fortitude to stay the course.

So, is slowing economic growth an indication of imminent recession? Here’s what we do know:

  • We do not see the levels of financial excess in place today typically associated with past recessions.
  • Tariff escalation is a potential tipping point in what may become the longest U.S. expansion in history.
  • For a healthy expansion to continue, it is essential that business-leader confidence in the strength and persistence of this recovery remain high.

While past recessions have occurred for a myriad of reasons, most often they are the result of economic imbalances that grow in the system and need to be rebalanced. Major triggers in the past have included rising interest rates, higher inflation, or unsustainable debt levels. According to some of the top global investment strategists, including Capital Group, J.P. Morgan, and others, current imbalances don’t appear extreme enough to derail near-term economic growth.

Unlike past cycles, in the current era central banks appear more willing to go to extremes to stimulate the economy and reassure markets. This is a global phenomenon. Subdued inflation provides this latitude. Weakening of unions and globalized supply chains have helped keep inflation at bay.

Short-term interest rates are no longer rising. In fact, last week’s strong equity market rally was largely supported by comments from the Federal Reserve (“Fed”) indicating rate hikes are most likely behind us and the highest probability is a rate cut, potentially soon. Fed Chairman, Jerome Powell, said:

“We are closely monitoring the implications of these [trade] developments for the U.S. economic outlook and, as always, we will act as appropriate to sustain the expansion.”

In its latest comments, the Fed has signaled its readiness to play a central role in extending the economic cycle.

Typically, as expansions lengthen regulation weakens and people take on more debt. It appears in the current expansion the hangover from the 2007-09 recession may have restrained building of (financial) excesses that led to past downturns. In the past five years, U.S. financial sector debt has increased 9% vs. a 64% increase in the five years preceding the last recession.1 Household debt is up 14%, compared with a 65% increase in the five years before the recession.1 Growth in mortgage debt has also been modest in this expansion.

Exhibit 1

Government and business debt do bear watching as both have grown faster in this cycle than the last one, with the trajectory of government spend particularly concerning. See Exhibit 1.2 Yet, their day of reckoning does not appear imminent. In the current cycle, nonfinancial corporate asset growth has outpaced that of corporate liabilities.3

In the absence of financial excess of past cycles -- such as high consumer debt, lofty equity valuations, or euphoric investor sentiment -- we must look elsewhere for potential recessionary triggers.

Reflecting on our December 2018 investment memo, Beware the Madness of the Mobs, a decomposition of the building blocks of gross domestic product (“GDP”) underlied our belief the market was oversold and slowing growth was just that, slowing, but still growing. Eighty-five percent of U.S. GDP is derived from consumer and government spending. See Exhibit 2.4 With unemployment at record lows, a compelling case could be made in December that consumers and government would continue spending, and therefore the economy would grow. We did not believe asset prices reflected this reality and probabilities were high that the market would rebound. We maintained our equity positions participating in year-to-date global equity performance that has been nothing short of eye-popping. Considering those building blocks once again, we evolve our investment case.

Exhibit 2

Trend growth in the U.S., fueled by tax reform and deregulation, appears to be slowing from a 3% average year-over-year growth rate in 2018 to around 2% currently. With unemployment at record lows and cries for restraint in government spending, eighty-five percent of the economic pie appears tapped out; it may sustain, but will it grow? Unlikely, thus growth must come from other sources. Our conviction in the persistence of this economic recovery rests heavily with the actions of American business leaders. Business capital spending accounts for over 14% of U.S. GDP. With unemployment at historic lows and government debt at historic highs, it is essential that business leader confidence in the strength and persistence of this recovery remain high. It is this business capital spending piece of the economic pie that must grow for a healthy expansion to continue. The recent trend has not been encouraging. See Exhibit 3.5

At the heart of this declining capital spending trend, we need look no further than escalating trade rhetoric in our own backyard.

Exhibit 3

A New Technology Cold War

Tariff escalation is a potential tipping point in what may become the longest U.S. expansion in history next month. The stakes are high – in fact, some would postulate technological and military superiority and the dominance of the global economic system are at risk. While it appears that Trump has diagnosed the Chinese threat to US dominance correctly, it is hard to imagine that Chinese trade advantages gained over years of meticulously planned policy making will be given away in a single deal. It is more likely that both countries dig-in for a prolonged fight. With protection of intellectual property perhaps the highest U.S. priority, we may see more actions like the recent sales ban on Chinese telecommunications company, Huawei, with China responding in kind. Tariffs are the stick. The Chinese appear far less likely to conform to U.S. demands than ally partners such as Mexico.

Yet, supply chains are shifting as U.S. importers favor Mexico, Vietnam, South Korea, Taiwan, among others, over China year to date. See Exhibit 4.6

The long-term implications of these shifts are powerful motivators for China to seek compromise with the U.S.

The U.S. has currently levied tariffs on $250 billion of Chinese exports. China has responded in kind with tariffs on $110 billion in U.S. goods. Potential 25% tariffs on another $300 billion of Chinese imported goods are in play depending on the outcome of U.S./China trade negotiations. The G20 meeting in Japan, June 28-29, is the next scheduled meeting between President Trump and President Xi.

Exhibit 4

Business leaders in both countries remain distracted and uncertain. Neither economy is positioned to grow at full potential until this uncertainty is removed. While financial markets appear to celebrate the potential “Powell Put” with an expectation that short-term interest rates will be lowered should trade differences and tariffs escalate, our confidence rests in the confidence of our business leaders. Only with reduction in trade (and particularly tariff) uncertainty will their confidence be restored. Markets can, and frequently do, climb a wall of worry. For this ascent to continue, uncertainty around potential trade outcomes must decline allowing healthy economic fundamentals to persist. A trade deal is never about one size fits all. The magnitude of the stakes in play, and the extreme uncertainty around possible outcomes and the probabilities of those outcomes in this latest tariff escalation, keep us soberly measured and appropriately diversified.

While the markets may climb a wall of worry, you need not. While the future is uncertain, your financial success should not be. Let the lessons of Alex’s journey carry forward in ours:

  • Create a [financial] plan customized to your specific needs and goals;
  • Consider multiple potential paths and their probability of success;
  • Then design an investment strategy to achieve your goals with the highest likelihood of success; and
  • Stick with it.

Footnotes:
1 Hilsenrath, John. Wall Street Journal, After Record-Long Expansion, Here’s What Could Knock the Economy Off Course, June 3, 2019.

2 Ibid.

3 Board of Governors of the Federal Reserve System (US), Data from 4Q09-1Q19.

4 J.P. Morgan Asset Management, Guide to the Markets, May 31, 2019.

5 Yardeni Research, US Economic Indicators: Capital Spending in Real GDP, June 6, 2019.

6 Wall Street Journal, The Daily Shot, June 7, 2019.


The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any opinions are those of Catherine Miller and Teri Benson and not necessarily those of Raymond James. Diversification and asset allocation do not ensure a profit or protect against a loss. Holding investments for the long term does not ensure a profitable outcome. Investing involves risk and you may incur a profit or loss regardless of strategy selected. No investment strategy can guarantee success.

Past performance may not be indicative of future results. International investing involves special risks, including currency fluctuations, differing financial accounting standards, and possible political and economic volatility. Dividends are not guaranteed and must be authorized by the company’s board of directors. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor's results will vary.

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