March Investment Comments
In January, after spending much of two years wrestling with trade issues, the U.S. signed two important pieces of legislation. The first, and likely more important, is the United States-Mexico-Canada Agreement, an update to NAFTA covering trade rules for North America. The second was a “Phase 1” agreement with China that reduced the likelihood of further tariff escalation and laid out a negotiating timeline to work through difficult discussions such as protection of intellectual property. The markets breathed a sigh of relief and began to rally on the thinking that businesses could now rely on (relative) certainty of trade and tariffs to support long-term product sourcing decisions.
Then along came the coronavirus (COVID-19). According to the World Health Organization, as of February 18, the virus has sickened more than 73,000 and killed 1,853. With most of these cases concentrated in the country of origin, China, the world has responded with various degrees of isolation. More than 30 airlines have suspended service to China and a 78-nation matrix of rules and quarantines from the U.S. to Singapore have all but banned Chinese travelers from foreign soil.
The impact of the virus is being felt by businesses. In late January, Apple guided for first quarter sales in a wider range than expected as the company faces two virus-related vulnerabilities. The first is to its supply chain as it manufactures much of its product in China. The second is sales, as close to 20% of the firm’s revenue comes from China and surrounding Asian countries. By mid-February Apple disclosed that it will miss this more-modest guidance altogether. Other firms are also seeing parts shortages from factories that are idled or producing at reduced capacity. Going forward, the still-fresh tariff uncertainty and vulnerability to Chinese supply chains will likely cause businesses to spread out manufacturing across multiple countries.
No one knows what will happen with the coronavirus, but for now the effects look like past outbreaks, such as SAARs, that had only a short-term impact. Unfortunately for the world economy, the virus couldn’t come at a worse time. In Europe, fourth quarter 2019 growth showed just a 0.2% advance. Germany, the engine of Europe, was flat, while France and Italy contracted. The dismal fourth quarter reduced Europe’s 2019 growth to just 1.2%, the weakest since 2013.
Japan decided to shoot itself in the foot by increasing its national sales tax from 8% to 10%. Predictably, fourth quarter GDP fell 6.3%, as household consumption dropped 11.5%. You would think the Japanese would learn their lesson as two previous sales tax increases in 1997 and 2014 had similar effects, marking the three worst quarters for consumption in the past quarter-century.
Then there is China. The government reported that fourth quarter GDP grew 6.1%, the slowest rate in three decades. However, we question the validity of this data in the face of weak housing demand and an auto sector that saw sales fall 8.2% in 2019. Government spending appears to be propping up growth as investment in fixed assets, mainly buildings and structures, was up 9.9% in the quarter. A truce with the U.S. on trade should help, but it wouldn’t surprise us to see growth roll over in the first quarter, regardless of what the government decided to report.
This international weakness is quite a contrast to what is happening in the U.S., where growth is much better. Fourth quarter GDP grew 2.1%, a bit weaker than expected largely from a modest advance of 1.8% from consumer spending. The calendar during the quarter may have held back the consumer as the number of days between Thanksgiving and Christmas was shorter than usual. Net exports contributed 1.5% to growth while inventories detracted 1.1%, a positive for future quarters as businesses replenish inventories. However, private investment, largely driven by business, declined 1.1%, indicating that companies are still holding back on investment decisions.
The first quarter looks good so far. Employers added 225,000 new jobs in January, an acceleration from 2019. The unemployment rate ticked up 0.1% to 3.6%, but this is due to more workers coming into the labor force because job prospects are better, and employers are recruiting them more heavily. Warmer weather contributed to the fastest pace of housing starts since 2007 and new homes sold hit 694,000 in December, up 10% year-over-year. The consumer is in good shape as wages grew 3.1% in January. We watch wage growth closely as it provides the cash flow for consumers to spend in future periods.
Boeing is a wildcard in the first half of 2020. The timing of relaunching the 737 MAX is in doubt as the company struggles to recertify the plane. Analysts have estimated as much as 0.5% could be shaved off yearly GDP if the airplane remains grounded through the second quarter.
For now, the market appears to be concluding that the impact of the coronavirus and Boeing’s struggles are temporary. Valuations remain stretched. As of the February 14 issue of FactSet Earnings Insights authored by John Butters, the forward 12-month P/E ratio for the S&P 500 is 18.9, 13% above the 5-year average of 16.7 and 26% above the 10-year average of 15.0. With 77% of companies reporting, fourth quarter earnings are projected to grow 0.9% and sales 3.6%. Earnings are growing more slowly than sales due to the stronger dollar and labor cost pressures. Analysts expect sales and earnings to accelerate as 2020 unfolds, with sales growing 5.2% and earnings 8% for the entire year. Analysts are notoriously optimistic, but these estimates are more realistic than the roughly 10% earnings growth projected for 2020 just one quarter ago.
The market is expensive but there are some stocks available with the right growth and valuation balance. In the face of slow short-term growth and uncertainly, building a portfolio of these selections is far better than investing in speculative businesses that rely solely on accelerating growth.
Daniel J. Boyle, CFA