Three Key Thoughts:

1. US Economy: Weaker at the Margin

2. Impact of the Brexit Debate

3. China: Short Term vs Long Term

US Economy: Weaker at the Margin

In last quarter’s Thoughts on the Current Outlook, we stated our view that the strong rate of growth in the US economy was “unsustainable” and that in 2019 economic growth would begin to revert toward its long term potential of 1.5-2%. Because markets tend to move on the basis of the marginal change in the environment, this concern came to the fore in the fourth quarter as slightly weaker data coincided with the Federal Reserve’s interest rate increases. The result was a very powerful move lower, particularly in December.

A series of other concerns added to fuel to the markets’ dour view: ongoing trade disputes with China, weaker economic reports from China and Europe, the distinct possibility of a disruptive “no deal” Brexit in March, falling oil prices and the partial government shutdown.

At this writing, a strong December jobs report and news of progress on China trade talks has calmed the markets, which likely overshot to the downside. That said, it is likely that we will see US growth slow materially in 2019. And, any time that growth is slowing, there is a heightened risk that we tip into recession.

We think it is important to call out two particular risks. The first is the ever-changing story of US trade policy. In trying to re-write agreements with all of our major trading partners, we have created a great deal of uncertainty for international businesses. The result, not surprisingly, is that many of these businesses have been hesitant to make major investments in future growth. This has had the effect of limiting the positive effects of the generous business tax cuts that drove earnings dramatically higher in 2018.

The second major risk is complete dysfunction in Washington. We are currently in the midst of a partial government shutdown which is just beginning to have an impact on the real economy. The more important issue however is the continuation of extreme partisanship that prevents compromise. This is a movie we have seen before – when Republicans regained control of the House of Representatives in 2010 with a new class of representatives dead set against negotiating with President Obama. This time, we can add a special counsel investigation and other Congressional inquiries to the toxic mix.

Our concern from an investment perspective is that the consumer has been and will continue to be the key driver of economic growth. If Washington dysfunction reaches a point that it damages consumers’ confidence, we could inflict a recession on ourselves, where one would otherwise not have existed.

Impact of the Brexit Debate

In 2016, Prime Minister David Cameron fulfilled a campaign promise to hold a referendum on UK withdrawal from the European Union. Cameron believed that voters would certainly vote to stay and that this result would put an end to the debate within his own party about withdrawal. His bet proved disastrously wrong as voters approved Brexit and ultimately Cameron was replaced by Theresa May.

May has faced the task of negotiating the terms of an exit under impossible conditions: unrelenting criticism from various home factions and unbending demands by the European Union which has no interest in making Brexit good for the UK. These unyielding forces on each side are about to collide as May’s deal faces a final vote of Parliament, which is widely expected to disapprove it. This may set off several different courses of action, the outcome of which is completely unpredictable.

What is clear from this entire episode, however, is that political dysfunction is not limited to the US. Indeed, it has shown a light on the structural weaknesses of the European Union and the common currency in particular. It has also demonstrated that the rise of populism can lead to illogical and damaging results. (Who would vote to crater their own economy in order to preserve local border control? I wonder…)

Regardless of the Brexit outcome, we believe the concept of economic union in Europe is severely damaged and will need major changes to survive. We don’t know what form this will take but we expect that the economy will continue to be weak until a new generation of political leadership is identified and a decisive path forward is defined. This will likely take many years and success is by no means assured.

China: Short Term and Long Term

We have written extensively about our views on China, which are quite different than the prevailing “China bear” sentiment. There is no doubt that 2018 turned out to be a challenging year for China. The deleveraging policies that had been initiated in 2016 ran headlong into concerns about the impact of a possible trade war with the US. As a result, consumers in China became less confident and pulled back on spending. Not only did this impact local Chinese companies (where the stock market declined throughout the year) but also multinationals like Apple who saw their China sales affected significantly. The government has responded by easing up on the deleveraging program and becoming more amenable to a trade deal with the US.

We believe these are short term issues that don’t really impact the long term story of the rise of China. Now the second biggest economy in the world, China has continued on its slow path of opening up to the rest of the world. With a consumer population of a size that can only be matched by India, China understands that long-term, growth-oriented policies are critical to managing the prosperity of its people. And, importantly, it follows that the prosperity of its people is essential to the survival of the regime. This should be a hospitable environment for long term investors.

But what is troublesome is the increased focus by the Communist Party on censoring external views, forcing businesses to expand or contract “strategically” and embedding the party leadership for an undefined term. These contrasting themes of “opening up” and “shutting off” should give investors pause. Over the long term, we believe the growth need will outweigh the control desire but the path forward may be bumpy. Because China contributes so much to global growth, its development will be a key driver of global markets. In the near term, striking a reasonable deal with the US on trade will go a long way toward alleviating concerns about the Chinese economy, both at home and around the world.

Investment Approach

With the sharp market declines of the fourth quarter, we spent a great deal of time harvesting tax losses for taxable client portfolios. For the most part, we remained invested in both US and international equities. However, we have kept a moderate amount of cash on hand as we would not be surprised to see more market volatility, particularly in Europe and the US as economic reports weaken. We made a number of small changes to asset allocation in preparation for slowing growth as well: reducing investments in high yield bonds, eliminating direct commodity exposure and adding to municipal bonds, where appropriate, on the expectation of falling yields.