Contagion

In October, we wrote that Sept/Oct has historically produced a negative return, which is usually reversed in November, and markets did indeed produce a reversal in November. However, we also wrote about the possibility of a combined recession/inflation scenario in the long run, which became much more probable due to fourth quarter economic news coming from China and the European Union (EU). Reacting to that news equity markets took a beating in December.

Almost every long period of strong economic growth ends with firms and individuals highly over-leveraged. The high degree of leverage results from the desire of these investors to take advantage of seemingly ubiquitous investment opportunities. China had just gone through an extremely long period of very strong growth, and firms and individuals in China were highly levered. For example, by the end of 2017 the ratio of total borrowings by Chinese firms (non-financial) to China’s Gross Domestic Product (GDP) was close to 160%. By comparison, the same ratio in the US was a little above 70%. Recognizing the dangers of this leverage, the Chinese government started moving in late 2017 to reduce leverage in their economy through a series of policy changes designed to restrict credit availability. However, the result of those policies became magnified due to the escalating trade war with the US and the combination caused a substantial economic turndown in China. Chinese stock markets fell about 25% in 2018 (compared to about 6% for the S&P 500) as a result. While economic numbers published by China are always a bit dubious, it is certain that the Chinese GDP growth has slowed down considerably and probably has declined.

The same story of weak growth holds for the EU due to its considerable trade interlinkages with China as well as the rising trade and political tensions with the US. The last 6 months have been very difficult for many EU countries including Germany, the largest EU economy (and fourth largest in the world) and which typically leads the EU in terms of economic growth. Germany’s economy shrank by 0.2% in the 3rd quarter and is expected to do the same in the 4th quarter. Other EU countries are doing similarly, with Great Britain’s economy in particular doing poorly due to their anticipated exit from the EU. The EU stock markets in aggregate were down 22% for 2018.

Due to significant tax cuts and deficit spending, the US had been insulated from the effects of China and the EU, but that changed in December. With the third and second largest economies in the world both simultaneously struggling, it was inevitable that US firms that do significant business outside of the US would be affected. Earnings warnings have come in from a broad set of companies ranging from Federal Express to Apple to Delta Airlines to PPG (all due to slowdown in their overseas operations). The US markets have become very concerned that the struggles in the rest of the world will start to affect all US companies. Even though it is the foreign operations of US companies that are struggling, most of these companies source significant labor and material from US companies. So, a slowdown in foreign operations of US companies will have a contagion effect and eventually cause a slowdown in US companies that have no foreign operations. The realization of this is primarily what led to the 10% decline in the S&P 500 in December.

The question now is whether China and the EU can fix their problems before they spread to the US. China has begun both fiscal and monetary stimulus to get their economy going again. The EU has less scope for fiscal stimulus due to their restrictive rules about budget deficits. The White House has also started to see the danger of contagion and appears more willing to resolve trade tensions with China in order to help spur China’s economy (and thereby also help the EU due to the strong economic linkages between them and China). In the coming months, we will see whether these

efforts are successful in getting both China and the EU going again. However, as the data comes in and markets learn what is happening and adjust their expectations, there could be more market volatility like we experienced in December.