I started out to write a blog earlier this week about the Federal Reserve and their balance sheet and discovered that I was spending way too much time trying to explain myself rather than just writing. This is when it dawned on me that many people probably have little to no idea how financial “stuff” works. Exactly what is a bond and how does it work? What does the Federal Reserve do, and why do I care? What is the difference between a mutual fund and an ETF (exchange traded fund)?
With that in mind I decided to embark upon a series of blogs that will attempt to explain many financial concepts. If you have an idea or concept in mind that you particularly want addressed, please feel free to leave me a comment below or drop me an email with the request. For now, I thought I would like to start with a concept that even the President seems not to quite comprehend but is quite relevant currently – trade deficits. This is particularly timely as it was announced this week that our trade deficit is at record levels despite tariffs.
I recently watched an informal news conference Trump did from the Oval Office. During the question and answer time one reporter asked about a trade deal with China. Trump’s answer included a line that took me aback. In attempting to explain the current negotiations with China, Trump stated: “Our country lost $800 billion last year with trade. Eight hundred billion.”
On the face of it, this sounds quite scary! We lost HOW MUCH?! We need to stop this! Immediately! But wait a minute…. Lost how? Did we really “lose” here? What the President was referring to is our trade deficit. Let me explain what a trade deficit is and how we are not, in fact, “losing” when we have a trade deficit with another country.
Let us start with the basics. The U.S. manufactures many things – Fords, Budweiser beer, Jack Daniels whiskey, Harley Davidson motorcycles and so on. At the same time, other countries manufacture things we want – BMW’s, Apple iPhones, Nike sneakers, Moet champagne and so on. We send Budweiser beer to Europe while they send Moet champagne here. This is international trade. At the end of the day, the government scorekeepers add up how much we shipped overseas and subtract from that what we spent buying goods shipped to us from other countries. If we shipped and sold more Budweiser or Harley Davidsons than we spent on Moet or Mercedes, we have a trade surplus. If we bought more foreign goods than foreign nations bought from us, we have a trade deficit.
So, with that concept in mind, a trade deficit simply means we bought more goods from foreign manufacturers than we shipped and sold overseas. Does that mean that we “lost”? After all, if we want champagne more than we want Budweiser, is that a negative thing? Let me explain this another way. If I fill up my gas tank and pay cash for the gas, I now have a trade deficit with the gas station. I have sent more money to their side of the ledger than I have received from them. But here’s the rub. I got a benefit for that $25 “trade deficit”. I received the benefit of a tank of gas. Am I worse off for having spent the money? No, of course not!
This is exactly how trade deficits work in the real world. If we send more money overseas than we take in, we have a trade deficit, but we have (presumably) received some benefit from this bargain. We have more Samsung Galaxy phones and Nikes and BMWs than we did before. This is not necessarily a bad thing. Where I think people – including the President – seem to miss the boat is conflating a deficit with “bad for America”. Just because we buy more goods or services from a country than they buy from us does not equal “bad for America”. In fact, we must have received some benefit from this relationship like my tankful of gas, or we would not have made those purchases. We wanted those Nikes or BMWs or Samsung Galaxy phones.
Our biggest trade debt is with – no surprise here – China. We mainly import consumer electronics, clothing and machinery from China. The first two should be no surprise. Think Apple iPhones or Nike shoes. Even the President’s family isn’t immune from outsourcing to China as first daughter Ivanka, until the middle of last year, ran a now shuttered clothing line that was manufactured in China. Why don’t U.S. companies keep all manufacturing here at home? Cost is obviously one answer. It is much cheaper, even with shipping, to have an iPhone made in China than here at home. With minimum wages going up throughout states, either by law or by pressure from other companies, these labor-intensive jobs are likely to remain offshore.
Let’s dig a little deeper into how we rack up a trade deficit, even on goods that are made here. One of the key items traded in the NAFTA zone – Canada, the U.S. and Mexico – is auto parts. The Ford Escape is assembled in Kentucky making it an American-made car. However, 55% of the parts that go into the car, including the entire engine, come from Mexico or Canada. The engine that we purchase from Canada counts in the calculation of what is bought and sold between countries. That is, when we purchase engines without shipping something of equal or greater value back to Canada, we have incurred a trade deficit. So, the Ford Escape is assembled and resold mainly in the U.S. with Canadian engines and we end up with a trade deficit. But did we lose on this deal or not? Presumably, if Ford could source engines as cheaply here in the U.S., they would. Using Canadian engines is apparently saving Ford on the cost of building the Escape and allowing consumers to more easily afford this vehicle. That would seem to be a benefit to everyone involved – Canadian and American.
The bigger issue and thornier question concern the outsourcing of manufacturing to foreign countries at the expense of American jobs. I don’t pretend to have any easy answers here. From an economic standpoint, I would argue that we should outsource some manufacturing overseas to countries with cheaper labor. I do have a problem with using child labor at $1 a day, even if that wage is high for that country. There is no one single answer to the question of whether we should outsource or not. In the end, if we are getting the products we want at prices we want, outsourcing to other countries can be mutually beneficial. I would love to hear your thoughts and ideas below.
The last quarter was one of extreme volatility. In fact, the fourth quarter had more days where the market moved 1.5% or more since….2011. Yeah, I don’t remember what exactly happened back then either, so I had to dig out my 2011 year-end letter to see what caused such volatility back then. This was the year of the “Greek debt crisis” when markets worldwide were roiled over the fears that Greece would go bankrupt, and this bankruptcy would start another contagion like the 2008 meltdown. Markets fell around 14% in the third quarter of 2011 only to come roaring back in the fourth quarter. To find a fourth quarter that had both this much volatility and a decline of 14% or more we must go back to 2008, and the start of the financial crisis. No wonder I was having flashbacks during October and early November. I do admit that my stress level was through the roof for a bit over client accounts.
At least this time around we are not in the middle of a financial crisis, though you wouldn’t necessarily know it from the fears and rumors that flew around. There were several factors that all occurred in short order that caused markets to plummet quickly. The interest rates on 30-year Treasury bonds spiked dramatically (for bonds, anyway), jumping 5% in three days. This led to a fear of inflation. Add to that Amazon’s announcement they are raising their starting pay to $15 per hour for all employees. If Amazon is paying that everyone else will have to match them, leading to pressure on wages and likely forcing companies to raise prices to cover these higher wages. Then we move to the second week of October….
Seriously, those two incidents merely lit the fuse of fear and uncertainty. We had (and still have) the ongoing trade wars with China. We did face the prospect of the G20 Summit in Argentina – a meeting of the 20 largest economies in the world – at the end of November. Chinese and U.S. officials met at the summit to discuss the ongoing trade issues, but little came from that dinner. The best we achieved was a 90-day delay in the threat to increase tariffs on Chinese goods coming to the U.S. When conflicting reports came out just a couple of days after the meeting about when the clock started ticking on those 90 days – in other words, just when might tariffs go up – the uncertainty led to another 3% drop
In addition, in December we had the fourth interest rate hike of the year from the Federal Reserve and Fed Chairman Jerome Powell spoke about the decision to increase rates. The message he conveyed was essentially “we may raise rates a couple of more times in 2019, but it depends upon what the data tells us”. What the markets wanted to hear was “we are done raising interest rates given how far stocks have fallen”. The way Chair Powell conveyed his message further spooked the markets causing another big leg down. It’s funny, because in early January, Chair Powell was at the American Economic Association’s annual meeting in Atlanta and essentially said the same thing as he did in December – he just used what is referred to as a more “dovish” tone – and markets reacted by jumping near 3.5% for the day.
So what happened in our accounts? As you know, one thing that I do when I purchase any security is I set a “stop loss” on each holding. That is, if the stock price falls to a certain level, I will exit the position. Given how the markets fell this quarter, we did a lot of selling. We closed out most of our stock positions during the quarter. Only four of the fourteen stocks we sold resulted in a net loss. What didn’t help, though, was selling stocks that had been 10%, 15% even 20% or more higher just days or weeks earlier. For example, we sold Ecopetrol (ticker: EC) in November at around $19.60 per share. This was over 27% below where the stock traded at the end of September but was well above the $12 per share we originally paid when we first bought shares. Similarly, we sold Best Buy for $71 per share, which was, again well above the $59 we originally paid but 10.5% below the price at the end of September. However, I still think we did the right thing to bail out of the stocks when we did. For example, we sold out of Macy’s (ticker: M) for just over $30 per share in mid-December. Today, as I write this letter, Macy’s suffered almost an 18% drop for today, falling to $26 per share on very weak sales during December.
Aside from the loss in value on our stock holdings, the other issue we faced was from our options. Through the end of September, we had done reasonably well with options transactions. This all reversed in the fourth quarter as the extreme volatility hit pretty hard. We did try to exit some of our positions but oftentimes the market moved so quickly the orders we entered were never executed. In hindsight I do wish I had “chased” some of the orders that I placed – that is, instead of setting a certain price, just bailing out regardless – but there was no way to know how much the markets would melt down and how quickly. Going in to the quarter, we had always experienced a “buy the dip” mentality. That is, whenever we had a sharp drop in the markets, investors seemed to view it as a buying opportunity. This time around, it turned into a “sell the rally” type of mentality. That is, whenever markets jumped, investors used it as an opportunity to sell stocks (much as we did). I certainly tried to make the best decisions possible to minimize losses. Markets just did not seem to want to cooperate or make things easy for me.
Combine these two events and suffice it to say that I was not happy with how client accounts performed for the quarter. I am better than what occurred this past quarter. This was a “perfect storm” of what could go wrong. So, in the short-term, things have been less than fun. The big key is to remain focused on the long-term view. Over the long-term, stocks will do well – much better than the rate of inflation, so it is important that we remain exposed to stocks. I will say that, for now, the model that I am using to find stocks to purchase is not giving me any purchases. That does not mean we won’t have any exposure to stocks at all. We do have some exposure to small and mid-sized companies through mutual funds we hold. In addition, I am in the process of adding a good balanced fund – a mutual fund that holds both stocks and bonds – as a ‘core’ holding to client accounts. This fund, the Janus Henderson Balanced fund (ticker: JABAX), has a great and consistent long-term track record, which is what I want for my clients. I am working on “tweaking” my model to see if I can reduce the volatility it has shown but maintain solid long-term returns.
We are currently a bit overweight in bonds, primarily through the PIMCO Income mutual fund (ticker: PONAX) across most client accounts. I am a bit worried about the potential for a recession. Much will hinge on what happens with the current trade negotiations with China. The expectation is that all will go wonderfully. I am not so sure, and even if there is an agreement reached, it won’t be a quick end to things. Should negotiations fail the administration is threatening to raise tariffs on Chinese goods to 25% from the current level of 10% and to spread these tariffs to all Chinese goods imported into the U.S. While this may have a somewhat muted impact on the overall economy at first the longer-term implications are darker. These tariffs would hit lower- and middle-income folks hardest. Until this threat is somewhat resolved one way or another I would prefer to prepare for the worst and hope for the best. Should we get clarity on trade issues, we will be shifting money out of the bonds and into stocks, though not everything will come out of bonds of course. With clarity comes the ability to take on a bit more risk. The amount of risk, of course, will depend upon your individual situation, needs, and age.
The bottom line – in spite of a very tough fourth quarter, we remain focused on what we do. We are focused on protecting client accounts and trying to earn a reasonable return for the amount of risk that we take. This has not and will not change. How we achieve those goals may shift a bit over time, but the goals remain the same. Over the past several years, we have had little or no volatility. That has likely changed now, which means we may see some larger swings over short spans of time. We will bounce back. The general trend in markets is higher which is in our favor. While we may endure short-term bumps and jolts we should see long-term growth of our assets. The best thing to do is fasten your seatbelts and not worry about day-to-day changes in account values.
As always, we truly appreciate the trust you have placed in us, and the opportunity you have given us to manage a portion of your assets. If you have any questions or need to discuss any issues, please feel free to give us a call.
Alan R. Myers, CFA
President / Senior Portfolio Manager
Aerie Capital Management, LLC