Based upon research we follow as well as our general market observations over the past several days, we believe many securities and commodities appear to be priced as if it is more likely than not that the U.S. is entering a recession. We see this in equity valuations, where safe havens like consumer staples names are trading at high multiples, while cyclical companies like transports are trading at low multiples, in each case at an extreme level as compared to where they typically trade relative to the overall market. We see it in U.S. Treasuries, where the 10 year yield dipped below 2%, anticipating economic growth well below the 3-4% nominal growth rates that have been the hallmark of this economic cycle. We also see it in energy and commodity prices, with $28 oil in West Texas and sub-$2 copper in New York—both suggesting a significant global slowdown in demand for basic materials.
In this case, we believe the message from the market is too dire relative to conditions on the ground. We believe the fear of a recession is driven by concerns about a hard landing in China, which could trigger devaluations and debt defaults across the emerging markets, where low cost dollar-denominated debt has been used too liberally to finance inefficient capacity expansions in the industrial and commodity sectors.
We have no doubt that China and the emerging markets are the weak link in the global economic picture. However, we must remember that in the post-World War II period, international turmoil has never before driven the U.S. into recession. In addition, the economic links between China and the U.S. are quite small. In the real economy, China represents a small fraction of U.S. export demand, and U.S. exports are a small portion of domestic economic growth. In the financial economy, China operates with controls on its currency and security markets that effectively limit foreign influence and ownership. Even when considering the second-order linkages—that is, the economies that depend on China and are also a source of demand for U.S. production— we believe it still appears unlikely that a China-driven emerging market debt crisis would be sufficient to drag the U.S. into recession. We see ongoing improvement in the U.S. consumer sector as enough to sustain the trajectory of slow and steady economic growth, even in the shadow of an emerging market debt crisis.
There is historical precedent for our view. A 60% decline in the price of oil during the first quarter of 1986 triggered a recession in Texas and contributed to the savings and loan crisis, but the U.S. as a whole avoided recession, and the bull market in U.S. equities lasted for several more years. Similarly, in 1997-1998, a currency crisis in Asia triggered sovereign debt default in Russia and the demise of Long-Term Capital Management, but the U.S. once again avoided recession, and the bull market in U.S. equities lasted until 2000. At this point, our view is that the market’s concerns could have real international consequences, but we think today’s volatile conditions are unlikely to mark the end of the current U.S. business and market cycle. Looking ahead, an acknowledgement from the Federal Reserve that international concerns will cause it to reconsider the expected path of the benchmark Federal Funds Rate could be an important catalyst for investors to come around to our view and rebuild confidence in the U.S. equity markets.
At the same time, we acknowledge that volatility is likely to persist at a level which may be higher than recent years, which is unsettling to many investors. We are currently positioned more defensively due to the recent spike in volatility and the heightened level of uncertainty, employing our ability to incorporate risk tools. Should current concerns materialize into something worse for the market and/or the economy, we stand ready to further reduce exposure to the market. On the flip side, should concerns abate and volatility recede, we will reduce our defensive posture. In any case, it seems likely that the near term may be choppy.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.