October 4, 2019 – A Manufacturing Meltdown Amongst Trade Turmoil

The fourth quarter has arrived, and global markets are hoping it will end up being friendlier than last year’s
closing quarter. As of the date of this letter, the S&P 500* is up +17.2% year-to-date, matching the performance
of gold and slightly underperforming long dated US Treasuries, which are up +19.8%. A gain of +17% for US
large cap stocks sounds fantastic until you zoom out and realize that stocks’ 2019 performance has been simply
making up for the ~20% loss that took place between early October and late December last year.

In fact, earlier this week the S&P 500 fell below the peak set back in January 2018. As you can see on the chart
below, US large cap stock investors have spent much of the last two years on a roller coaster ride but not gotten
very far for their troubles.

Diversifying globally or by market cap hasn’t helped much either. The Russell 2000 Index*, which tracks the

stock performance of a small American companies, is currently -14% below its peak from August 2018, and sits
now at a point it first reached more than two years ago in September 2017. The Global Dow Index, which tracks
stocks from all over the world, currently is -11% off the high it set in January 2018 and currently sits just above
its pre-crisis peak reached all the way back in 2007.

We spent much of our last letter discussing the likelihood of a global recession in the coming quarters, as
suggested by the inversion of the US Treasury yield curve. All year, and in fact for much of the past two years,
the bond market has been suggesting an impending slow down, even though the US stock market has been
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bouncing around all-time highs. Just this week we received more confirmation that the bond market may be the
more prescient of the two. (Bold passages that follow reflect our emphasis, not that of the original author.)

A weakening world economy, President Trump’s trade war with China and fears of a potentially tumultuous Brexit
have combined to produce a dramatic slowdown in global commerce, the World Trade Organization said Tuesday.

The Geneva-based organization slashed its forecast for trade growth for this year and 2020, a troubling indicator as
economists warn of continued weakness in the global economy.

The pronounced deterioration of trade reflects risks that have been building around the globe in recent months,
diminishing fortunes in major economies. On Tuesday, a closely watched gauge of American manufacturing activity
indicated the factory sector contracted in September for the second straight month. The Institute for Supply
Management’s manufacturing index fell in September to its lowest level since June 2009, the month that
marked the official end of the last recession.
- Peter S. Goodman, New York Times, October 1, 2020

The new export orders index was only 41%, the

lowest level since March 2009, down from the
August reading of 43.3%, ISM data showed.

“We have now tariffed our way into a

manufacturing recession in the US and globally,”
said Peter Boockvar, chief investment officer at
Bleakley Advisory Group…

“Global trade remains the most significant issue, as

demonstrated by the contraction in new export
orders that began in July 2019…” Timothy Fiore,
ISM chair, said in a statement.
- Yun Li, CNBC, October 1, 2019

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 The more optimistic response to the unexpectedly poor ISM
Manufacturing number was that manufacturing now only
makes up approximately 12% of the US economy. As can be
seen in the ISM Services chart on the prior page, the much
larger non-manufacturing sector is still expanding, albeit at a
rapidly deteriorating rate.

The problem is that on Thursday, we got the ISM Non-

Manufacturing Report, and it was also below expectations. The
reading was 52.6, which was the lowest in three years. Wall
Street had been expecting 55. Since it’s above 50, we know that
the Non-Manufacturing is still expanding, but it challenges
the theory on Wall Street that the consumer is holding up
the economy while the factory sector is in a recession.

Until this week, it had been popular to believe that the Fed
might not be in such a hurry to cut rates again. They’ve already
done so twice, but would a third be necessary?

The [Federal Open Market Committee] meets again at the end

of this month. At the start of the week, the futures markets
thought there was a 40% chance of a Fed cut in October.
Thanks to this week’s news, the odds of a rate cut are now up to
88%.
- Eddy Elfenbein, CWS Market Review, October 4, 2019

That dramatic shift in market expectations this past week

puts the voting members of the Federal Open Market
Committee (FOMC) in a tough position. When the FOMC cut rates for the first time in a decade earlier this year,
Fed Chair Jerome Powell suggested to markets that the move should be viewed as a mid-cycle adjustment, an
“insurance cut,” intended to cushion the US economy from economic trouble abroad. That sentiment was
echoed following the most recent FOMC meeting when the Fed again cut rates but signaled no further easing in
2019 or 2020 via their “dot plot”, which is a representation of where Fed officials expect short term interest rates
to be at specific points in the future.

As you can see in this chart of the Fed’s

official dot plots over the past year, the
Fed’s rosy assessment of economic
conditions, and therefore their ability to
normalize interest rates, has been steadily
declining. The market’s expectation, as
indicated by Fed Funds futures pricing, is
that the Fed is still way too optimistic and
that rates have considerably further to fall.

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As we have discussed in past letters, President Trump has been insistent that it is the strength of the US Dollar
relative to the currencies of our trading partners, driven by the Fed’s relatively tighter monetary policy, that has
weakened our economy. He has repeatedly called for the Fed to aggressively loosen policy by lowering interest
rates to zero and relaunching quantitative easing, as is being done overseas. This very public, and historically
uncommon political scrutiny has further complicated the Fed’s position as it attempts to extend this already
decade long economic expansion and at the same time maintain its political independence.

“There is no end in sight to this slowdown; the recession risk is real,” said Torston Slok, chief economist at Deutsche
Bank. “The sharp retreat we are seeing on manufacturing confidence is exactly what a recession looks like,” noted
Chris Rupkey at MUFG Union Bank. “Manufacturing weakness is close to dangerous levels,” said FTN Financial’s
Christopher Low…

The central bank already faces something of a credibility problem for not anticipating the strains in the repo market.
Now it looks as if the Fed will have to drop its benchmark rate again, just a month after policy makers’ median
projection called for no more rate cuts through 2020. To reiterate: The median on the “dot plot” not only implied
that interest rates would stay where they are this year but that they would be unlikely to move next year, either.
That’s not to say that forecasts can’t change, but it calls into question the usefulness of the Fed’s forward projections
if they wind up having little to no bearing on what actually happens…

[Fed Chair Jerome] Powell has admitted that the central bank has no playbook for dealing with a prolonged trade
war. So far, his answer has been to drop interest rates time and again. This time might be trickier: He might have
to both announce another cut and reveal that the Fed will increase the size of its balance sheet [to facilitate the proper
functioning of the overnight repo market] just a few months after shrinking it – and avoid spooking markets at the
same time.

- Brian Chappatta, Bloomberg Opinion, October 1, 2019

This morning’s labor statistics were disappointing, showing fewer jobs added and wage growth slower than
expected. This hypothetically should give the Fed sufficient cover to ease at their next meeting, as inflation
expectations are now the lowest they’ve been since just after the surprise outcome of the UK’s Brexit referendum
the summer of 2016. Belying this weaker than expected data, however, was the unemployment rate which was
reported to be just 3.5%, the lowest figure since 1969. With a 50-year low unemployment rate and US stock
indices less than 4% from all-time highs, should the Fed really be expending dry powder by cutting rates for the
third time this year?

The Fed was unable to normalize interest rates as much as they had
hoped, as we saw in the fourth quarter of last year which began with
the Fed insisting it would continue hiking rates and ended with the
Fed having reversed course in response to the equity market tailspin.
Now, having already cut rates twice to stabilize the flagging
economy, one wonders how much firepower the Fed will have
available once we actually tip into recession and the unemployment
rate starts to move in the other direction. Central banks around the
world will be just as ill-prepared should the global economy be dealt
any additional shocks, with more than half already in market-
support mode. We are currently experiencing the highest percentage
of central banks easing since the Great Financial Crisis (GFC).
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US recession indicators are growing stronger and there’s one bigger-than-usual reason why the world should be
worried: China isn’t coming to the rescue this time.

In the past week alone, a gauge of US manufacturing unexpectedly fell to its weakest reading in a decade and payrolls
at private companies grew less than forecast. Economists are starting to wonder whether the US has approached so-
called stall speed, the slowest pace of growth without careening into a recession. The International Monetary Fund,
meanwhile, will likely downgrade global growth estimates this month.

One of the engines that drove a global economic recovery after the last two downdrafts in America – the relatively
shallow one in 2001 and the catastrophe that began in 2007 – was China. As the financial crisis escalated, Beijing
opened a floodgate of credit and cut interest rates, which stoked demand for everything from Australian coal to
German cars.

We’re unlikely to see anything like that this time. Beijing has shown little appetite for another round of massive fiscal
stimulus as it atones for the profligacy of the last decade, which left a massive buildup of debt and fueled asset
bubbles…

China is now recording quarterly economic growth

of about 6%, not the 15% notched in 2007 or the
roughly 10% in 2001…

Not every recession is like 2007, nor are they

always accompanied by a financial collapse. The
next slump, whenever it comes, will still be
painful, so the US might want to start casting
about for an enthusiastic partner. It’s probably a
mistake to expect that’ll be China this time around
– it’s not only less willing, but less able.

- Daniel Moss, Bloomberg, October 3, 2019

The JPMorgan Global Manufacturing PMI rose

marginally to 49.7 in September from 49.5 in
August, marking the fifth consecutive month
below the 50 mark, which indicates a majority of
businesses reporting falling output. The last time
the index was in contraction for such a stretch of
time was in the six months to November 2012…

The data were released as the World Trade

Organization sharply downgraded its forecast for
trade growth in 2019 and 2020. World
merchandise trade volumes are now expected to
rise by only 1.2% in 2019, substantially slower
than the 2.6% growth projected in April.

-Valentina Romei, Financial Times, October 1,

2019

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 We’ve been told that the Fed will do everything in its
power to extend this business cycle and protect the
economy and labor markets, but there is a limit to how
much they can do. There has been much discussion, both
by US policy makers and those abroad, about the need to
transition away from a dependence on monetary policy
and toward globally coordinated fiscal stimulus in the
next downturn. The Trump Administration’s tax reform
of late 2017 did not deliver the bump to economic activity
that was advertised, with both consumers’ and businesses’
contributions to GDP growth falling slightly over the six
quarters since the law went into effect.

There are plenty of potentially stimulative fiscal policies and reforms that have been proposed, not least from
the Democratic presidential primary contenders, but those policy prescriptions are at best 15-18 months away.
In the meantime, with the 2020 presidential election looming large and Congress embroiled in an impeachment
investigation, it is unlikely that a large infrastructure program or other fiscal package can be expected anytime
soon. The most immediate shot in the arm the global economy could receive would be an end to the US-China
trade war, ideally with an across the board reduction or elimination of many of the tariffs that have been
hampering global export flows. Unfortunately, there was bad news on that front this week.

The Trump administration is discussing whether to block Chinese companies from listing shares on American stock
exchanges, the latest push to try to sever economic ties between the United States and China, according to people
familiar with the deliberations.

The internal discussions are in their early stages and no decision is imminent, these people cautioned… but the
prospect of further limiting American investment in China underscores the challenge that the two sides will continue
to face even as they try to de-escalate a trade war that has shaken the global economy. The administration has already
increased scrutiny of foreign investment with a particular eye toward China, including the types of investments that
can be subject to a national security review.

Last week, the Treasury Department unveiled new regulations detailing how a 2018 law, the Foreign Investment
Risk Review Modernization Act, will work to prevent foreign firms from using investments like minority stakes to
capture sensitive American information. And the United States has already blacklisted some Chinese companies,
including Huawei, effectively barring them from doing business with American companies.
- Alan Rappeport & Ana Swanson, New York Times, September 27, 2019

Ray Dalio, the billionaire founder of the world’s biggest hedge fund, said preliminary discussions on limiting US
investments in China make him wonder if the Trump administration is “inching toward bigger moves.”

In a new essay posted on LinkedIn Tuesday, the Bridgewater Associates co-chairman points to the US freezing
Japanese assets and embargoing oil to Japan in the late 1930s and early 1940s as a potential example of how special
emergency powers could be used by the president.

“Regarding the capital and currency wars, the ability of the US president to unilaterally cut off capital flows to China
and also freeze payments on the debts owed to China, and also use sanctions to inhibit non-American financial
transactions with China must be considered as possibilities,” Dalio wrote. “That’s why the proposed step of limiting
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 American portfolio investments in China makes me both think about the implications of this step and wonder if it is
inching toward bigger moves.”

Bloomberg News on Friday reported that Larry Kudlow, the head of President Donald Trump’s National Economic
Council, was leading deliberations inside the White House over what some hawks have labeled a potential “financial
decoupling” of the world’s two largest economies…

Dalio said the news last week “seemed like the most recent logical steps in this classic dangerous journey that is
analogous with that which occurred in the 1935-45 period.”

During those years, as is the case today, America experienced a widening gap between the rich and poor, and
intensifying conflicts between populist politicians on the left and right, Dalio wrote. It was also a time, like now,
when the world’s central banks were limited in their ability to stimulate economies in a downturn and there was a
rising world power challenging the existing one.

“From not having to worry about such things in the past, now all market participants need to worry about them,” he
wrote.
- Peggy Collins, Bloomberg, October 1, 2019

A “financial decoupling” of the world’s two largest economies does not sound like a very positive development
for the global economy and global financial markets. The situation in the world’s third largest economy, the
European Union, does not offer much consolation. Germany, typically the engine of EU economic growth, is
expected to have slipped into recession in the most recent quarter and the likelihood of a no-deal Brexit is
increasing by the day.

In a no-deal scenario, the UK would immediately leave the European Union with no agreement about the “divorce”
process. Overnight, the UK would leave the single market and customs union – arrangements designed to help trade
between the EU members by eliminating checks and tariffs (taxes on imports).

No deal also means immediately leaving the EU institutions such as the European Court of Justice and Europol, its
law enforcement body. Membership of dozens of EU bodies that govern rules on everything from medicines to
trademarks would end…

Under a no-deal Brexit, there would be no time to bring in a UK-EU trade deal… If this happens, tariffs will apply to
most good s that UK businesses send to the EU… No deal would also mean that the UK service industry would lose
its guaranteed access to the EU single market.

That would affect everyone from bankers and lawyers to musicians and chefs.
- BBC News, October 3, 2019

To add insult to injury, the ongoing trade skirmish between the US and the EU is at very serious risk of
intensifying into a full-blown trade war.

The World Trade Organization on Wednesday gave Washington the green light to slap annual tariffs on $7.5 billion
worth of EU goods in retaliation for the bloc’s illegal support of Airbus.

The ruling is the largest arbitration award in WTO history and a landmark moment in the Airbus-Boeing battle, which
threatens to intensify already strained relations between the US and the European Union.

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 The EU immediately threatened to respond to any US
move.

“If the US decides to impose WTO authorized

countermeasures, it will be pushing the EU into a
situation where we will have no other option than do
the same,” Brussels said in a statement.

- Ben Simon, AFP, October 2, 2019

While an imminent recession in the US and

around the globe is not yet a foregone conclusion,
the most historically reliable warning signs are
flashing red. It would be irresponsible of us not
to recommend a defensive portfolio allocation,
with an underweight to equities, particularly in the US where they are by many metrics at the most expensive
valuations ever, and an overweight to safe haven assets such as US Treasuries, precious metals and cash.

Thank you for taking the time to read our thoughts. We would love the opportunity to hear your response;
please do not hesitate to call or email with any questions or concerns.

Sincerely,

Clay Ulman Jim Ulman

CBU@UlmanFinancial.com JWU@UlmanFinancial.com
410-557-7045 ext. 2 410-557-7045 ext.1

*The Standard & Poor’s 500 Index (S&P500) is a capitalization-weighted index of 500 stocks designed to measure
performance of the broad domestic economy through changes in the aggregate market value of the 500 stocks representing
all major industries. The Russell 2000 Index is a small-cap stock market index of the bottom 2,000 stocks in the Russell
3000 Index. Indices such as the S&P 500 Index and the Russell 2000 Index are unmanaged, and investors are not able to
invest directly into any index. Past performance is no guarantee of future results.

Government bonds and Treasury bills are guaranteed by the US government as to the timely payment of principal and
interest and, if held to maturity, offer a fixed rate of return and fixed principal value.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or
recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial
advisor prior to investing. The economic forecasts set forth in the presentation may not develop as predicted and there can
be no guarantee that strategies promoted will be successful.

All indices are unmanaged and cannot be invested into directly. All investing involves risk, including loss of principal.

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