I’ve just updated my Keeping Score page for February 2019.
In an opinion piece in the Financial Times a few days ago, Gillian Tett points to and expands on a comment in a Wall Street advisory committee letter to the Treasury Secretary. Although it may not have implications for financial markets today or tomorrow, it’s still worth keeping in mind, I think.
The comment concerns the changes in the income tax code the administration pushed through Congress in late 2017. Touted as “reform,” the tax bill is such only because it brings down the top domestic corporate tax rate from 35%, the highest in the world, to about average at 21%. This reduces the incentive for US-based multinationals (think: drug company “inversions”) to recognize profits abroad. But special interest tax breaks remained untouched, and tax reductions for the ultra-wealthy were tossed in for good measure. Because of this, the legislation results in a substantial reduction in tax money coming in to Uncle Sam.
Ms. Tett underlines the worry that there are no obvious buyers for the trillions of dollars in Treasury bonds that the government will have to issue over the coming years to cover the deficit the tax bill has created.
A generation ago Japan was an avid buyer of US government debt, but its economy has been dormant for a quarter-century. Over the past twenty years, China has taken up the baton, as it placed the fruits of its trade surplus in US Treasuries. But Washington is aggressively seeking to reduce the trade deficit with China; the Chinese economy, too, is starting to plateau; and Beijing, whatever its reasons, has already been trimming its Treasury holdings for some time.
Who’s left to absorb the extra supply that’s on the way? …US individuals and companies.
The obvious question is whether domestic buyers have a large enough appetite to soak up the increasing issue of Treasuries. No one really knows.
Three additional observations (by me):
–the standard (and absolutely correct, in my view) analysis of deficit spending is that it isn’t free. It is, in effect, a bill that’s passed along to be paid by future generations of Americans–diminishing the quality of life of Millennials while enhancing that of the top 0.1% of Boomers
–historically, domestic holders have been much more sensitive than foreign holders to creditworthiness-threatening developments from Washington like the Trump tax bill, and
–while foreign displeasure might be expressed mostly in currency weakness, and therefore be mostly invisible to dollar-oriented holders, domestic unhappiness would be reflected mostly in an increase in yields. And that would immediately trigger stock market weakness. If I’m correct, the decline in domestic financial markets what Washington folly would trigger implies that Washington would be on a much shorter leash than it is now.
I’ve updated my Keeping Score page for January’s movement in the S&P 500.
issues for the S&P 500 in 2019:
–about half the earnings of the S&P come from outside the US. For 2019, that’s not a good thing, since China is slowing down (more tomorrow) and the UK’s ham-fisted approach to Brexit is stalling business activity in the EU
–in the US,
—-last year’s corporate tax cut is no longer a source of year-on-year aftertax earnings growth
—-tariffs continue in place. Tariffs redistribute, but in the aggregate also slow, economic growth. The current ones are designed to shift economic energy toward sunset (often private) industries and away from ones with better prospects. Some, like those on steel and aluminum, appear arbitrary, adding a layer of uncertainty to the whole process
—-the government shutdown is already pushing the US economy from a plodding advance into reverse, according to White House economists. The central issue is a border wall, which, if news reports are correct, was originally intended only as a memory aid for a candidate who couldn’t remember his key policy positions very well
—-the lack of sensible–or even coherent–economic strategy from Washington is making corporations accelerate domestic restructuring plans and to question future investment in the country. The administration’s hostility to admitting highly skilled foreign workers based on their religion/ethnicity is making the shift of r&d activity across the border to Canada an easy decision
In short, an embarrassing parade in Washington of own goals/self-inflicted wounds.
where to look for growth
The business cycle isn’t going to be much help. In times like this, the defensive sectors–utilities and telecom, and, to a lesser extent healthcare and consumer discretionary–typically come to the fore. But utilities + traditional telephone now amount to much less than 10% of the S&P. More important, both areas are in the throes of fundamental alteration that is damaging to incumbents. This leaves us with healthcare and consumer discretionary.
In both these areas, I think it’s important not to implicitly take a business cycle approach. A key factor here is Millennials vs. Baby Boomers.
In very rough terms, a Baby Boomer earns about twice what a Millennial does. But Millennials are entering a period of rapid growth in wages. In contrast, as Boomers retire, their incomes are typically cut in half. It seems to me that in all consumer areas it’s important to concentrate on firms that serve mostly Millennials, and avoid those (department stores are an easy example) that serve mostly Boomers, no matter what the level of current profits is.
My personal belief is that Americans don’t approve of making money from others’ illnesses. That’s the simplest reason (there are others) I can give for avoiding hospitals or nursing care or other healthcare service providers. But the premise of no business cycle help implies as well looking for smaller, more innovative, say, medical treatment development, firms …early-stage companies with the potential for explosive growth.
In the tech area–a more business cycle-sensitive area than healthcare–I think seeking out smaller, more innovative firms is also the way to go (but I always say this). In a so-so economy these should continue to prosper. The big risk is that they would likely be hurt very badly if the administration continues to add to the damage to the domestic economy that it is already doing.
the Employment Situation
The Bureau of Labor Statistics made its monthly Employment Situation report this morning: +312,000 new jobs, +58,000 upward revision to the prior two months’ data, annual wage gains of an inflation-beating +3.2%. Yes, it’s just one month and, yes, the margin of error is +/- 100,000 jobs, but it’s still a very strong report, indicating a robust domestic economy.
Despite this show of employment strength, the stock market has been on a sharply downward path since late September. What is the market thinking/anticipating?
–the 10-year Treasury, which was yielding 3.22% in late September now yields 2.56%; the middle of the yield curve is now mildly inverted. This suggests bond buyers believe a marked slowdown in economic activity in the US is in the offing–one that will force the Fed to soon begin to lower short-term interest rates again. Why would that be?
–the Trump tariff war with the rest of the world seems to be affecting publicly traded companies much more negatively than one might have imagined
–only about half the earnings of the S&P 500 come from the US. Both the EU, dealing with Brexit and Italy, and China are slowing down
–some pundits argue from the bond market situation that the Fed is the problem, having –they think–raised short-term interest rates too far.
Two pieces of data from yesterday seem, on the surface at least, to reinforce the sharp slowdown narrative: Apple (AAPL) and business investment activity.
–AAPL announced Wednesday night that its December quarter revenues would be about 8% below the midpoint of the guidance it gave in October. What makes this significant, besides AAPL’s size, is that the company rarely misses its quarterly estimates.
Two reasons given: falloff in sales in “greater China” and slower than expected takeup of the newest generation of iPhones by existing customers (the smartphone market is completely saturated–there are no more “new” customers). Neither reason is clearly a sign of broad-based consumer distress, however.
AAPL recently said it would no longer reveal unit sales of its smartphones, a decision I take to mean it intends to make revenue gains through price increases rather than unit volume gains. Is the slowdown in replacement demand caused by economic weakness or AAPL pricing new phones so high that other, cheaper phones are suddenly more attractive?
Also, the latest issue of Foreign Affairs reports that popular sentiment in China has turned sharply against the US in the past half year or so as Washington initiated its tariff war. Maybe, in addition to higher prices, flaunting the newest iPhone is no longer as culturally acceptable in China (think: the century of humiliation), as having a home-grown product.
–the Institute for Supply Management issued its monthly report on US manufacturing activity yesterday. It shows a continuing slowdown in industrial activity. The reason most often cited in survey respondents’ comments is the administration’s tariff war. Manufacturers are, predictably, shifting production out of the US to avoid import tariffs on raw materials and export tariffs on finished goods.
It’s important to remember, too, that manufacturing is not the key to US economic strength that it was a generation or two ago. Spending on software is the largest investment item for most service companies. Yes, this activity is also being shifted abroad as the administration makes it more difficult for foreign-born computer scientists to work in the US. But I don’t think the ISP report is “new” news, so I’m not sure why it had such a negative effect on the market yesterday.
In the short term, figuring out the root cause of the worries about the US economy is probably less important than trying to gauge how far along in the selling we are now. Better to figure out when the storm will be over than debate the direction of the wind. My guess–and it may be more of a hope–is that we made the lows on Christmas Eve when stocks broke decisively through the February 2018 lows.
Personally, I think the ultimate problem is Washington and the tariffs, not the Fed. I’m all for protecting US intellectual property, but the levies on, say, steel and aluminum seem so arbitrary and generally harmful. In a way, it would be a lot better if the Fed is the issue, since then the problem would be a familiar one, the market situation clearer and the fix relatively easy.
I see four main issues, which–now that I’m on semester break–I’m planning to write about over the next few days. They are:
—machines vs. humans. This is the question of increased short-term volatility. How do we cope with the apparently mad dashes in and out of the market by trading robots using, by historical standards, half-baked trading algorithms?
—decelerating earnings growth. EPS growth in 2018 for publicly traded companies was around +20%. Increases for 2019 will likely come in at +8% – +10%. This kind of sharp falloff is normally a bad sign for stock prices. In the current case, however, the 2018 EPS surge is only in after-tax earnings and is due mostly to the one-time decrease in the Federal corporate tax rate from 35% to 21% that went into effect last year. Pre-tax earnings grew at a much more sedate rate of around 10%, I think. While the 2019 situation isn’t wildly positive, it would seem to me to imply a flattish market where the investor’s job is to identify areas of potential strength to buy and areas of potential weakness to avoid.
But is this the way algorithms will operate?
—the business cycle and interest rates. Typically, the Fed raises short-term rates when it perceives the economy is overheating. Higher rates make bonds less attractive. They make other financial instruments, like stocks, less attractive, too. But the negative effect of higher rates is offset by surging earnings growth. Is +10% enough to do the job in 2019?
–tariffs. (A side note first: it seems to me the Trump administration argument that it can usurp Congress’s power to set trade policy because everything economic is a matter of national security is ludicrous. Not a peep from Congress, though. To me, this implies that Mr. Trump is simply the spokesmodel for policies the forces in Congress want enacted but don’t want to be held responsible for.)
Tariffs have, at best, a checkered history. They invite retaliation. They have unforeseen/ unintended negative effects: Apple’s preannouncement of weaker than expected results in its current quarter may only be the first. In addition, the rapid and seemingly arbitrary way tariffs have been enacted in the US has already given both domestic and foreign corporates pause about expanding operations here. One thing is certain, though –tariffs slow economic growth. The question is by how much and for how long.
—the independence of the Federal Reserve. By conventional measures, there’s still too much money sloshing around in the US. So there’s every reason for the Fed to continue to shrink its bloated balance sheet and to slowly raise short-term interest rates (the specter of Japan’s three decades of stagnation–resulting in large measure from saveral bouts of premature policy tightening–continues to be a cautionary tale against moving too quickly). Because of this, Mr. Trump’s musing about firing Jerome Powell has a distinctly Nixonian ring to it, conjuring up echoes of the runaway inflation and currency collapse in the US of the 1970s. From a stock market point of view, threatening the Fed may be the single most damaging thing Mr. Trump has done so far.
More details over the next few days.
I’ve just updated my Keeping Score page for full-year 2018, 4Q18 and the month of December. Uglier than I’d imagined it could be. Where to from here?