I’ve just updated my Keeping Score page for the end of the stock market “summer.” …continuing S&P 500 strength.
On August 16th, WMT reported very strong 2Q18 earnings (Chrome keeps warning me the Walmart investor web pages aren’t safe to access, so I’m not adding details). Wall Street seems to have taken this result as evidence that the company makeover to become a more effective competitor to Amazon is bearing enough fruit that we should be thinking of a “new,” secular growth WMT.
Maybe that’s right. But I think there’s a simpler, and likely more correct, interpretation.
WMT’s original aim was to provide affordable one-stop shopping to communities with a population of fewer than 250,000. It has since expanded into supermarkets, warehouse stores and, most recently, online sales. Its store footprint is very faint in the affluent Northeast and in southern California, however. And its core audience is not wealthy, standing somewhere below Target and above the dollar stores in terms of customer income.
This demographic has been hurt the worst by the one-two punch of recession and rapid technological change since 2000. My read of the stellar WMT figures is that they show less WMT’s change in structure than that the company’s customers are just now–nine years after the worst of the financial collapse–feeling secure enough to begin spending less cautiously.
This interpretation has three consequences: although Walmart is an extraordinary company, WMT may not be the growth vehicle that 2Q18 might suggest. Other formats, like the dollar stores or even TGT, that cater to a similar demographic may be more interesting. Finally, the idea that recovery is just now reaching the common man both justifies the Fed’s decade-long loose money policy–and suggests that at this point there’s little reason for it not to continue to raise short-term interest rates.
One of Mr. Trump’s first actions as president was to withdraw the US from the Trans-Pacific Partnership, a consortium of world nations seeking, among other things, to halt Chinese theft of intellectual property.
Trump has apparently since discovered that this is a serious issue but has decided that the US will go it alone in addressing it. His approach of choice is to place tariffs on goods imported from China–steel and aluminum to start with–on the idea that the harm done to China by the tax will bring that country to the negotiating table. In what seems to me to be his signature non-sequitur-ish move, Mr. Trump has also placed tariffs on imports of these metals from Canada and from the EU.
This action has prompted the imposition of retaliatory tariffs on imports from the US.
the effect of tariffs
–the industry being “protected’ by tariffs usually raises prices
–if it has inferior products, which is often the case, it also tends to slow its pace of innovation (think: US pickup trucks, some of which still use engine technology from the 1940s)
–some producers will leave the market, meaning fewer choices for consumers; certainly there will be fewer affordable choices
–overall economic growth slows. The relatively small number of people in the protected industry benefit substantially, but the aggregate harm, spread out among the general population, outweighs this–usually by a lot
is there a plan?
If so, Mr. Trump has been unable/unwilling to explain it in a coherent way. In a political sense, it seems to me that his focus is on rewarding participants in sunset industries who form the most solid part of his support–and gaining new potential voters through trade protection of new areas.
Mr. Trump has proposed/threatened to place tariffs on automobile imports into the US. This is a much bigger deal than what he has done to date. How so?
–Yearly new car sales in the US exceed $500 billion in value, for one thing. So tariffs that raise car prices stand to have important and widespread (negative) economic effects.
–For another, automobile manufacturing supply chains are complex: many US-brand vehicles are substantially made outside the US; many foreign-brand vehicles are made mostly domestically.
–In addition, US car makers are all multi-nationals, so they face the risk that any politically-created gains domestically would be offset (or more than offset) by penalties in large growth markets like China. Toyota has already announced that it is putting proposed expansion of its US production, intended for export to China, on hold. It will send cars from Japan instead. [Q: Who is the largest exporter of US-made cars to China? A: BMW –illustrating the potential for unintended effects with automotive tariffs.]
More significant for the long term, the world is in a gradual transition toward electric vehicles. They will likely prove to be especially important in China, the world’s largest car market, which has already prioritized electric vehicles as a way of dealing with its serious air pollution problem.
This is an area where the US is now a world leader. Trade retaliation that would slow domestic development of electric vehicles, or which would prevent export of US-made electric cars to China, could be particularly damaging.
This has already happened once to the US auto industry during the heavily protected 1980s. The enhanced profitability that quotas on imported vehicles created back then induced an atmosphere of complacency. The relative market position of the Big Three deteriorated a lot. During that decade alone, GM lost a quarter of its market share, mostly to foreign brands. Just as bad, the Big Three continued to damage their own brand image by offering a parade of high-cost, low-reliability vehicles. GM has been the poster child for this. It controlled almost half the US car market in 1980; its current market share is about a third of that.
In sum, I think Mr. Trump is playing with fire with his tariff policy. I’m not sure whether he understands just how much long-term damage he may inadvertently do.
stock market implications
One of the quirks of the US stock market is that autos and housing are key industries for the economy but neither has significant representation in the S&P 500–or any other general domestic index, for that matter.
Tariffs applied so far will have little direct negative impact on S&P 500 earnings, although eventually consumer spending will slow a bit. So far, fears about the direction in which Mr. Trump may be taking the country–and the failure of Congress to act as a counterweight–have expressed themselves in two ways. They are:
–currency weakness and
–an emphasis on IT sector in the S&P 500. Within IT, the favorites have been those with the greatest international reach, and those that provide services rather than physical products. My guess is that if auto tariffs are put in place, this trend will intensify. Industrial stocks + specific areas of retaliation will, I think, join the areas to be avoided.
Of course, intended or not (I think “not”), this drag on growth would be coming after a supercharging of domestic growth through an unfunded tax cut. This arguably means that the eventual train wreck being orchestrated by Mr. Trump will be too far down the line to be discounted in stock prices right away.
I’m taking off my hat as an American and putting on my hat as an investor for this post.
That is, I’m putting aside questions like whether the Trump agenda forms a coherent whole, whether Mr. Trump understands much/any of what he’s doing, whether Trump is implementing policies whispered in his ear by backers in the shadows–and why congressmen of both parties have been little more than rubber stamps for his proposals.
My main concern is the effect of his economic policies on stocks.
the tax cut
The top corporate tax rate was reduced from 35% to 21% late last year. In addition, the wealthiest individuals received tax breaks, a continuation of the “trickle down” economics that has been the mainstay of Washington tax policy since the 1980s.
The new 21% rate is about average for the rest of the world. This suggests that US corporations will no longer see much advantage in reincorporating abroad in low-tax jurisdictions. The evidence so far is that they are also dismantling the elaborate tax avoidance schemes they have created by holding their intellectual property, and recognizing most of their profits, in foreign low-tax jurisdictions. (An aside: this should have a positive effect on the trade deficit since we are now recognizing the value of American IP as part of the cost of goods made by American companies overseas (think: smartphones.)
My view is that this development was fully discounted in share prices last year.
The original idea was that tax reform would also encompass tax simplification–the elimination of at least part of the rats nest of special interest tax breaks that plagues the federal tax code. It’s conceivable that Mr. Trump could have used his enormous power over the majority Republican Party to achieve this laudable goal. But he seems to have made no effort to do so.
Two important consequences of this last:
–the tax cut is a beg reduction in government income, meaning that it is a strong stimulus to economic activity. That would have been extremely useful, say, nine years ago, but at full employment and above-trend growth, it puts the US at risk of overheating.
–who pays for this? The bill’s proponents claim that the tax cut will pay for itself through higher growth. The more likely outcome as things stand now, I think, is that Millennials will inherit a country with a least a trillion dollars more in sovereign debt than would otherwise be the case.
One positive consequence of the untimely fiscal stimulus is that it makes room for the Fed to remove its monetary stimulus (it now has rates at least 100 basis points lower than they should be) faster, and with greater confidence that will do no harm.
Two complications: Mr. Trump has begun to jawbone the Fed not to do this, apparently thinking a supercharged, unstable economy will be to his advantage. Also, higher rates raise the cost of borrowing to fund a higher government budget deficit + burgeoning government debt.
Tomorrow: the messy trade arena
I’ve just updated my Keeping Score page for a surprisingly strong (to me, anyway) July. Sector rotation is the main message.
I’ve just updated my Keeping Score page for S&P 500 performance in June, 2Q18 and year to date.
Modern economics has been founded in study of what caused the Great Depression of the 1930s, with an eye to preventing a recurrence of this devastating period. We know very clearly that tariffs and quotas are, generally speaking, bad things. They reduce overall economic activity in the countries that apply them. Yes, politically favored industries do often get a benefit, but the cost to everybody else is many times larger. We also know that the use of tariffs and quotas can snowball into a storm of retaliation and counter-retaliation that can do widespread damage for a long time.
My point is that it’s inconceivable that high-ranking public officials in Washington don’t know this.
HOG motorcycles are Baby Boomer counterculture icon. The company’s traditional domestic male customer base is aging, however, and losing the strength and sense of balance required to operate these heavy machines. At the same time, HOG has had difficulty in attracting younger customers, or women or minority groups to its offerings. So it’s an economically more fragile firm, I think, than the consensus realizes.
HOG has been damaged to some degree by the Trump tariffs on aluminum and steel, which are important raw materials. (As I understand them, the tariffs are ostensibly to address Chinese theft of US intellectual property, although they are being levied principally against Japan and the EU. ???)
Completely predictably, the EU is retaliating against the tariffs. In particular, it is levying its own 25% tariff on HOG motorcycles imported from the US. This affects about 20% of Harley’s output. HOG says the levy will cost it $100 million a year in lost income, implying that all of the EU-bound Harleys are now made in the US. HOGs response is to shift production targeted for the EU to its overseas plants. My guess is that this will take 1000+ jobs out of the US.
In contrast to the job loss from this one company, public reports indicate the total job gain from the steel/aluminum tariffs to be about 800 workers being recalled to previously idle steel/aluminum plants.
Mr. Trump’s response to the HOG announcement was to threaten punitive tariffs on any imports of foreign-made Harleys–a move that could threaten the viability of HOG’s network of around 700 independent dealerships. 7000 jobs at risk?
The stock market declined sharply on the day of the HOG announcement. I think that’s because the HOG story is a shorthand illustration of how tariffs, and quotas, cause net losses to the country as a whole, although they may bring benefits to a politically favored few.
A second negative effect of trade protection is a long-term one. My experience is that most often the protected industry, relieved of immediate competitive pressure, ceases to evolve. After a few years, consumers become willing to pay the increased price to get a (better) imported product. In my mind, General Motors is the poster child for this.
Stock market implications? …avoid Industrials. The obvious beneficiary of Washington’s ill-thought out trade policy is IT. For the moment, however, I think that this group is expensive enough that Consumer Discretionary and Energy are better areas to pick through.