January 12, 2017

Stocks resumed their rally yesterday, as bond yields receded.  Two big banks, JPMorgan Chase and Wells Fargo, reported earnings this morning that seemed positive, at least according to the headlines.  Both stocks, however, are lower in pre-market trading, suggesting that perhaps equities are priced to perfection in front of earnings calls.  We can draw much better conclusions over the next couple of weeks.  In the meantime, while we and others might speculate at problems that could lie ahead and derail this rally, the skies overhead remain clear with virtually all nations around the world enjoying better growth rates with few signs of increased inflation.  Until facts replace speculation and storm clouds begin to form, the path of least resistance continues to be higher.  That is not to say that the pace of gains we have seen over the past two weeks will continue uninterrupted.  But it does mean simply waiting on the sidelines for an imminent 10% correction could leave you waiting a lot longer than you might expect.

One of President Trump’s great themes, within the context of his Make America Great Again campaign, is to make us a “winner” in every one-on-one trading relationship.  At least in his mind, he seems to measure winning by the ability to achieve a positive trade balance.  Obviously, that can’t be achieved universally.  The huge trade deficit we have with China isn’t going to disappear overnight, and Trump can’t bully China the way he tries to do with Mexico.  Nor are we going to have a positive trade balance with the oil producing nations that supply refineries along the East Coast.  Trump has often said in speeches that his goal in every negotiation is to put America first.  Simultaneously, he has criticized almost every existing trade agreement as some form of awful.  Trump can do better each and every time, at least in his own mind.  He almost immediately backed out of the Trans Pacific Partnership (TPP) upon taking office and he threatens to pull out of NAFTA if Mexico and Canada don’t capitulate to his wishes.

All this doesn’t just apply to trade.  This past week the President has threatened to cut most aid to Pakistan unless they behave more in line with our wishes along the Afghanistan border.  He even canceled a trip to London, allegedly because he believes our new embassy is a step down from before.  That is not how to make America great again.  There might be other reasons to cancel the trip, but I will ignore them for the moment as they are irrelevant to the economic point I am about to make.

Browbeating weaker foes was a trademark Trump tactic used again and again when he was a real estate developer.  Sometimes it worked; sometimes he had to go to court to settle differences.  Rarely did he cave in.  It was natural that he would try the same thing as President.  These tactics might even work if the adversary lacked alternative options.  America may be the greatest power on the planet, but it isn’t the only one, and the gap between the U.S. and China, for example, is closing.  When we backed out of TPP, nations along the Pacific Rim did two things, both natural and obvious.  First, they continued to proceed with a broad trade partnership among themselves.  It would have been better and bolder to include the U.S., but if America doesn’t want to trade, that doesn’t preclude the rest from trading among themselves.  Second, they went to China and invited the Chinese into the discussion.  Of course, China is also a Pacific rim nation.   While no agreement has been finalized yet, what is happening is that China is gaining influence as we step back.

The same applies to Pakistan.  Not only have we backed away from Pakistan, we have aligned ourselves closer to India, Pakistan’s true mortal enemy.  Even though Pakistan is a nuclear power, it is not a big economic power.  It needs outside support.  So, as we back away from a few billion in aid and infrastructure development, China more than fills the gap, helping fund over $60 billion in infrastructure.  Indeed, China and to a lesser extent Russia, and even Iran stand ready to fill the voids we leave behind.

One way to eliminate trade deficits is to stop trading with any nation that sells us more than we sell them.  That’s a rather simplistic and dumb approach, and I am not suggesting that is being pursued anywhere to that extreme.   But understand the math, because directionally, we threaten to move down that path.  If the U.S. sells country XYZ $60 billion in goods but buys $80 billion, there is a $20 billion gap which reduces GDP by the same amount.   But the $60 billion we sell also goes into the GDP calculation.  Thus, in my simple example, trade with XYZ adds $40 billion to GDP.  If trade goes to zero, nothing is added.  Obviously, the first example with a deficit provides a better outcome not only to the U.S., but to our trading partner.   Clearly, I nor anyone else is against trying to negotiate better terms that will reduce future trade deficits, raise GDP and create more U.S. jobs.  That’s what all these rounds of NAFTA trade talks are all about.  Perhaps the threat to pullout is just a Trump negotiating tactic.  We will see.   He has certainly been non-conventional to date with some success.  But the Trump team needs to understand two key points.  First, China, Russia and others are on the sidelines, willing and able to fill any void we create.  Second, businesses plan for the long term and they hate uncertainty.  On one hand, the President wants more businesses to locate in the U.S.  In large part, that is what the corporate tax rate cut was all about.  But businesses have to operate under a set of rules, and until that rulebook is printed in ink, investment decisions will be delayed.  That is going to be particularly true for companies that operate near our northern and southern borders.  A lot of the benefit of tax reform can be wiped out by mishandling trade agreements.  The trade balance matters, but the volume of trade matters more.  Business isn’t always, I win; you lose.  Properly designed good agreements allow both sides to benefit.   If, for instance, American actions push Mexico toward economic chaos, drug trafficking and illegal border crossings will increase, wall or no wall (and if there is to be a wall, it isn’t going to be there for several more years even if it is funded tomorrow).

Next week, Congress needs to pass a spending bill to fund the government for the rest of the fiscal year to September 30, or more likely, pass yet again a continuing resolution covering a much shorter period of time.  The DACA situation gets tied into this and could muddy the waters.  Congress usually goes to the last minute before passing an extension.  Neither political party wants to be blamed for shutting the government down.  But this time the rhetoric is heating up more than normal.  Trump’s crude quote yesterday doesn’t help, nor does his stubborn insistence on wall funding.  Political brinksmanship is normal under any Presidency, but Trump’s tactics raise it to another level.  Needless to say, any elongated shutdown wouldn’t help the economy.  While I don’t expect that to happen, things like this threaten to interrupt Wall Street’s party.

But the dominant theme of the next two weeks will be earnings, and they are going to be good, in many cases very good.  So, while the noise from Washington may serve to be an irritant today and potentially trouble down the road, the focus for the next two weeks will be on earnings.   Enjoy the party.

Today, Jeff Bezos is 54.  Howard Stern is 64.  Rush Limbaugh turns 67.  Hard to believe those three have the same astrological sign.

James M. Meyer, CFA 610-260-2220

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