June 28, 2017

Stocks fell, led by the NASDAQ which dropped by close to 2%. Economic data continues weak, interest rates rose following sharp increases overnight in Europe, the Senate Republicans failed in an effort to move healthcare reform to the floor of the Senate, and the FANG stocks took a beating after getting close to their recent highs, but failing to push through.

Let’s examine each factor a little more closely. Whether it be retail sales, oil prices, capital spending, auto sales or housing demand, the economic numbers are coming through generally short of expectations. It now appears that Q2 GDP growth may not be much greater than 1%. This is a bit disconcerting given weakness in the first quarter and improving economies overseas. Part of the modest shortfall can be laid on the inability of the Trump administration and Congress to make any meaningful progress on the legislative front. While the rollback of regulations is beginning and starting to have some impact, companies are holding back on major investments until managements gain a clearer picture of what lies ahead, particularly related to taxes. Meanwhile, overseas, thanks to ongoing easy money, growth in Europe and Japan is improving. The widening disparity evidences itself through dollar weakness against both the euro and the yen.

The strength overseas has also started to show in rising bond yields in Europe. There was a particularly strong move upward in rates yesterday after ECB head Mario Draghi pointed to stronger growth without any signs, at least yet, of rising inflation. As a result, the ECB plans to stay on course and continue to be highly accommodative, although Mr. Draghi hints that tapering of the monetary expansion process may not be far away. Rates are rising again this morning. While rates in this country didn’t move up as sharply as they did in Europe, they did respond and are moving higher in early trading today.

Although oil rallied slightly yesterday, it remains in a serious downtrend and in its own bear market. The reasons are both stark and obvious. We are at seasonal peak demand with only modest drawdowns in inventories. With demand in the U.S. likely to fall by 2 million barrels per day between now and September as production continues to rise, the table is set for further declines in prices. Despite the recent drop, rig counts and drilling activity have continued to increase. While both may peak soon, the damage has been done. OPEC talks about the possibility for further production cuts but, so far, only Saudi Arabia and Russia (not even an OPEC member) have purposefully cut production in a meaningful way. OPEC members that were exempt from the first rounds of cuts, namely Libya and Nigeria, have both had significant production increases. Iran and Iraq are also rebuilding after sanctions were lifted and war subsided. Historically, oil prices peak around Memorial Day and bottom around Thanksgiving. I wouldn’t be surprised to see gasoline prices below $2.00 by Thanksgiving. Lower prices may give some of us more discretionary spending power, but we learned the last time oil prices fell sharply that the combination of lower profits in the oil patch and less absolute dollars spent at retail (including gasoline) weren’t positive for the economy.

That brings me back to healthcare. Mr. Trump’s campaign theme was that Obamacare was a “disaster” and that he was going to fix it, part of his broad plan to make America great again. At the same time, Republicans wanted to repeal the tax increases put into place when Obamacare was passed, and use the opportunity to begin to rein in entitlement spending. While both are admirable goals, cutting taxes and entitlements don’t solve the flaws of Obamacare. To be fair, there are some initiatives in the current bill to entice competition that could lower prices. The CBO’s scoring of the Republican plan reduces the number of insureds by more than 20 million and cuts Medicaid by over $1 trillion over 10 years. While it didn’t make the same headlines, the CBO did note that rates would begin to come down over time as well, thanks to the creation of high risk pools and the elimination of the requirement that all policies look the same. It also allowed those who were healthy to opt out without a tax penalty. That is an important reason that so many fewer would be insured under the Republican plan. The decline is not completely related to the fact that some will be priced out of the marketplace.

So far, Republicans are losing the media battle, and whether you like the media or not, it does hold significant sway. The focus so far is on the huge premium increases for the frail elderly and not on lower costs to others. The Republicans need to do better messaging than they have so far if they are going to get this done.

The math is hard. There are 52 Republicans. No Democrat is going to support the bill. President Trump can label the Dems obstructionists all he wants, but they weren’t invited to the table to create this legislation and have been allowed no say. It probably wouldn’t have made a big difference anyway. Obamacare was the former President’s signature legislation and Democrats don’t want to see it repealed. Period. Of the 52 Republicans, it appears one, Senator Rand Paul of Kentucky, wants repeal without replacement and is steadfast in that belief. It is doubtful he will be swayed otherwise. That leaves the party with the awesome task of keeping 50 of the remaining 51 in line. In politics, votes can be swayed with promises to support pet projects or to make changes directionally that could make recalcitrant Senators content. However, in this case, there is opposition from both the very conservative members and the moderates. That means making the bill more conservative risks losing moderate support and vice versa. Majority Leader McConnell is as smart a politician as there is, and I wouldn’t bet against him very often. But, realistically, he has about 2-3 weeks to get this done, and there are now 12 Republican Senators who say they cannot support the bill in its current form. As you remember, the House failed to get a floor vote the first time around, and then ultimately passed a bill. Perhaps the Senate can do the same. But the math is a lot trickier now.

Should the bill fail, Republicans are left with several options. But the first task, after the August recess, is to get budgets, appropriations, and debt ceiling legislation done to keep the government running after September. While most suggest that should they fail to get healthcare reform passed, Republicans will then pivot to taxes, but they ignore an important factor relative to Obamacare. President Trump states that he will step back, allow Obamacare to implode, and blame the Democrats for the failings, but that isn’t the way it will play out. Republicans chose to usurp the health care debate, and they now own it whether their reform bill passes or not. One of the reasons it is important to tackle healthcare legislation now is that insurance companies soon need to roll out new 2018 policies. These policies must conform to current law and are subject to state approvals before they can reach the market no later than October in time for the annual enrollment period. Unless the Republicans can write a new law, Obamacare is the law of the land. If that remains the case, more and more insurance companies are going to back away from offering individual coverage through the exchanges, and those that stay are going to hike rates significantly as adverse selection continues to wreak havoc with the actuarial process.

President Trump may choose to point fingers at the Democrats for the flaws of Obamacare, but affected Americans are going to demand that he and a Republican Congress fix them. The end result will probably be a bipartisan negotiation to modify rules in a way that will either encourage insurance companies to offer modified policies that don’t create losses, or head toward a one-payer system with the government basically underwriting all insurance written by the exchanges. Clearly, the Republicans don’t want to go in that direction. Thus, what is most likely are some modifications made to (1) allow younger healthy Americans to either opt out or to buy a cheaper bare bones plan, (2) create high risk pools for those who are frail, poor and elderly, and (3) give insurance companies more latitude to design policies that meet market needs. Democrats recognize that Obamacare has flaws that need fixing. But they don’t want the plan obliterated. If Republicans can’t repeal and replace it with what they believe is a better plan, the minimum is that they should work across the aisle to fix the most flagrant flaws in the current plan. In that way, all sides can take a step forward, and then move on to tax reform where there might even be some common ground.

As for markets today, remember my two-day rule. Yesterday was nasty. But if today isn’t a repeat, the bulls are still in charge. The key to watch is the performance of the FANG stocks. Alphabet#, in particular, took a big hit yesterday after the EU fined it almost $3 billion for non-competitive practices. More importantly, Google will be required to change how it displays search results, no longer being able to favor its ad sponsors as it does now. That may hurt the value of the ads and hit Google’s top and bottom line. Historically, these events seem worse when they happen, but corporate ingenuity has a way of lessening the pain long term. With that said, if the FANG stocks were to fall another 2-5% today, that would be worrisome. On the other hand, if they stabilize, they remain in a trading range with the low end being where they traded down to a month ago in a similar one-day hiccup, and the top being recent highs.

Today, Elon Musk is 46. John Elway is 57. Mel Brooks turns 91.

James M. Meyer, CFA 610-260-2220

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