Stocks staged a solid rally on Friday led by financials, reacting to solid earnings from JPMorgan Chase# and others, and by energy stocks, reacting to an announced takeover of Anadarko Petroleum by Chevron#. In addition, Disney#, a Dow component, made a well received presentation of its new planned over-the-top streaming channel that will begin service in November.
This morning, the news is relatively quiet. Earnings season heats up this week, but Monday mornings are usually quiet. Goldman Sachs and Citigroup both reported earnings that were roughly in line with expectations. Given the market’s strength on Friday, we could see a bit of a pause this morning, but the tone for the week will be set by key earnings reports to come including names like IBM#, Netflix, Johnson & Johnson#, Honeywell#, and a host of regional banks. Next week and the week after will be the heart of earnings season. Expectations at the moment are for relatively flat earnings compared to a year ago. While U.S. GDP is still growing, Europe is barely in the black and China has been slowing. The biggest headwind will be the translation impact of foreign earnings related to the strong dollar. That pressure will be most extreme in the first quarter.
As I pointed out last week, our economy appears to be on very steady footing with moderate growth of 2-3%, low inflation, and a steady currency. President Trump chooses to blame the Federal Reserve for not being more accommodative. Forcing interest rates lower or expanding the balance sheet further is not a step central banks normally take with a stable, moderately growing economy. The net benefit of the President’s tax cuts does not appear to be a sustained 3-4% growth in part due to two factors. The first is tariffs. The Fed didn’t raise tariffs across the board over the past year; the President did. As I noted, the intent of certain tariffs, notably those on imported steel and aluminum, simply haven’t demonstrated themselves through a surge in profits in those industries. While it did cause some increase in production, at least initially, the increases also served to cut demand. The net result has been lower prices and lower profits. Tariffs are both a tax and an artificial interference in the supply and demand equation.
The second barrier to growth has been the lack of an expected surge in capital spending. First, in terms of bricks and mortar investing, our nation still has adequate excess capacity. Thus, most capex today is going toward technology investments to lower costs and/or improve productivity. Indeed, productivity is rising and approaching 2%. Given the growth slowdown in the first quarter, productivity may actually slide back a bit before moving higher.
Another factor putting pressure on capital spending growth is the uncertainties related to Washington’s economic policy. While lower taxes are helping, there are some quirks in the new law that actually disincentivize companies from spending capex dollars here rather than overseas. Congress can make the appropriate fixes but partisanship stands in the way. While there is a trickle of bipartisan legislation working its way through Congress, for the most part, the White House is not in active conversation with Democratic leadership. Instead, it spends its time berating the Federal Reserve, which isn’t going to accomplish anything, and spending its energy on other issues, like immigration and border security.
Sustaining productivity growth over 2% is hard. From a government standpoint, it requires coordinated policy, interaction with industry, and long term incentives given that returns on capital spending are long term in nature. That is not to say that the current economic situation is unhealthy. The opposite is quite true. We are probably at the low point for growth in 2019 and inflation remains at bay. Interest rates are beginning to creep back up reversing what was probably an overreaction to the Fed’s dovish approach in January.
One way growth might surprise on the upside is if Congress and the White House collectively decide to repeat the explosive expansion of Federal spending it did last year. Many believe governments can steer growth to almost any level but, in fact, short of major moves, it is natural economic forces that determine GDP growth and inflation. The three levers government does have are monetary policy, taxes and government spending. Last year, the tax cut triggered some increase in growth but, since most of the cuts went to business, the impact was muted. Business took the added money and added some to investment, some to stock buybacks and some to dividends. There is a bit of trickle down impact to the latter two but nothing like the impact of an old fashioned tax cut to lower and middle classes. The Fed is likely to stay on hold for some time and is now in a neutral gear. Thus, from here forward, the Fed shouldn’t be a significant factor raising or lowering GDP growth. That leaves government spending. Congress, over the next six months, is going to have to authorize fiscal 2020 spending programs. Both sides of the aisle will profess fiscal conservatism. But if history is any guide, both sides will then start spending like drunken sailors. That is exactly what happened last year. The net result was a significant expansion of the annual deficit and a boost to 2018 GDP.
But with gross Federal debt now approaching $24 trillion and already scheduled to rise by over $1 trillion per year, more spending and an even faster growth in our national debt would be dangerous. The danger might not show today but, for instance, if we simply stay on the present course and rates stay as low as they are today, interest on our national debt will exceed the entire defense budget within 5 years. Should interest rates rise even moderately, the net interest burden will exceed all discretionary spending. While there are some who believe the deficit is irrelevant because the government can print money need to go back and read appropriate histories, whether it be the Confederate government of civil war times or Germany post-World War I. Simply stated, debt levels don’t matter until they matter. We are nearing a point where enough members of both sides of the aisle understand the limits and risks of too much spending and too much debt.
As a result, what you see is what you get; moderate growth and low inflation. That doesn’t mean we live in a risk-free world. China’s growth rate and debt levels are both important factors to watch. The migrant issues plaguing Europe in recent years suggest paying attention here to how the situation on our southern border plays out, not so much for its direct economic impact, but for its impact on future political choices. Last year, tariffs were President Trump’s key economic priority. After a lot of threats, he implemented some and backed off on others. This year, his main focus is on border protection and the migrants from Central America. Congress is unlikely to help untangle the situation. In some ways, Mr. Trump’s tough stance is accelerating the flow of migrants to our border. At best, this plays out as an economic distraction; at worst, it alters policy and the economic playbook in ways no one sees at the moment.
But with those red herring risks aside, the path for the economy looks to be both smooth and comforting. As long as stocks don’t move too far too fast, investors should enjoy a solid year.
Today, Seth Rogen is 37. Country singer Chris Stapleton is 41.
James M. Meyer, CFA 610-260-2220