Stocks continued to rally on good economic news. The Dow Jones Industrials fell but only because of a sharp drop in the price of Walgreens Boots Alliance after a very disappointing earnings report. In other headline news, Britain’s Parliament continued to reject compromise bills that would allow it to exit the EU gracefully. Now the government is asking for more time and probably general elections that would lead to a change in leadership. For now the stock market yawns expecting some sort of solution that won’t materially disrupt worldwide economies. The same holds true for President Trump’s threat to close the border to Mexico. It sounds tough and it might get more proactive efforts on Mexico’s part to contain the flow of migrants to our border. But completely closing the border would be much more disruptive to our economy than a 35-day partial shutdown of the government. At the moment, at least, few expect that to happen.
In this relatively quiet time where there isn’t a lot of news, analysts and investors are looking for some hint of change in the wind. But the facts suggest there is little change. China may be stabilizing, removing one major fear for now. Europe is a complete mess, but it also doesn’t seem to be getting any worse. The U.K. seems to be muddling through until it can get its exit from the EU sorted out. Macron is still unpopular in France. And Germany’s export markets remain weak in part because of weak Chinese demand. Relations between Europe and the U.S. remain strained, but even threats of auto tariffs or more spending by the Europeans to support their own defense aren’t making much of a difference. IMF head Christine Lagarde said that world growth forecasts will be lowered next week, but the IMF is behind the curve and any changes aren’t likely to be market moving.
On our shores, the outlook seems to be improving a bit. Q1 growth could be close to 2%, a bit better than earlier expectations. The biggest current concern, besides all the threats out of Washington, are the floods in the Midwest that likely will at least delay spring plantings. It is still a bit early to tell how serious the ultimate damage might be. A lot depends on weather over the next six weeks. Manufacturing data seems to be improving, and there are lots of signs of a pick-up in housing demand along with lower mortgage rates. Consumer spending is restrained, perhaps in part to uncertainty surrounding the level of tax refunds coming this spring. But with record employment and solid real growth in wages, one shouldn’t worry about the consumer too much over the balance of this year.
The basic set of facts that investors have to deal with are as follows:
- Underlying growth is governed by the growth rate of the working class and the rate of productivity improvement. The pace of employment growth is likely to slow as it takes longer to fill job openings in a tight labor environment. As for productivity, in an economy more reliant on services than manufacturing, sustained gains higher than 2% are unlikely. Since the end of the Great Recession, our economy has grown very close to 2%. For all the fuss made by the Trump White House of how we were entering a new sustained growth environment, even a huge tax cut and a massive increase in Federal spending could only get the growth rate to 3% last year. Even that doesn’t seem sustainable. But, as stock investors will attest, 2% growth along with low inflation is a perfectly fine environment for stocks.
- Despite fears that a tight labor market and some growth acceleration would lead to accelerated inflation, there have been few signs of any uptick. As a result, long term bond yields have settled below 3%. As long as that remains the case, stocks can maintain 16-18x P/E ratios and debt service costs for businesses, individuals and government will remain manageable.
- Slow growth brings with it less need to invest in additional manufacturing capacity. As a result, capex can remain subdued leading to higher than normal free cash flow. The tax cuts only expand the level of free cash. That becomes available to pay higher dividends and to reduce market capitalization via stock repurchases. While some liberal progressives are calling for restraints on stock repurchases, it is a horrible idea for government to tell businesses how to allocate their capital. Moreover, even if there were to be legislation restricting the ability to buyback stock, businesses would find other ways to reward owners, including raising dividends further or returning capital in some other form.
While the stock market has experienced some bumps along the road over the past decade (e.g. during the European debt crisis, the crash in oil prices, and U.S. government threats to default on its own debt), the path forward has been generally consistent. 2-3% real growth plus 1.5-2.0% inflation plus a dividend averaging close to 2% yields a growth of 5.5-7.0%. Add another 1-2% from stock repurchases and you come up with a historic growth rate of 7.5-9.0% without taking into consideration any changes in P/E ratios. Furthermore, 7-9% looks particularly attractive compared to 3% or less available from high grade bonds.
One can’t be complacent. First quarter earnings are not going to be very exciting, world politics always threaten to mess things up, and there is always a risk that euphoria will create its own set of problems. The measured response to the Lyft IPO, however, suggests we are nowhere near the euphoria danger zone yet.
Today, Eddie Murphy is 58. Alec Baldwin turns 61. Jane Goodall turns 85. Finally, Doris Day is 97.
James M. Meyer, CFA 610-260-2220