Stocks gave back a bit of the gains achieved late last week as interest rates began to slip again. There was no significant economic news. Dow component Home Depot# reported solid results and the stock rose smartly. Without Home Depot, the market’s losses would have looked quite a bit worse. This morning, however, continued good earnings reports, this time from Lowe’s and Target, are pushing the futures back higher. Interest rates have stabilized once again, although they are not far from recent lows.
Speaking of interest rates and that over-discussed 2-10 yield curve inversion that happened last week for about two hours, let me posit a question. What world would you rather live in, the one that has 2-year yields of 1.52% and 10-year yields of 1.55%, or the one that has 2-year yields of -0.90% (as in negative) and 10-year yields of -0.60%. The former has a spread of just a couple of percentage points and could invert at any moment. The latter has a positive spread of 30 basis points and has held firm. Of course, it wouldn’t take a rocket scientist to figure out that the former is the U.S. and the latter is Germany. I picked on Germany, but I could have used Japan or almost any European nation other than the U.K. The realities are that we are not in a recession and there are precious few signals that a recession is imminent while Germany, Japan and most of Europe are either flirting with recession, actually in recession or growing just a smidge.
I am not trying to belittle the meaning of the yield curve. And I understand that leading economic indicators are pointing lower. Manufacturing activity in the U.S. has been weak for months. Housing has been spotty and auto sales lag behind strong numbers posted last year. Capital spending is still growing, but corporations are confused by both the economic and political environments. Don’t look for any dramatic increases soon.
Washington isn’t helping with inconsistent messaging. On Sunday, President Trump sent his economic team out to the morning news talk shows to extol the strength of our economy. On Monday, rumors surfaced that the White House was planning to seek a payroll tax cut to buttress the economy. That rumor was denied. The President, personally, lashed out at Jerome Powell and suggested the economy needed a 100-basis point cut in the Fed Funds rate plus more quantitative easing. Huh? If the economy was so great, why all the need for stimulus. On Tuesday, the White House confirmed that indeed it was talking about cutting the payroll tax among other steps to stimulate. Of course, all this comes after it had signed a spending bill that will create a deficit approaching $1.3 trillion for each of the next two years. Then, of course, there are the tariffs against Chinese imports due to start September 1. No wonder corporate executives don’t know what to do.
If the President is bad at messaging, the Fed may only be slightly better. Home, supposedly, to some of the world’s best economists, the Fed’s dot plots of future expectations released throughout the year show an FOMC that has persistently overestimated economic growth and overestimated future inflation. That has led to interest rates that were higher than necessary. The Fed rightfully cut rates in July and will almost certainly cut twice more this year. With that said, the notion of getting more in-line with the rest of the world is preposterous if the rest of the world is executing bad policy. The lack of fiscal initiatives, especially in Europe, has forced central banks to do as much heavy lifting as possible to support economic growth. But interest rate policy alone is not very effective in that regard. Low rates can stimulate borrowing but only to a point. There are absolutely no signs that the negative interest rates we now see across Europe and Japan are stimulating a strong economic response. And making these rates even more negative doesn’t seem to work at all.
When you go shopping, how many times do you see something and say to yourself, “I wouldn’t want that if they paid me.”? Cutting the price alone won’t make the sale. People will pick and choose how they spend their money. Price is an important component but not the only one. That is not to say that cutting rates won’t help boost activity. The recent rate decreases in the U.S. are already leading to a sharp rise in mortgage refinance applications, for instance. But when rates go negative, an unnatural state is created. Lenders slow down lending even if borrowing demand increases. If banks can’t make a reasonable spread or profit, they will only loan to the best customers. Savers don’t know what to do. Banks are not yet charging individuals a negative rate but they do charge fees. In theory, savers might respond by shifting money to riskier assets or spend it. The strength of European stock markets reflects some of that, but the investor class isn’t increasing spending enough to offset the impact of lost income on lower income savers. Low rates may entice more spending for some but rob others of needed interest income. Very simply, look at growth around the world. As rates have fallen steadily all along the curve this year, growth has slowed in almost every country. Whether the Fed is behind the curve or not is almost irrelevant to the facts presented globally that lower rates reflect an expansion of oversupply.
Money is a commodity just like oil or an airline seat. If the commodity is scarce, the price goes up. If there is too much supply, the price goes down. Look at the U.S. Prices are being raised where labor is the primary cost component. Restaurants are a good example. Food eaten away from home is seeing 2-3% price increases, but food eaten at home is barely increasing in price. At some point, this will push people to eat more meals in, but that point hasn’t been reached yet. Rents are rising, an indication of demand overwhelming supply. Two other areas where prices continue to increase, hospital services and higher education, may be at tipping points. Health care inflation has been falling for some time from drugs to doctors’ fees. Hospitals will get in line soon under political pressure. Too many mediocre colleges charge virtually the same tuition as Harvard. Education can be valued by the present value increment its graduates earn versus a high school or community college diploma. Big data someday soon will calculate that value. Institutions where the present value doesn’t exceed four years of tuition will have to make changes or die.
As for money itself, the cost is represented by interest rates. When rates fall there is too much money. Is there ever too much money? I would contend that when monetary velocity is near an all-time low, when hundreds of billions of bank deposits are sitting at the Federal Reserve earning a few basis points, and when the savings rate is the highest it has been in 20 years, except for a brief spike during the European debt crisis, then if there isn’t too much money, there is more than enough to satisfy existing demand. The obvious conclusions are:
1. Adding more money alone won’t result in much more spending.
2. Instead it will reduce monetary velocity further, lead to even lower interest rates, and increase savings.
The solution to oversupply isn’t more supply; it’s more demand. Demand is growing. The thought of tax cuts in a nation with $1+ trillion deficits, 2% growth, and near record low interest rates makes no sense. If there wasn’t going to be an election next year, we wouldn’t be hearing about this. Sure, cutting payroll taxes will increase demand. So will dropping $100 bills out of a helicopter. But there is an ultimate cost if all this money is borrowed. If you own a home free and clear and then take out a $400,000 mortgage, that may seem like free money today but someday you have to pay it back.
I will say this for a payroll tax. It is a much more effective tool to getting a short-term increase in demand. It is certainly going to be more effective than indexing capital gains to inflation, another thought being considered. In an election year, cutting taxes has an obvious appeal, especially when most voters have no clue what the deficit even means. The President might actually get more support from Democrats than conservative Republicans on this. Stranger things have happened, but that doesn’t make the idea good policy. If there is any growth retardant out there today, it would be the impact on tariffs, a self-inflicted headwind.
As for markets, with daily incremental changes in interest rates getting a bit smaller, equity market volatility is declining. Low rates and decent earnings point to higher prices. But one has to be both selective, regarding stocks, and mindful of valuation. As the S&P 500 reaches toward 3000 again, it will face valuation headwinds unless you can make the case for higher than expected earnings. In addition, the lower levels of trade worldwide and the soft economies overseas continue to hurt multi-nationals, commodity producers, and the manufacturing sector. I would continue to avoid industries with a lot of storm clouds overhead unless you can see when the rain might stop.
Today, track star Usain Bolt is 33. Country singer Kacey Musgraves is 31. Speaking of country, Kenny Rogers is 81 today.
James M. Meyer, CFA 610-260-2220