Stocks fell sharply at the open yesterday after President Trump, in an off-the-cuff comment at the NATO summit, said Phase I might not happen until after the 2020 election. Mr. Trump has made similar apocalyptic remarks days before previous negotiation deadlines only to come to a positive conclusion at the last minute. That is not to say markets shouldn’t be rattled when he makes a statement like he did yesterday, but actions count more than words. We’ll see what happens when the December 15 deadline arrives.
With that said, maybe markets have a right to be nervous. I don’t believe yesterday’s remarks reflect an actual change in the state of negotiations with the Chinese. Progress is being made slowly. Whether everything wraps up by December 15 is anyone’s guess. But what should be disturbing is that Mr. Trump, a man who professes the love of tariffs as a key weapon in trade negotiations, is once again wielding the threat of tariffs around the world away from China. This week, he announced new steel and aluminum tariffs on Brazil and Argentina purportedly in response to currency manipulation by both countries. He threatened tariffs on French wine and high-end luxury goods in response to a threatened tax France wants to impose on digital services.
It isn’t for me to get into the political debate whether there are merits or not to support Trump’s actions. But it is in my purview to note once again that tariffs are a tax, a tax paid by U.S. companies that import Brazilian steel or fine French wine. Obviously, we can all live without a glass of Bordeaux but tariffs clearly slow trade. Exports to and from China are down appreciably over the past year. While prices to American consumers may not have risen much, profit margins through the supply chain have been squeezed. Corporate profits over the past 12 months in the U.S. are down. They are down because margins are down. Part is tariffs. Part is higher wages. Part is slumping productivity. Part is the impact of a strong dollar. Tariffs are only part of the cause. But uncertain trade policy has caused a slump in capital spending. The lack of capex leads to smaller productivity improvement. There is a direct link.
Stocks are up almost 25% year-to-date even after yesterday’s losses. But don’t overread that. They are only up mid-single digits from the end of the third quarter of 2018. Don’t forget to take into account the 20% slide in last year’s fourth quarter. The rise this year has been uneven. Companies that cater to consumers and are at the top of the mind when consumers make buying decisions have done quite well whether it be Apple#, Disney# or Lululemon. It has been a good year for technology as well. Healthcare stocks started the year slowly but have been strong performers recently. The laggards are just where you expect to find them, in manufacturing, capital spending and commodities, the weak sectors in the economy.
The big rise this year, however, on a macro basis, is all about lower interest rates and, therefore, higher price/earnings ratios. As noted above, corporate profits are actually down. They are up slightly on a per share basis due to the impact of stock buybacks, but the heavy lifting this year is all about P/Es.
For markets to go up next year, interest rates have to fall further or earnings have to reaccelerate. It is hard to make a case for sharply lower interest rates given the 1.75% rate 10-year Treasuries trade at today. In my mind, the only way for rates to fall sharply would be for the economy to slip into recession. That, of course, would mean lower earnings that would probably more than offset the impact of lower rates. But we don’t see a recession. That suggests for stocks to move higher in 2020, earnings have to move higher. For that to happen, in a world that seems destined to stay at or near its recent 2% growth pace, margins have to recover. There could be some benefit from a more stable dollar. There could be some productivity improvement on a company-to-company basis. But the idea that earnings will rise 5-10%, as many analysts currently predict, just seems unsupported by the macro details. After a 20-25% up year, a year of more normal 5-10% gains might be quite acceptable.
I think we can all assume that Congress will do little next year. It might pass the USMCA trade deal with Canada and Mexico and will do what it has to do to keep the government running. But that’s about it. By next fall, the attention will be on the Presidential election. Assuming that the Senate doesn’t confirm impeachment, if it gets that far, by next fall impeachment will be yesterday’s news. It will be a non-event in the election. The two obvious issues that will be in focus will be healthcare and taxes.
Let me take a shot at both. Mr. Trump will talk about lowering taxes further. Whoever the Democrats nominate will push to raise taxes, at least on the investor class. But whoever wins will have a tough time moving tax legislation forward without a strong Congressional majority. Given the huge budget deficits, I don’t think there is going to be a lot of excitement for more tax cuts and even higher deficit spending. As for tax increases, should a Democrat win, raising taxes is a tough vote to cast for any member of Congress. Yes, there could be selective tax changes, such as higher estate taxes, that might move forward, or a new bracket for very high income individuals, but I don’t see anything that will change the economic needle a whole lot. We are almost two years into the Trump tax cuts and GDP growth is about where it was before the tax cuts were enacted.
As for healthcare, Americans simply don’t want Medicare-for-all. They may want a Medicare for all option but they want control of who they see and when. Thus, no matter who the next President might be, what is most likely is a tweaking of our current system. No one is going to wipe out the health insurance industry, drug price inflation is already coming down, and all Americans have access to some level of health care. There is plenty of room for improvement. Republicans can “repeal and replace” and Democrats can come up with a whole new scheme but, in the end, what we will get is a tweak. The real issue, entitlement reform, is one that neither party wants to tackle until it has to. When that time comes, “reform” will mean the transfer of some part of the cost of care from the government to the frail and elderly. That won’t sit well and no one, Republican or Democrat, wants to tackle that until forced to. That won’t happen in 2021.
Thus, as is usual when it comes to Washington, perceived change is always much greater than actual change. What really governs our economic growth rate is demographics and productivity. Technology affords some productivity improvement and the working class employment growth will be in the 1.0-1.5% range, on average, for years to come. All the Trump talk about 3% or more won’t happen on a sustained basis, and all the Democratic ideals of a brave new world won’t happen either. As long as we live in a well balanced economy, we will stay on a path of slow, steady progress. That might mean two steps forward, and one step back on occasion. Don’t overread the one step back. At any time, markets will correct. But without a recession, the damage will be contained and short-lived.
Today, Tyra Banks is 46. Jay Z turns 50. Jeff Bridges is 70.
James M. Meyer, CFA 610-260-2220