After persistent gains, stocks gave back some yesterday as investors finally started to focus on a steady stream of worse than expected economic news both in the U.S. and abroad.
Weekly unemployment claims have begun to gradually increase. Although still low, they indicate some corporate reticence to hire and maybe even some moves to right size companies. Manufacturing survey data indicates continued growth but at ever slower rates. Retail sales, as reported by the government, were abysmal in December. Many think the data will ultimately be revised but, again, there is a new trend in place.
Overseas the trends are worse. Germany, France and Italy are nearing recession levels. Chinese growth is showing some signs of stability but at a lower level than previously expected. Japan is back in recession. There have been at least three causes:
- Less expansive monetary policy throughout most of the developed world.
- The impact of U.S. tariffs on trade.
- Political uncertainties (e.g. Brexit).
Markets have been encouraged by prospects that U.S. tariffs against China will not be increased further, at least for a few months. But the prospects of another round of auto tariffs once again raises uncertainty.
With all the clouds suddenly appearing, perhaps the biggest pending storm is an early indication that tax refunds in the U.S. are down almost 9% versus last year.
Let me go back a bit over a year ago when the IRS was adjusting withholding tables to account for the new tax law. While the law was primarily a tax cut for corporations, proponents extolled the benefits to individuals as well. Along this line, if employees didn’t adjust their exemptions with employers, the percentage of income withheld declined. The good news is that this provided more cash in the pockets of workers in 2018. The early boost helped to allow GDP growth of over 4% in the second quarter of 2018. But the bad news is that all this is coming home to roost now. Not only are refunds likely to decline, but a significant percentage of workers are going to be socked with a significant tax bill instead of the usual refund.
Employees can begin to file returns in early February, and refunds are just beginning to be dispersed. The government shutdown has the IRS a bit behind in processing refunds. If one expects a refund, there is an incentive to file early. Those expected to pay on April 15 have the incentive to wait. While tax refunds aren’t “income” in the same sense as wages, many families count on them to repay credit card debt or to fund special projects.
We won’t see the impact fully until we start to see economic data for February and March. Maybe as more returns are filed, the refunds will come closer to matching 2018 levels. But so far that doesn’t seem to be the case. Those hit hardest will most likely be workers in high tax states that will have sharply lower deductions this year. A few who can benefit from the higher standard deduction will be smiling. But overall, this may be the most important economic factor to consider over the next several months. Weak refunds and less spending are clearly a toxic combination. Combined with the impact on earnings from weaker operations overseas and the impact of a strong dollar, this is a bad near-term set-up.
Technically, stocks are quite overbought after the strong January-February rally. Bargains have disappeared. If there was a lesson from 2018, it is that stocks rise gradually and fall suddenly. I have no idea what the trigger for a correction might be. It might be delayed as the China tariff talks are resolved. But it is a time to make sure that your asset allocation is set properly. A combination of slower growth, more tariffs and lower tax refunds suggests a correction could happen sooner rather than later.
Today, Drew Barrymore is 44. Julius Erving turns 69.
James M. Meyer, CFA 610-260-2220