Stocks staged a mild gain once again yesterday, and the S&P 500 set another all-time high. 10-year Treasury yields fell below 2.0%. This morning they are trading at about 1.96% as yields throughout Europe tumble further into negative territory. Economic data this week continues to show some slowing in the pace of economic growth in the U.S., but the pace of deterioration in the growth rate appears to be slowing a bit. Manufacturing continues to grow, albeit at a slow rate. Housing is still sluggish despite the lower interest rates and their impact on mortgages. Home prices remain a barrier and young potential buyers are still choosing to rent.
Stocks continue to rise, however, because the impact of lower interest rates on P/E ratios is greater than any negative adjustment to earnings forecasts caused by the slowing pace of growth. In addition, currency translation in regard to overseas income is much less of a headwind from here on than it was during the first half of the year. Lower interest rates have exerted some modest downward pressure on the dollar.
The one remaining key piece of economic data this week is the June employment report due out Friday morning. Today’s forecast from ADP, which processes approximately one out of every six private sector payroll checks, is for an increase of about 100,000. That is far below the 300,000 number that has been reported occasionally over the past couple of years, but it is still a healthy long term number, one that will either keep the unemployment rate around the current 3.6% or see it decline slightly over time. Weekly jobless claims remain near record lows. Businesses may be slowing their pace of hiring but they are not laying people off. Job security isn’t a problem people are talking about. The pace of wage growth has slowed slightly in recent months but still clearly exceeds the pace of inflation. When I listen to Democrats debate and talk about how the bottom 99% of the nation is losing ground even in a good economy, I find it hard to connect the dots of their discourse with the facts. Real wages have not only been rising, over the past two years, but they have been rising at an accelerating rate. While that fact doesn’t contradict statements about income inequality, I would contend the average American is focused on what he or she is making and not on what some CEO, athlete or actor may be making. Headway may not be as quick as one would like, but for the first time in decades, middle class American families are getting ahead and that has been evidenced by high levels of consumer confidence over the past year.
Will the political discourse weigh on the American psyche? Could a souring mood created by greater acrimony tied to the Presidential race actually cut consumer spending? These are tough questions to answer. Clearly, the mood of Americans can be affected by the actions of its leaders. But ultimately, Americans spend most of what they make. If they make more, they will spend more. And today, there are few indications that, collectively, they will make less or spend less as long as they remain employed and have job security. The immigration controversy, for instance, is front page news almost daily. But for most of us, it is irrelevant to how we live our own daily lives.
Thus, while the political mood may be sour and could get worse, the economic mood remains strong. Liberals hate everything about Mr. Trump and fear that, somehow, he will manage to wreck their lives. Conservatives hear the Democrats scream about higher taxes, Medicare for all, and free public college education and see economic Armageddon. The stock market, at least for now, suggests neither extreme is close to right. Look at the stock of UnitedHealth Group (UNH), the leading private healthcare insurer. At the moment it is about 20% below its 52-week high set last December and about 20% above its 52-week low. It trades at just about a market multiple. Obviously, if Medicare for all was inevitable, the fortunes of UNH would be disastrous. At the same time, that threat has kept the shares well below 52-week highs at a time when the S&P 500 is setting records. In other words, some fear is in the price, but it is a long way to go before something akin to Medicare for all is possible. Even if Democrats win the White House and both chambers of Congress, it is no layup that something so radical as a total revamping of how healthcare is delivered in this country is going to become the law of the land. President Obama fought mightily for the Affordable Care Act, and barely got it passed with control of both chambers of Congress. And I would contend that ACA was a mild change in how we deliver and pay for healthcare compared to what Medicare for all would be like.
Early in Presidential races, both sides set markets far left and right of what future reality will become. Democrats run the risk of pushing so far left that they will nominate a candidate Americans view as too extreme. History has shown repeatedly that when parties go too far left or right, they get clobbered in the general election. George McGovern and Barry Goldwater are two classic examples. It certainly is possible, in theory, that the country’s mood itself shifts radically that a progressive candidate isn’t far off center but there are very few signs to suggest that is happening despite loud noises from the fringes.
Often, I have noted to investors that the stock market isn’t a barometer of emotion, it is a measure of the current value of future cash flows. It absolutely doesn’t care if President Trump stepped into North Korea or not. It does care about all the immigration controversy. It cares about earnings, interest rates and the value of the dollar. I find it interesting that during the 4 hours of debates last week, the economy barely came up except for broad statements about how 1% was doing great and 99% were not, a consistent statement backed up with no facts. It harks back to the “billionaires and millionaires” talk of the last campaign. There wasn’t any mention of tariffs, China, Iran or North Korea. Instead, what we heard were rants designed to please a progressive base, akin to Trump rallies that appeal to his base. Essentially, the stock market ignored all this and it should. The reality is that business today is OK or even a bit better than OK.
Perhaps, then, the key question to ask isn’t a political one. It is why are interest rates falling? There are three choices. One, suggests it is a reaction to falling rates in Europe. Those rates have been falling since the ECB suggested its monetary policy going forward would be more accommodative. Europe is teetering with recession once again. Demographics and lack of strong fiscal policy dictate that growth there will be anemic at best for some period of time. Central banks can make money cheap, but they can’t force people, corporations or governments to spend. Without support from fiscal policy, Europe is probably destined to show very little long term growth for some extended period. But that doesn’t mean its GDP has to go into perpetual decline either. With that said, rates across the continent are now mostly negative and that weighs on our rates as well. It is a global world.
Second, the rates may be declining because the Federal Reserve has changed course and now suggests strongly a rate cut at the end of July of at least 25 basis points. With the likelihood of new tariffs on Chinese imports now off the table for at least the next several months, the possibility of a 50-basis point cut in July is less. But the likelihood of a 25-basis point cut in four weeks has sent rates down about 25 basis points in anticipation.
A third possibility is that lower rates and a partially inverted yield curve signal a recession soon. That’s certainly possible. But I would suggest that, at least for now, the stock market doesn’t believe it. If it did, earnings forecasts would have to be cut sharply. Of course, this could all change if Q3 corporate outlooks issued in conjunction with second quarter earnings reports are much more cautious than current consensus believes. Perhaps, this is the biggest near term risk to stocks besides valuation. Stocks currently sell for about 17x forward earnings and that level has proven to be a short term barrier in the past.
In sum, markets are fairly if not fully priced. Better earnings in the second half and an improved 2020 outlook are needed to push prices much higher. Obviously, President Trump, running for reelection, will try to do what he can to accelerate growth. But we all know that natural economic forces are more powerful than any one world leader. With that said, employment is high, inflation is low, consumers generally feel good, and there are few signs of economic imbalances. The Fed should remain accommodative in the second half of 2019. The path of least resistance long term remains higher but not at the pace recent stock market gains indicate. An interim 10% correction is quite possible, although like the last few, shouldn’t be long lasting unless a recession is really on its way.
Happy Fourth of July. There will be no letter on Friday unless major news events occur in the interim.
Today, Julian Assange is 48. Tom Cruise is 57. While there are no remarkable famous birthdays on the Fourth of July, it might be interesting to note that both John Adams and Thomas Jefferson died on July 4, 1826.
James M. Meyer, CFA 610-260-2220