Welcome to the Ides of March. If the futures are any indication; it doesn’t appear U.S. investors are all that scared. There was little in the way of corporate or economic news yesterday that will change anyone’s view. However, this week we saw a bunch of pricing data to suggest that inflation remains MIA. The 10-year Treasury, at 2.62%, is just above 2019 lows and a good part of the reason stocks have acted so well. Despite repeated pressure over the past couple of weeks on the sell side, stocks keep pushing back to the 2800-2820 resistance level. This morning it looks like they may poke through. International news, which often gets more attention when the domestic calendar is light, is mixed. North Korea is making some more noise again, and trade talks with China show little progress although last night President Trump again expressed optimism that a deal isn’t too far off. But the big news this week has come from Great Britain where Parliament, in a series of votes, has turned down Prime Minister May’s latest proposal. Parliament voted not to allow a hard Brexit where everything returns to pre-EU conditions, and delays separation for at least a few months. The EU will almost certainly allow the delay. The pound has rallied all week as this was the likely outcome and now appears set to break out to the upside. The challenge now rests within Parliament. For many months, it has voted no several times to various plans put forth by Ms. May and the EU. While everyone by now knows what they don’t want, it is highly uncertain what they do want. At any rate, fear of major near-term disruption in the U.K. and across Europe has been mitigated.
Indeed, there are some signs both in Europe and in China that the recent slowdowns are tapering. China began massive monetary stimulus about 9 months ago, and it takes about that long for the impact to wind its way through the economy. Obviously, fewer tariffs won’t do any harm but the biggest problem facing China is recovering from a pause created by massive overbuilding and excess capacity. China is at the point where it cannot sustain growth higher than 6% for any sustained period. Trying to do so with excess stimulation will only create other problems. China wants to become more independent technologically, but that is going to take time. Working in unison with the rest of the world may actually help its case, but weaning itself off of previous bad habits isn’t going to be simple. As is so often said, it’s a process.
Back home, one would hope low interest rates would stimulate interest sensitive industries like housing. While the downturn of late 2018 may be subsiding, there doesn’t appear to be a lot of positive momentum despite very favorable demographics including a sharp rise in household formations. The problems center on pricing and the large gap between what sellers want and what buyers are willing to pay. In today’s soft market, buyers have the upper hand. Unlike 2008-2010 when there were no buyers, today there are plenty of buyers. At the low end, buyers have money but not an endless pot. Many still have to deal with student debt as well. Price is important. Builders are responding by building smaller homes with fewer expensive add-ons. That appears to be working. As for existing homes, sellers are either mispricing homes or feel they need to achieve a certain sales price to justify moving. Either way, the mismatch is keeping housing soft.
Speaking of real estate, in New York City today, the largest urban development project in U.S. history is scheduled to open. Hudson Yards, which encompasses eight full city blocks initially, will house a combination of office, retail and residential space. All will be very expensive. Situated just south of Penn Station, east of the Javits Center and north of Chelsea, it will attract millions of visitors over the months ahead. Whether they will keep coming back is a big unanswerable question at the moment as is its ultimate impact on New York City’s real estate market. Recently, that market has been quite weak, a result of overbuilding in the 2012-2018 period. Huge new midtown high rises still have plenty of empty apartments, and more are coming in addition to Hudson Yards. The first huge high rise there is 60% sold, and at least two more are planned. More than 100 restaurants are ready to open as is much of the retail space anchored by Neiman Marcus’s first New York store. Neiman as a chain has been having a tough time lately. Hopefully, a NYC presence can turn it around. It will be many months before we see the overall impact of Hudson Yards. Whether it is the forerunner of what is to come in urban real estate or a big mistake will take years to answer.
Away from real estate, however, there are signs that Q1 may once again be the worst quarter of the year. 2018 ended with bulging inventories. That may have helped to lift Q4, but that same inventory now needs to get worked off. That should be largely done by the third quarter of this year if not a bit sooner. Stabilization or even some improvement overseas will help as will any trade agreement with China that can boost exports, particularly agricultural products. The good news is that consumers are employed, wages are up, and they are both saving and spending. Over time, that can only be a positive.
Investment spending remains tepid with growth less than that of overall nominal GDP. Most of the investment spending growth is technology related, the root of any improvement in productivity. Until there is greater clarity regarding tariffs, capex will remain modest. If there is any bright spot in that regard, it appears President Trump has a much-reduced appetite to start a trade war with Europe by imposing large tariffs on imported cars and auto parts. Such a move would not only hurt trade activity, it would increase prices of all cars built in the U.S. because so many components come from outside the U.S.
Government spending, on the other hand, remains robust. Indeed, if one takes the $400 billion expansion in our deficit year-over-year, that alone accounts for more than half of our GDP growth last year. The deficit is going to rise again this year and remain over $1 trillion per year for the foreseeable future. I have written (probably too often) of the long-term negative effects of deficit spending but, in the short term, it is additive to growth.
Thus, the recent pause in both the economy and the stock market, which could extend into Q1 earnings season, probably won’t go much further. By the end of Q2, much of the inventory overhang will be worked off, housing should be a little better, and hopefully there will be some resolution of the Chinese tariffs. In addition, the worst year-over-year impact of the strong dollar will be felt in Q1. Q2 will also be impacted but to a lesser extent. By the second half of the year, the impact on multi-national earnings translation should be just 1-3% instead of 7-9%, a big difference. Indeed, I expect overall earnings in Q1 to be down versus last year almost entirely related to the strength of the dollar. They may turn positive in Q2 but will almost certainly be solid in the second half of the year. Since stocks look ahead, further upside is likely. While stocks are now at or above average historic P/Es, in post-World War II periods when inflation has been below 3%, the average P/E has been close to 18. Thus, there is still upside to this market if my economic outlook is remotely accurate.
Today, will.i.am of the Black Eye Peas and Eva Longoria are both 44. Fabio is 60. Justice Ruth Bader Ginsburg turns 86.
James M. Meyer, CFA 610-260-2220