Although stocks staged a solid rally, a late afternoon selloff sapped any serious optimism that the gains were the start of a new move higher. It felt more like a dead cat bounce after the 600+ point decline of Monday.
I’ll start today with the pessimistic side. First, valuations are high. They aren’t as inflated as they were last September but using any historic measures, let’s just call them full. Although first quarter economic data was solid, it wasn’t quite as sensational as optimists suggest. Half of the 3.2% gain in first quarter GDP came from trade and expanding inventories. Capital spending trends still point lower. The breakdown in trade talks isn’t going to turn that around. Leading economic indicators are also slowing. Besides the recent weakness in the stock market, bond spreads are beginning to edge up.
Unemployment claims are bouncing off of recent lows, although it is much too early to call that any trend reversal. Manufacturing survey data points to slower growth. Housing data continues weak, although there are signs that lower rates are starting to have a positive impact. Auto sales are off their best levels even with the lower rates. Now we face additional tariffs once again. We can argue how “much” they will suppress growth, but we can’t argue whether they will suppress growth. And there might be still more to come.
Obviously, there are two sides to the argument whether using tariffs to force changes in Chinese behavior is proper strategy or not. On one hand, proponents argue that no nation since China’s economic emergence has sought to challenge its illegal behavior, including stealing intellectual property and forcing technology transfers from joint venture partners. On the other hand, there is no certainty that imposing tariffs will achieve the desired goal. Mr. Trump is going to run for reelection and wants a strong economy as his backdrop. Clearly, a trade war won’t help in that regard. Thus, if tariffs are going to succeed, it would be most favorable for Mr. Trump if the Chinese capitulated in some fashion over the next several months. President Xi of China isn’t standing for election, but clearly his stature will relate to his ability to drive China’s economy forward. He is not immune to pressure. China’s stated goal of gaining world leadership in key technologies is accelerated by the theft of intellectual property. Clearly, should it catch up and even gain leadership in key categories, China will become more protective of its own intellectual property and, presumably, play by international rules. But that is still years away. China is destined to be our primary international economic competitor for many years to come. We don’t want to make it easy for them to catch up. Mr. Trump’s goals are admirable. His tactics, however, can be questioned.
There are some who say that carrots work better than sticks when it comes to dealing with Asian minds. Even granting that some pressure works, skeptics will also point out that the U.S., fighting the battle unilaterally, may have weakened its own position by not presenting a unified Western front. It isn’t for me to select who is right or wrong. What we can say, especially after this past week, is that closing the chasm that exists today isn’t going to be easy, and it may not happen over the next few weeks or even months. Yes, the U.S. and China could take initial steps or develop a framework. But it seems clear today that the Chinese simply aren’t ready to capitulate to our standards, and they aren’t about to show weakness by giving in to bullying tactics.
The net result is that whatever growth forecasts one had two weeks ago, should be moderated today to account for long trade negotiations and higher tariffs. That doesn’t mean a recession is near or that earnings are going to suddenly decline. The American consumer is still confident, employment and wages are growing, the dollar will be less of a burden during the second half of 2019, and economic growth continues. But as the full impact of 2018 interest rate increases flow through the economy, and as the negative impact of rising tariffs hit home, growth rates will decline.
History shows that declining growth rates bring with them lower P/E ratios. Given that P/Es are a little above historic norms today, we are faced with a ying/yang situation going forward with the likelihood of better earnings and some moderation of P/E ratios. The obvious conclusion is that further gains in 2019 will be a struggle, although with rising earnings, there isn’t much downside risk either.
Fed Funds futures are pricing in almost a 100% chance of a rate cut before the end of next January. The odds of a cut by September are now over 50%. With the 10-year Treasury yield now slightly below the Fed Funds rate, that is entirely possible, especially if the 10-year Treasury yield shows any more slippage. Normally, rate cuts are good for stocks but not if they portend future economic weakness.
Looking really short term, I think one should expect a bumpy summer with the one caveat: that a breakthrough trade deal will change the entire dynamic for the positive. With productivity still improving, I believe the likelihood of a recession is substantially less than 50-50. But that also could change if the tariffs wars escalate.
You have heard often in these comments that our economy is well balanced at this time. But external events like trade wars, expanding budget deficits, or other political actions could change that. The most logical catalysts near term would be a trade war truce or a Fed rate cut. Neither looks imminent. Thus, near term, we could be in for a bumpy ride. Longer term, into 2020, actions by the Fed and/or the White House will dictate trends.
Today, Emmitt Smith is 50.
James M. Meyer, CFA 610-260-22