While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from Maris Ogg.
Not much in the stock market has been clear lately. We saw the irrational decline in December of 2018 corrected quickly in 2019, which seemed to suggest that the domestic slowdown in economic growth would reverse in the second half of 2019, but events in May have bogged down the market’s progress and investor optimism has shifted to uncertainty. In fact, there are more serious uncertainties facing the stock market today than we have experienced for a number of years. By “serious uncertainties,” I mean issues that could compromise economic growth, possibly worldwide.
The first issue that will jump to everyone’s mind is the trade/tariff conflict. As Jim Meyer has written extensively in these comments, President Trump has chosen to call out China’s violation of international laws (reverse engineering, stealing of intellectual property and forced technology transfers) by imposing tariffs to bring China to the bargaining table. Recently China has begun voicing its own defense with harsh rhetoric about America’s “arrogant requests” in trade talks and the US’s “attempt to violate China’s economic sovereignty.” The lack of actual trade talks and the continuing negative back and forth implies that the next round of tariffs may very well be imposed. At the very least, many US businesses have concluded that sourcing a majority of goods or parts from China regardless of the near term outcome of the trade dispute, should probably be changed in favor of manufacturing diversification. This will be disruptive and expensive. The stock market dislikes uncertainty.
The second issue which seems to be coming to a boil faster than anyone expected is the unease in Europe. The election last weekend surprised many observers and sent many center right and center left politicians to the losers column in favor of euroskeptics, greens and right wing party candidates. The election in Britain was even more worrisome because the two traditionally largest parties there received less than 25% of the vote combined and the Brexit party received more than 31%, with the anti-Brexit Liberal Democrats registering about 20%. Again the message of the European and British electorate is in favor of change, never a good outcome for stability. In Britain, the so-called hard Brexit option seems to be gaining steam. Although the Brexit uncertainty has been present since the “leave” vote in 2016, uncertainty has increased with the inability of Theresa May to reach a deal with Europe and her subsequent resignation as PM. Europe has a structural problem which complicates all of this. When the EU created the Euro currency and all members (except the UK) joined the currency union, they did not also merge the individual country’s fiscal policies. Currency union and fiscal disunion is a recipe for problems. Labor unrest, embodied in the “yellow vest” movement in France, but even more prevalent in the southern tier of countries like Italy and Greece has resulted in a political rejection of the centrist parties. Because the Eurozone is roughly the same size from a GDP standpoint as the US, what happens in Europe and the UK matters to the world economically. Add that uncertainty to the economic deceleration in China, which is also about the same size as the US and the Eurozone, and it is apparent that risks of a global slowdown have increased. At a minimum, global uncertainties have increased with the most recent change mandate of the elections.
The third issue creating worries is the message of the recent decline in interest rates. The 10 year Treasury dropped to about 2.27% yesterday, the lowest level since the end of 2017. The 2 year Treasury is about 2.12%, so the yield curve remains slightly positive, but the bond market seems to be increasing its expectation that the Fed will lower interest rates rather than raise them. In fact, compared to short rates, the Fed Funds rate may be slightly higher but the problem is that in an environment of low interest rates and low inflation, the Fed has few tools to fight a recession whenever a slowdown arrives, if its ability to lower rates is truncated. Normally lower interest rates would provide stimulus to the economy, and with business and consumer confidence currently at high levels, that is probably the logical outcome today, but if global economic deceleration is in the future, positive sentiment can reverse quickly.
Are we recommending that clients become more cautious? No, because the economic outlook remains positive, with some signs of “green shoots” in China and the reality that uncertain politics does not normally have much correlation to economics. We are, however extremely aware that the odds of a negative outcome are higher today than in the past several years and we have our antenna up. The probable outcome of the above problems? 1) President Trump and President Xi have strong incentives to resolve the current trade dispute. The next round of tariffs, if imposed, will have much more dramatic negative impacts on both economies than the last several tariffs that have been implemented. 2) It will be difficult for politicians in the EU to ignore the last election. The EU took a hard line toward Britain in its negotiations to exit the Union. It will be much more difficult for the bureaucrats in Brussels to go on from here as if there is no groundswell of dissatisfaction. I suspect that the next Prime Minister in Britain will find the EU to be a little more practical in the coming round of talks as they may find themselves dealing with more pressure from the “southern-tier” of European countries for change. Finally, it is likely that the market’s lower rate environment will stimulate the US economy, opening the possibility for a strong earnings environment for the second half. The summer will probably be characterized by a lot of market movement with no real trend but Q3 and Q4 could see a resumption of earnings growth and a calmer environment. The next most likely scenario is a down draft in the market that brings in buyers. Either way, the economy will probably continue to grow, albeit slowly, which will allow earnings and stock prices to stabilize and grow. We will see!
Maris A. Ogg, CFA 610-260-2216