Stocks move higher once again as rumors circulated that a trade agreement was imminent and that both sides would be rolling back tariffs. While the Chinese seemed to embrace this story, reports from the White House were conflicting. We have been here before. Rumors, both good news ones and bad news ones, simply don’t turn into reality. It makes sense for both sides that some sort of deal will happen but it isn’t likely to be a major one. Leaders on both sides of the ocean will overplay the significance of any deal but reality is that tariffs will remain in place, as will threats of new tariffs in the future. U.S. companies will continue efforts to diversify supply chains no matter what the outcome. The timing of some short term purchases may be affected whether some tariffs are rolled back or not but it is hard to believe that a small deal will bring a surge in investment spending.
One measure of GDP growth is to multiply the percentage increase in our workforce times the improvement in productivity. GDP is a measure of economic output. Take all of your productive workers and make them more productive, you get more growth. But improved productivity doesn’t happen magically. New investments in hardware and software make people more productive, whether it be a software program or an industrial robot. Without incremental investment and accompanying productivity gains, the only way to grow is to add more workers. That is why monthly employment growth has been so strong. There are plenty who will argue that is all good news. Wouldn’t you like more workers earning a salary than more robots?
That’s true up to a point. But what happens when you run out of new workers? There has been an argument that we are close to full employment. Yet every month the economy continues to add 150,000-200,000 new jobs.
But there is a fly in the ointment. Wages are rising and they are starting to rise at an accelerated pace, particularly at or near entry level positions. Wage growth is now near 3% and it is higher than that at entry level. So far, that can be absorbed. But the closer one gets to full employment, the more wage pressures will increase. Without increases in investment spending, productivity falters. This week we learned that productivity actually fell in the third quarter and is only up 1.4% year-over-year. That level is right in synch where productivity gains were in the Obama years. But wasn’t the large corporate tax cut designed to provide more free cash flow to fund more investment? It turns out that tariff related uncertainties caused corporations to allocate more free cash to dividends and stock buybacks. There were many who predicted just such an outcome when the tax bill became law although, to be fair, tariffs were not yet on the table when the law was passed.
The bottom line is that despite the continued strength in the labor market, our economy has settled into the same growth pattern that has existed since the Great Recession; 2% growth and 2% inflation. That combination has kept interest rates low and asset prices high. Hence, we are in record territory in the stock market. All good!
While growth can continue, and with overcapacity still in place, inflation will remain low. That is a healthy combination for equities. As I point out almost continuously, stock prices are a function largely of earnings and interest rates. If wages continue to accelerate, margins, and therefore profits, could be squeezed. The pressure will vary from industry to industry but it could become real. When there is labor slack, the employer has the negotiating advantage. When labor is tight, the advantage shifts to the employee. It has been a very long time since the employee has had the advantage. If you remember back to the 1970s or the second half of the 1990’s you can see the impact of wage pressures on margins.
If interest rates stay low, earnings can still be strong enough to allow the stock market to stay at elevated levels. But to grow to the 3300 or 3500 price targets that some are espousing for next year, either profits have to reaccelerate or interest rates have to keep trending lower. The former requires economic strength. The latter requires economic weakness. It is unlikely that we will witness economic acceleration and declining interest rates at the same time. In fact, over the past month or so, as stocks pushed back to record highs on the back of strong performances by economically sensitive sectors, yields on 10-year Treasuries have advanced by about 50 basis points. So far, markets have ignored that but they won’t forever.
I can’t predict when momentum will slow. Seasonally, this is often one of the best times of the year for the stock market. A lot of investors with large unrealized profits want to hold off selling until January. It isn’t hard to make a case for stocks moving forward until year end. But valuation does matter. Right now, stocks sell for 17.5-18.0 times forward earnings, not wildly expensive but certainly not cheap by any historic standard. Yes, compared to bonds, stocks still look like the better bet and I wouldn’t be a big seller here. But I wouldn’t be an aggressive buyer either. Many of the industrial, financial and energy laggards have rallied 20% in the last month. Despite a somewhat better outlook, many still face significant economic challenges. 2020 growth isn’t assured. In the short run, momentum takes over and you shouldn’t fight it. But bull markets are two steps forward and one step back. If I had sideline cash today, I would wait for the next step back. What could cause a pullback? Almost anything. Stocks now are largely pricing in a trade agreement. Any pothole on the road to conclusion would certainly send equities lower. If 10-year Treasuries continue to rise at their current pace, that could set off a correction as well. Election 2020 fears will increase over the next 12 months. Life on Wall Street isn’t a one-way affair. Stay invested but invest with care.
Today, David Muir is 46. Restauranteur Gordon Ramsay is 53.
James M. Meyer, CFA 610-260-2220