Stocks once again rose to record highs on Friday after a White House spokesperson expressed optimism that a Phase I trade deal with China would be completed shortly. It is remarkable how many times markets can discount the same news flash, especially when talks of optimism don’t end up with a deal. Perhaps the only explanation is that trade optimism alone is not what is driving the market.
To understand better, one has to look back a few months when interest rates in the developed world were becoming increasingly negative, when talks of recession in this country were rising, and when our own interest rates were returning to multi-year lows. In hindsight, the fears of just a few months ago, punctuated by an inverted yield curve, were simply dead wrong. To paraphrase Nobel Laureate Paul Samuelson, once again the stock market has predicted nine of the past five recessions.
It turns out, again with hindsight, that what has been causing the negative rates and inverted curve were more structurally tied to the enormously loose monetary policy around the world, and less about the actual pace of economic growth. To be sure, China was and is slowing. Europe was and is hovering around the zero-growth line. Japan threatens to turn negative. But that may turn out to be the normal state of the world. Tariff issues aside, China simply is reacting to two seismic trends. One is simply the law of large numbers. It cannot grow 8-10% and account for 10-20% of world GDP at the same time. Second, within the nation, the shift from a rural-based society to a big city industrial economy is well along and no longer providing the tailwind it used to provide. The massive buildup of infrastructure that accompanied that shift has also run out of steam. In fact, the infrastructure buildup was so extreme that significant pockets of overcapacity and empty real estate now weigh on both Chinese and worldwide economies. The overcapacity in productive space (e.g. steel) has forced worldwide price collapse. While the rise in wealth within China has boosted consumer spending, the slowdown in the buildout of infrastructure counteracts that trend and serves to reduce China’s overall growth rate. Forget, the 6%+ the government reports. Actual growth is closer to half that rate.
As for Europe and Japan, the good news is that there are some green shoots indicating that growth in both areas is stabilizing, although at very low levels. Demographics throughout much of Europe and all of both China and Japan suggest that growth going forward will be less than it has been in recent decades. China will feel the effects of its one-child policy for decades. Japan’s population is falling and getting older at the same time. In Europe, while there are pockets of solid growth, any growth at all along the continent’s southern tier is hard to find.
Switching back to the United States, our demographic picture is also in slow decline, but the rate of decline is very low. There was promise a year ago that the impact of the Trump tax cut would be an increase in corporate cash flow leading to greater investment spending. But the decision of the Trump Administration to pursue tariffs in order to realign world trade in our favor has created enough uncertainty in corporate board rooms to effectively push corporates away from spending on investments. Instead, they have reacted by returning more excess free cash to shareholders via higher dividends and increased share repurchases. A Phase I China trade deal might help, but stability in trade policy would be the stimulus to increase investment spending. That may not happen in the world of Trump, an executive who views chaos as an ally. For instance, while markets are assuming that some trade deal is imminent and that the next level of announced tariffs on December 15 won’t happen, it would be perfectly in character for Trump to tweet that the December 15th tariffs are on without major concessions.
Think back to the migrant crisis along our Southern border. Even after negotiating a new trade agreement with Canada and Mexico, Mr. Trump angrily said he would impose tariffs on Mexico if it didn’t work harder to reduce the flow of migrants. A week later, all was well and the tariffs never happened. Yes, Mexico said the right things in the interim, but the flow of migrants continues. The same happened with Canada. Mr. Trump tweeted all sorts of nasty words about Justin Trudeau shortly before final negotiations resulted in a deal. Thus, is wouldn’t be out of character for him to try a little hostility to get a final tweak in the Phase I deal in his favor. Wall Street would have a hissy fit for a moment as that occurred but would celebrate the actual deal assuming it happens. In fact, there are some who say that what may be in store over the next year are a set of mini-deals that are timed to coordinate with the 2020 Presidential campaign. That could happen but it would also require the Chinese to play along. That is hardly a certainty.
The economic reality is that where we are today isn’t all that much different than where we have been for many years. Growth meanders around 2%, sometimes a little more, and sometimes a little less. Inflation is inching upward ever so slowly. Depending on which measure of inflation you are looking at, it is near 2% or a bit under. Europe waivers back and forth with a 0-1% center point. Japan struggles to stay positive. China is growing faster than everyone else but the pace of growth is slowing. Worldwide, because Chinese growth has been such an important part of the equation, growth of 3%+ is now more likely to be 3% minus.
Equity markets, against this backdrop, are slowly rising. The last month’s rise is more than “slow” but that is because markets were too negative to start. Earnings have been fairly flat for 3-4 quarters. They could creep up a bit over the next several quarters in part due to less pressure from the translation of foreign earnings. As for interest rates, they are materially lower than last year and are likely to stay low for some time to come. But with that said, directionally, rates appear likely to creep higher from here. They are not likely to be an equity investor’s best friend as they have been in 2019. The bottom line is that instead of being range bound between 2800 and 3000 on the S&P as markets had been for much of 2018 and 2019, the new range may be a bit higher, let’s say 2900-3200. I continue to believe that once the trade deal is signed (hopefully!) and once the calendar moves in 2020, the good news will be fully reflected in stock prices. Whatever level the market is at then could prove to be the top of the range. If 2020 sees slightly higher earnings and slightly higher interest rates, the odds of a solid double digit gain once again diminishes. It doesn’t mean it can’t happen but for a repeat, stocks would have to rise to valuation levels that may reward in the short run but wouldn’t be sustainable. That would increase the chance of a valuation correction. If investors sitting on big gains are waiting until 2020 to realize some of those gains, then a mild correction could happen sooner rather than later.
Today Owen Wilson is 51. Megyn Kelly turns 49.
James M. Meyer, CFA 610-260-2220