Stocks rallied yesterday, with momentum continuing in the overnight futures market, on reports that a trade truce with China is imminent. Vice-Premier Liu He is expected to meet with President Trump at the White House today. It is unlikely the meeting will end in anything but smiles.
But, despite yesterday’s gains and this morning’s likely follow-through, let’s not overstate the importance of whatever is announced today. What we will see today is nothing that approaches our initial objectives when President Trump started implementing tariffs on Chinese imports. There is not likely to be any discussion of respective intellectual property rights and no termination of forced technology transfer. Instead what we are likely to hear are some Chinese commitments to buy U.S. agricultural goods, efforts by Chinese central bank to stabilize the yuan, a commitment from the U.S. to allow some American suppliers to cell to Huawei, and a deferral of further tariff increases this month and possibly in December as well. What is possible but less likely is a willingness on the part of the U.S. to reduce tariffs from current levels. Using a baseball analogy, we are about in the second inning of a long effort to find compromise between the ways the two countries try and do business.
If existing tariffs remain in place, as most expect, the headwinds caused by these taxes also remain in place. At the moment, it is unclear where we go from here, i.e. what is the next step. If the next step is to try and tackle the harder issues, what happens if there is success and what might Mr. Trump do if no progress is made over the next several months recognizing that the Presidential election is just over a year away?
As we repeat often, stock prices are all about interest rates and earnings. Over the very short term, markets do react to Presidential tweets. Trump must love that! But those moves are quickly reversed if they result in no fundamental economic change. No one is going to change an earnings forecast based on the outcome of these talks. Yes, less future pain is important but markets never really priced in the December tariffs anyway. Will corporate managements, with the air cleared slightly, reaccelerate investment spending? That is a key question and my gut reaction is to say, “not immediately”. We are at the cusp of earnings season, beginning next week as the large banks report. Third quarter earnings, like those of previous quarters, should beat reduced expectations slightly. But the risk is that Q4 expectations are pulled lower as managements play the uncertainty card. By the middle of next week, therefore, tariffs will be off the front page while earnings and interest rates once again ascend.
As for interest rates, there is some good news to report. Rates have stabilized recently and the yield curve has largely uninverted. The 2-10 year Treasury spread is now a positive 12 basis points. Perhaps more importantly, the 3-month to 10-year spread that has been negative for several months, reversed yesterday and now is positive by over 50 basis points. Interestingly, the 3-month rate at about 1.65% presumes two more Fed Funds rate cuts in the coming months. One is almost certain at the end of October. It is too early to say with certainty that a second cut will come in December.
It is also worth noting that, slowly, rates have been rising in recent weeks. Combining the picture of rising rates and a steepening of the yield curve, the message of the bond market is that threat of recession appears to be receding. Clearly, with the specter of no further tariffs against China this calendar year, the skies are a bit brighter. In addition, lower rates this year are helping to move housing higher and stabilize any decline in auto sales. Consumer spending remains solid, not only in the U.S. but overseas as well. Government spending, thanks to the tendency of elected officials to keep spending to make constituents happy campers, continues strong at both the Federal and local levels. There are weak spots to be sure but they remain isolated to manufacturing, transportation, commodities, and energy.
If interest rates continue to creep higher, the relative outperformance of stocks mostly dependent on high dividends for support is likely to wane. At the same time, depressed groups like financials could make a comeback. Valuation remains both a concern and a headwind. Without rising earnings expectations, and nothing we see this week will change them, stock prices still seem range bound. Indeed, after a euphoric blowoff related to the trade truce, assuming our presumptions are roughly correct, we will be back in a market that will react to individual company earnings and expectations.
We face a relatively flat economy, one that might average 2% growth for some time, with low inflation. Nominal growth is likely to be 3-5%. Add in 2% from dividends and that is a pretty tepid outlook. Stock buybacks will improve that but only to normal. Normal for stocks, is 5-6% plus the rate of inflation. That means 7-8% total return but with P/Es slightly elevated and given gains to date this year approaching 20%, 5-7% over the next twelve months might be a center point of expectations. Actual numbers could vary significantly depending most importantly on the outcome of the elections next year. History says trying to predict an election 12 months hence is almost a fruitless exercise so I even won’t begin to try.
What I can say about the near term is that early October is seasonally scarier than later October according to history. Mutual fund tax selling will probably peak over the next 10 days and companies will be back in the stock buyback business once earnings are announced. Economic signs show that the Q2-Q3 slowdown is starting to abate. While there are few signs of significant strength, there are few signs of recession. Companies that can grow independently of the economy should do well and so should their stocks. Any signs of recovery in world trade would be especially welcome.
Today, Cardi B is 27. Joan Cusack is 57. Daryl Hall, on half of Upper Darby’s Hall & Oates, turns 73.