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.
In recent weeks Jim’s letter has been focusing on near term events with potentially market moving consequences. Obviously, tariff talks, the Fed meeting and economic data have been front and center. Today I would like to direct your attention to the possible positives and negatives for the coming 6-12 months and the potential impact of these trends for stock prices. In other words, will the market be higher or lower as we approach the election? Starting with the worries:
1) The European and Chinese economies are decelerating. Some are speculating that Germany has entered a recession. Certainly, industrial production has been down each month since late 2018 and in the June quarter, German GDP was negative -0.1%. The technical definition of recession, two quarters of negative GDP growth, may be met this year. On top of that, Chinese growth has been decelerating for the past 10 years. Even by China’s own dubious economic statistics, growth fell below 10% in 2011 and growth has been declining steadily since, officially registering 6.2% in June. Most independent economists who study China would argue that the real growth rate is about half that. Why is growth in China slowing so significantly? The simple answer is that China’s working age population is stagnant, mostly as a result of the previous 40 years of the “one child” policy. Without an increase in population, an economy can only grow if productivity rises. In China productivity boomed as workers moved from farms to factories. Farm workers made about $600/year while factory workers made about $6000/year when these trends started in the 1990s. At that point, over 60% of the population in China were farmers and last year less than 17% of the population was engaged in farming. As the migration from farm to factory has slowed, so has GDP growth and productivity. With both Europe and China slowing, the US is feeling the impact, particularly in the industrial sector. If the deceleration continues and US unemployment begins to rise, consumer sentiment may be impacted.
2) The imposition of tariffs by the US acts economically like increased taxes. Lowering returns to businesses and increasing prices to consumers always has a negative economic impact.
3) The yield curve is close to inversion. We have discussed this thoroughly in past letters, so I will not dwell here, but suffice it to say that a persistently inverted curve generally causes an economic slowdown. In addition, leading indicators, a good predictor of economic direction, are slowing which is a cause for worry. Leading indicators are not negative at this point, but were flat in August.
4) Finally, the market hates uncertainty. President Trump is the master of creating change and change often causes uncertainty. He may have started a fire that he cannot contain with the tariff gambit. We agree that it was probably time to call out China’s persistent flaunting of international trade law, but China may now have a tool to make President Trump’s re-election more difficult if that is their preferred outcome. Keeping tariffs in place is a negative for the global economy and we’re all linked together.
Obviously there is a lot to worry about, but the US economy and the resilience of corporate America are often underestimated by investors. How could the outlook be more positive than the above discussion implies?
1) Global monetary easing is increasing. There is a reason that the old adage “Don’t fight the Fed” is often repeated and that is because it is usually very good advice. While Jim has been very insightful about the reasons that the world does not need more money to be printed, the fact remains that low interest rates and easy policy are stimulative. China has been very aggressively easing and Europe has begun another round of QE. Of course, the Federal Reserve is also lowering rates and these measures will probably keep the US from tipping into recession.
2) The point above is important, but add to that the strength of the US consumer today. Remember that the consumer contributes more than 70% of US GDP. Not only is the consumer spending, but they are spending relatively prudently. Today the savings rate is around 7%. This is at the high end of historic trends. In addition, the US consumer has strengthened their balance sheets significantly since the last downturn. Debt to disposable personal income is as low as it has been since the 1980s. As long as consumer confidence continues, a downturn is unlikely.
3) It is very unusual to have a recession in an election year, especially when a sitting president is running for a second term. Presidents have many options to provide short term stimulus to the economy. For example, one of President Trump’s options today is to settle the tariff issues with China. This would relieve markets and improve earnings. He could also compromise with Democrats and pass fiscal stimulus, like a highway bill which both parties agree is needed. In short, a President running for re-election will pull all his levers to keep the economy rising prior to the election.
4) This has been a long recovery, which makes people worry that the expansion will end, but we see few signs of excess, little speculation and little or no economic imbalance that could turn a period of economic softness into a real recession. That does not mean that the future is clear, but the odds favor continued slow growth, not a dip into recession. If the world did slip into recession in the next 6-12 months, it is likely that a downturn would be relatively mild.
Our crystal ball is not clear, but the odds favor a continuation of slow global growth, not a recession. In these uncertain times, it makes sense to keep equity exposure to reasonable levels and to hold stocks with earnings power and decent growth prospects.
Will the stock market be higher or lower next year? No one knows but unless global economic prospects shift considerably, investors should probably expect more of the same. The global economy in the next 12 months will probably be similar to the past 12 months and the stock market may take some time to digest 2019 gains, but should continue in an upward trajectory in line with earnings growth.
Maris A. Ogg, CFA 610-260-2216