Stocks fell about 1% amid a confluence of negative news. The latest wave of tariffs on Chinese imports went into effect on Sunday. Britain’s new government is intent on forcing a Brexit showdown by October 31 and could force new elections that would elevate uncertainty. While a Parliamentary vote last night reduced the odds of a hard Brexit, uncertainties remain elevated. Protests in Hong Kong continue to get a bit more violent begging the question of an end game. That may have been helped overnight by a decision of Hong Kong’s government to take the bill allowing extradition completely off the table. While it was a step in the right direction, it is unclear whether that alone will ameliorate the protestors. On the economic front, new manufacturing surveys in the U.S. point to a slowdown in manufacturing activity. While not a precursor to a recession by itself, the dilemma posed is whether weak manufacturing will drag down consumer confidence or whether strong consumer spending can lift manufacturing. The Parliamentary vote and the actions to reduce tensions in Hong Kong suggest a positive open to markets this morning. But with interest rates still in a downtrend, angst remains high.
September and early October are notoriously difficult times for equity markets, particularly when the fundamental backdrop is weak or deteriorating. There will be significantly more economic data this week culminating in Friday’s August employment report. Investors will be looking for any further signs whether manufacturing weakness is infecting other parts of the economy. So far it hasn’t. Virtually all real time retail spending surveys to date show no signs of weakness. The bottom line is that as long as Americans remain fully employed, wages continue to rise, and layoffs remain MIA, then there is little reason to get overly nervous.
Stocks have been caught in a very narrow range of 2800-2950 for the S&P 500 since early August. If I look further back to the start of 2018, the range widens from 2600 on the downside to a bit over 3000 on the upside, with the slight exception of the market’s dip (and quick recovery) last December. Using $165 as a round figure for earnings for the S&P over that span, it means the market’s P/E ratio wavered between 15.75 and 18.50 times earnings. With interest rates near their lows over the same time span, one can argue for P/Es at the higher end of the range. Should economic weakness, here and abroad, create a slump in future earnings, however, the lower end of the trading range comes into play even if rates stay low. Higher tariffs that squeeze margins and a strong dollar, which negatively affects the reporting of overseas earnings, could lead to slumping profits even if the consumer remains robust.
Next up is the FOMC meeting that concludes two weeks from today. The 2-10-year yield curve remains flat wavering between 5 basis points positive or negative. The Fed is under pressure to lower rates based on market rates and economic conditions overseas plus political pressure from Donald Trump. Commentary to date suggests another 25-basis point cut is coming with perhaps one or two more this year. However, if one simply looks at U.S. growth and inflation, without staring at the negative rates overseas, it is hard to make a strong case today for any rate cuts, much less the 4 or 5 predicted over the next twelve months. Inflation is slightly below targeted ranges and the economy continues to grow close to 2%. Those numbers might allow a tweak to rates but hardly the need to cut rates in half.
Perhaps a look at weekly mortgage data gives a hint as to how ineffective lower rates are as a stimulus either to economic activity or inflation. For the past few weeks, as rates have been plummeting, mortgage refinancing activity has remained stable. While still well above earlier levels, one would have thought that with rates plunging in August to near historic lows, we would see a wave of refinancing activity comparable to what occurred in 2012 or 2016. That hasn’t happened yet. Maybe it will. Maybe mortgage holders are waiting to see if rates go even lower. As for home purchases, they inched up this past week according to data released early this morning, but housing demand remains quite weak. Some point to high prices. Houses today are about 3-4% more expensive than they were a year ago. Some suggest a lack of inventory of homes for sale. But lower rates (almost a full percentage point below last year) should offset any hesitancy caused by higher prices, and while inventories are below historic norms, I find it hard to believe if someone wanted to buy a home they couldn’t find one to match their needs. There is probably a bigger answer. Without exploring what the answer may be, I simply want to make the point that lower rates, designed to accelerate both growth and price, so far have not created much of an inflection in each. That points to the ineffectiveness of changing rates to move the needle on either growth or inflation.
As I note many times, we live in an oversupplied world and that extends to money. If interest rates paid are the cost of money, a rise in bond prices and a decline in rates suggests too much liquidity in the system, not too little. Monetary velocity, which is near record lows, suggests the same. So does a rising savings rate. A rising savings rate during times of sharply lower returns on cash equivalents also appears to be a contradiction only explainable by too much money. Cutting rates, in theory, should push more spending and more investment. But if confidence wanes or confusion rises, what it will do is create more savings.
Demographics suggest slowing world growth. In the U.S. trendline, productivity combined with the growth of working population suggests a long term trendline growth rate of 2% or a little higher. Obviously, if I handed everyone a check for $500 that had to be spent over the next 90 days, I could spur growth for a short period of time. It isn’t that we aren’t spending. 20% of retail apparel inventory for sale either ends up getting shredded or dumped. 50% of what is in our closet gets worn less than 5 times. Ever. Some things never get worn at all.
Policy today is like pushing on a string. Central banks are trying to force people to buy. Why? Because the world has too much capacity that has to either be absorbed or abandoned. But the laws of supply and demand say that if supply exceeds demand, the result is lower prices. That’s called deflation. Deflation is currently rippling through societies around the world. What makes it opaque or invisible is that there is one primary shortage, labor, and it is the rising cost of labor that causes enough inflation (i.e. what you pay for any services that are labor intensive) to mask the appearance of deflation.
I am not a gold bug. I have never recommended gold and have actually never owned gold as an investment. I simply have no ability to suggest what an ounce of gold might be worth. But if in an oversupplied world, central banks persist in adding more and more liquidity, eventually money, in the extreme, will look like Confederate dollars or the German mark post-World War I. Printing more and more money without a commensurate increase in demand simply cheapens existing currency. Deflation, the direction the world is heading, deflates not only the value of goods but also the value of money. We see this today in a world with negative interest rates. There are only two reasons to own a debt obligation with negative rates. Either you believe rates will get even more negative, or you fear the value of currency will deflate faster than the negative yield implies. When your bond is paid off years down the road, you will get 100 cents to the dollar, but what will the 100 cents be worth in purchasing power. Gold isn’t the only asset that will be a store of value in such a world, but it is the easiest one to buy and sell. Yes, I know there is cryptocurrency as well, but gold has been around for thousands of years, is an accepted store of value, and isn’t subject to digital hijacking or trading fraud in the same manner as cryptocurrency.
Investors want the Fed and other central banks to use low interest rates, currency intervention, and other means, to offset the negative impacts of tariffs and trade wars. I understand that argument. On the other hand, central banks didn’t create the trade wars. What is happening is that tariffs and taxes distort normal commerce. Central bank interference simply adds more distortions. If political or fiscal policies are the cause of today’s headwinds, it should be up to governments to either find alternative offsets (e.g. infrastructure spending) or live with the consequences. Deflation isn’t a solution; it’s just another problem.
President Trump knows when the next election takes place. Despite his schedule of more tariff hikes in October and December, one would expect that, somehow, he will reach some sort of accommodation that will allow him to lower tariffs well before the actual election. I have no idea whether he can be so manipulative and avoid a recession in the interim, but that must be his primary goal. One reason equity markets aren’t lower is because investors see the same path forward I do. They see tariffs as a temporary pain, not a permanent one. But once you start fooling with Mother Nature, it becomes problematic whether you can restore the normal economic order. It is that unknown that raises investor concerns.
Today, Beyoncé is 38.
James M. Meyer, CFA 610-260-2220