There was nothing sinister to trigger the weakness, just some profit taking after a two-month run up.
This morning’s ADP forecast of a bit over 180,000 new jobs created in February adds one more data point to a set that now indicates a measurable slowing in the rate of growth that probably began late last year and continues through the first quarter to date. What we see is not a sign of something diabolical. There is no recession in sight; just a simple slowing in the rate of growth.
Internationally, the slowdown is more noticeable in a lot of countries. Japan has probably slipped back into recession. Its demographics are so bad that staying out of recession is considered a victory. China’s growth has slowed over the past year and U.S. tariffs certainly haven’t helped. But the Chinese government has taken bold and massive stimulative steps that should keep growth well over 5%. Thus, while China’s growth is the lowest in several decades, it still is higher than almost anywhere else in the world. Europe teeters with recession. That too is partly a function of demographics but political uncertainties in France, Germany, Italy and Spain are all contributing factors. Brexit looks likely to be delayed but kicking the can down the road, while avoiding a hard exit, isn’t a solution. The U.K. will hold a series of votes this month that most likely will move closer to a solution without invoking either a hard exit or a call for a new referendum. Look for a modified exit in the second quarter, one that will cause a bit of pain but will be seen my most as a victory.
Getting back to the U.S., to understand today’s economic picture, one has to look back to the passage of the new tax law in the fall of 2017. Many companies reacted by paying one-time bonuses. Others doubled up payments in late 2017 to gain some tax advantages. As a result, many workers started 2018 with some extra cash in their pockets, money they freely spent in early 2018. By the second quarter, growth had exceeded 4% and optimists within the administration were calling for a sustained period of 3-4% growth as far out as one could forecast. But, alas, that wasn’t to be. Just as “cash for clunkers” and first-time home buyer tax credits pulled demand forward when desperately needed during the depths of the recession, in the end there is a dead zone created once the demand is filled. To some extent, especially, when looking at numbers on a year-over-year basis, that is where we sit today. The U.S. consumer is still spending but not with the same enthusiasm as six months ago.
It would be a mistake to overread the slowdown. Not long ago, economists of leading investment banks were tripping over each other to see how low they could take forecasts for growth in the second half of 2019. Some were down to as low as 1%. But it now seems likely that growth could well hit bottom in the first half of this year. The government shutdown and tariffs certainly haven’t helped. I would like to think the tariff problems will soon go away but if President Trump succeeds (at least in his own mind) of reaching an agreement with China on trade and intellectual property, he might believe that the use of tariffs was the weapon that got the other side to agree. He has before him a Commerce Department proposal to raise tariffs on European car imports. Hardly anyone in the business world, including U.S. auto makers, believes imposing tariffs on European cars is a good idea. But Trump loves tariffs as a weapon and, therefore, to conclude tariffs will disappear overnight may be excessively optimistic. With that said, U.S. auto imports from Europe comprise a very small part of our economy and tariffs probably won’t move the economic needle much if imposed.
We have seen an interesting pattern in retail over the past few months. Low end retailer have reported very strong results, even better than expected. But fashion and high end retailers have generally missed forecasts. This includes virtually all the department store chains. Gasoline prices are started to edge up again adding a bit more pinch to the retail pocketbook. On the other hand, tax refunds, which were lagging early on, seem to be coming in fairly level with last year erasing one major fear. In total, retail is OK. It is growing at a tepid pace. Online remains strong while in-store sales remain spotty, stronger at the low end, with department stores bearing most of the negative weight. To a large extent, this is self-inflicted as few have developed a true omni-channel presence that can compete.
Housing is also showing some hints of sunlight. While starts have been down this winter, the spring selling season is off to an OK start, not great but not horrendous either. It has become a buyer’s market. Priced right, inventory sells. But sellers have to accept that buyers are not going to chase. Those who price homes based on wishful thinking will get little or no attention. But rising household formations, flat pricing and lower mortgage rates suggest a second half of 2019 significantly better than the last six months.
At the core of our economy there are a record number of jobs and productivity is slowly rising. That can sustain 2-3% growth. In the short run, that may not show on the top line as a bit of excess inventory has built up through the end of last year that needs to be burned off. That should happen during the first half of 2019. Thus, the combination of less cash in the pockets of many (fewer bonuses and perhaps smaller tax refunds for those in high tax states), and inventory liquidation could lead to growth of less than 2% in the first half of the year followed by better comparisons in the second half.
Tying this back to the stock market, equities are now priced at about 16.5x forward estimated earnings, a bit higher than normal but not out of line given low inflation expectations and interest rates. I would label it fairly priced. Given a recovery of almost 20% since Christmas Eve, some pause might be expected. If any further first half softness causes further moderation of earnings forecasts, then a pullback of something on the order of 5% wouldn’t be surprising. But if the second half of the year shows stability or even signs of slight improvement, then stocks could make a run toward 2900-3000 before the year is over. I wouldn’t recommend chasing stocks here but having a shopping list ready for a modest pullback makes sense.
Today, Phillies pitcher Jake Arietta is 32. Shaquille O’Neal turns 46.
James M. Meyer, CFA 610-260-2220
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