Friday was the 11th straight decline for the Dow Transports, an indication that slower growth in the U.S. is worrying investors.
Yesterday, March 10, was the 19th anniversary of the peak of the dot.com bubble all the way back in 2000. On that date, the NASDAQ closed above 5000. Over the next two years, the index fell by almost 80%. As Warren Buffet often quotes, you don’t know who is swimming naked until the tide goes out. We certainly learned to separate fact from fantasy right after the millennium.
Saturday, March 9, on the other hand, was the 10th anniversary of the stock market’s bottom during the Great Recession. The S&P 500 over the past decade has risen from its 666 low of that date to a high around Labor Day of a bit over 2900. Back then, there was talk of nationalizing the banking industry and putting other controls on big businesses. From those calls came Dodd-Frank which has clearly changed the face of the banking industry and insulated it from some of the more egregious risky behavior evidenced at the time by names like Lehman Brothers. As we enter the 2020 campaign season some of the more progressive Democratic candidates are making calls for even more stringent controls not only of banks but of all industry. But while these voices at the moment may be among the loudest, they don’t necessarily reflect a majority consensus of where America is or should be headed. For almost 250 years, America has grown into the world’s economic leader based on a combination of capitalism and democracy. Unregulated capitalism is subject to abuse. When the abuses become excessive, there have been times when the subsequent reactions overreached. During the Trump administration some of the more aggressive regulatory efforts have been softened. Clearly, the 2020 election will, in part, be a mandate as to whether regulation has gone too far, or not far enough.
While the rhetoric will heat up over the next 18 months, little is likely to change in the interim. Financial markets react to facts not media hype. While the recent correction might be construed as a statement on the weakening growth rates both here and abroad, the most obvious explanation is simply that markets move up almost 20% from late December lows and a correction necessary to reestablish bargains that would attract new money was long overdue. There was nothing in last week’s correction that could be interpreted as disorderly. At the same time, the extended decline in the Transports points to a fundamental slowing of fundamentals punctuated by the very small employment gains in February reported on Friday.
Looking forward, the elation felt after the tax cuts of 2018 has now worn off. Growth in the U.S. is back to levels seen consistently after the Great Recession, perhaps a touch higher. Productivity gains have improved a bit but should settle back down toward 1.0-1.5% in coming quarters as U.S. growth rates moderate. Combined with the likely growth of the work force of about 1% in 2019, the combination suggests that 2% overall GDP growth is a fair expectation. The Trump administration would like to suggest, particularly in front of election season, that it has changed the basic underpinnings of our economy enough to permanently raise economic growth rates. But given demographic constraints, a slowdown in net immigration, and difficulty in sustaining elevated productivity gains in a largely service-oriented economy, that doesn’t appear to be the case. None of this suggests that any economic damage has been done. There is no reason to expect sustained growth of less than 2%. Moreover, with labor force growth likely to moderate going forward, inflationary pressures will remain very modest. The bottom line is 2% growth, plus or minus plus inflation likely to remain below 2% is a pretty good long term backdrop for stocks. Grown will be a bit below historic norms, mostly due to the laws of large numbers. But inflation will also be well below post-World War II averages. Combined, the two should lead to a typical 7-9% growth in the fundamental value of equities. Offsets to lower earnings growth will be high free cash flows, better dividends, and more share repurchases.
Overseas, the picture has some similarities (e.g. worsening demographics) suggesting worldwide growth should continue to moderate over the years. With our growth being above average, one result is a rising U.S. trade deficit despite efforts of the Trump administration to alter that outcome. Indeed, evidence seems to indicate that tariffs have only worsened the trade picture. Retaliatory tariffs on U.S. agricultural exports have more than offset the reduction of U.S. imports of key products like steel and semiconductors. With that said, part of the cause of last week’s losses, apparent difficulties getting to the finish line in Chinese tariff talks, will continue to weigh on markets until forward progress is restored. The good news is that resolution is almost imperative for both China and the U.S. Indeed, reform of trade practices sought by the U.S. may actually strengthen China’s standing on the world economic stage in the long run. The trick now is to reach an agreement that allows both sides to create victory. That should happen before mid-year.
When markets correct, investor worries start to rise. With that said, there is no obvious reason today to become more worried. Bond prices and yields remain in a tight range. Lower mortgage rates should help housing and auto sales in 2019. Consumer spending growth has moderated a bit but individuals are saving a lot; their buying capacity is actually growing. Tariffs and politics always create some tension but it is hard to see problems escalating.
The obvious exception to the last statement would be if some of the policies of the progressive left become the core of the Democratic platform of 2020. But there are already indications that isn’t going to happen so quickly. Take single-payer health care. There have already been early steps taken within the House at the subcommittee level to proceed down that path but those steps ran into a brick wall when the subject of cost arose. Today, employers foot the vast majority of the cost of healthcare and our tax system allows that to happen without saddling individuals with a large tax burden. If the U.S. were to simply offer Medicare for all, clearly, it would have to charge everyone a premium in the form of a tax similar to today’s Medicare tax to pay for it. That means substituting a tax on every working person for the insurance premiums now paid by employers for the most part. Making that transition work is a hurdle no one has come close to solving yet. It’s easy to build a platform of multiple benefits, such as single payer healthcare, but anyone who has taken Accounting 1 knows, for every debit there is any offsetting credit. In English, every benefit has a cost. Thus, we will hear many times over the next 18 months wish lists of new benefits. But many of these suggestions will quickly disintegrate without cogent plans to pay the costs. That doesn’t mean however, that some progressive candidates won’t quickly whip up emotional support among the young, poor and most liberal among us. Some ideas will get more traction than others and could send some fear into markets. But it will still be the political center that selects the next President and no one should lose sight of that.
As for now, we are in that mid-quarter vacuum of data. Earnings season is over and it is still too early in March for any company to alter Q1 outlooks. Economic data for February is largely out already. Thus, other news events, like tariff talks, can take on outsized importance for the next few weeks. Also recognize that after this week, companies start to shut down stock repurchase programs until after Q1 earnings are released. Thus, markets can do a bit of a dance on eggshells for a couple of weeks until we get into earnings season. That could add some volatility but I don’t see any sharp change in direction.
Today, 76er General Manger Elton Brand turns 40.
James M. Meyer, CFA 610-260-2220
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