Before starting this morning, I want to thank my colleagues for pitching in so admirably during my vacation. Before switching back to the markets, I want to make one comment on infrastructure. Anyone who has traveled overseas knows that the gap between our roads, airports and rail systems compared with those of other nations, both developed and developing, has been widening. It is a tragic commentary to note that as the wealthiest nation on earth and with all the road and airport taxes we pay, the United States has to lag so far behind. Finger pointing won’t do any good; everyone in Washington is to blame. Economically, poor infrastructure hurts productivity. I guess the only conclusion I should make is that our government has become increasingly bifurcated over the last two decades. As a result, little gets done beyond the minimum. If we don’t work to stay first class, we will lose our leadership. The only way that will happen is for all sides to work to find common ground. Infrastructure is only one example. We obviously need improvement in health care and education as well where we are also falling behind. This is not a problem Democrats or Republicans can fix alone.
Enough of my soap box talk. Back to the markets. The first week I was gone, it couldn’t have been bleaker. Economic data was poor, bond yields fell sharply precipitating a fall in stock prices. Washington went on the attack against the FANG companies. German manufacturing data was scary. Trump wanted to place tariffs on Mexican imports of as much as 25%.
But a week isn’t enough to make a trend. Last week, stocks rose all five days and the Dow was up 5% for the week. The economic data didn’t get any better. But Fed speakers strongly hinted at a rate cut next week at its FOMC meeting with perhaps another one or two to come later this year. At least that is the message of the bond market where 2-year Treasury yields fell to below 1.8%. Friday’s weaker than expected employment report initially pushed stocks down in pre-market trading but they then rallied as investors determined that the weak data reinforced the likelihood of a rate cut next week. We should always remember that stocks and bonds compete for investor dollars. When bond yields fall, stocks become relatively more attractive.
There are two reasons for a Fed rate cut. The first is to stimulate the economy enough to maintain a 10-year economic recovery. The other is juice an economy in or falling into a recession. So far, there is little economic data to show a recession is imminent. Unemployment claims haven’t hooked up. Home building permits are rising and they should rise further as mortgage rates decline. Consumer confidence remains near record levels. Falling gasoline prices will help put more discretionary dollars into pockets. While the short end of the yield curve has inverted for several weeks, the 2-10 year Treasury yield spread has widened a touch, an indication, I believe, that markets believe that we are not near a recession and that a near term rate cut or two will insure continuation of our expansion.
The fly in the ointment, so to speak, has been the threats of tariffs, most recently against the Mexicans and China. Late Friday, Mr. Trump removed the tariffs threat against Mexico. According to Washington, the threat led to a major effort by Mexico to help stem the flow of illegal migrants across our southern border. According to skeptics, all the agreement did was memorialize agreements between the two nations earlier this year. Whoever you choose to believe is largely irrelevant. What is important economically is that the tariffs aren’t going to happen, at least for now.
The economic problem related to Trump’s repeated threats, some implemented and some not, is that it creates constant confusion and uncertainty. Mr. Trump, who likes to disrupt to his advantage, may not always realize the second derivative implications of delayed spending activity. A key driver for sustained economic growth of 3%, 4% or more that Republicans have been speaking about since the tax cuts were announced, has been a slow but steady gain in productivity. Some of that relates to technological advances that come from Silicon Valley, not Washington. Some of that relates to greater cash flow as a result of lower taxes. But recent trends in capital spending have begun to weaken. How much of that relates to a weaker economic outlook and how much relates to political uncertainty is open to debate. Suffice it to say, however, that capex growth is beginning to soften and if that trend sustains, then productivity advances will be tougher to achieve. Without sustained productivity growth of 2-3%, our growth rates will revert to those of the Obama Administration. From a stock market perspective, that may not be so bad. Earnings growth may be a bit less that previously forecasted but lower inflation and interest rates will be a healthy offset.
With stocks now within 2.5% of their all-time highs, and likely to open higher this morning with the Mexican tariff dispute solved for the moment, the question becomes what drives stocks higher from here. As is normal in volatile times, stock performance has varied greatly from sector to sector. Leaders one month can quickly fall out of favor the next and visa versa. With that said, steady staple stocks and high dividend payers have been recent leaders due mostly to lower interest rates. The weakest sectors have been commodities including energy, victims of weak pricing. Unless interest rates have much further downside, it would seem the leadership may rotate again. If we don’t go into a recession and business confidence rises with a more accommodative Fed, then tech may resume leadership.
For now, if you missed last week’s sharp rally, it is probably not a time to be very aggressive. One characteristic of a market and economy in transition is heightened volatility without much change in value. As Jim Vogt noted last week, that is exactly where we have been. Tops have been defined by peaks in January and September 2018, April 2019 and highs today. Lows were defined by the Christmas Eve bottom. Without a breakout to noticeable new highs, I think the safest bet is to presume that the 18 month trading rates stays intact.
Today, Kate Upton is 27. Prince Philip turns 98.
James M. Meyer, CFA 610-260-2220
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