But all isn’t perfect. German ten-year bund yields fell below -30 basis points overnight and 10-year Treasury yields in the U.S. are down to 2.0% after reaching over 3.25% at the start of this year.
After a spike last year, our economy’s growth rate has once again receded to its 10-year trendline. For all the talk from supporters of tax cuts, enhanced fiscal spending and wider deficits, it doesn’t appear, at least at the moment, that their impact was sustained. Sure, if Washington chooses to increase the deficit each year by $250 billion it could sustain a tailwind for short term growth. But even the most avid supply sider would see the folly of expanding deficits each year at that pace. The reality is that monetary velocity is slowing once again after briefly rallying off of multi-decade lows.
The culprit is over capacity. And I mean everywhere with the single exception of labor. Our plants still run below 80% of capacity. While China has slowed its pace of capacity additions, the expansion of production capability over the past decade continues to cast dark clouds all over the world. President Trump tried, last year, to impose steel tariffs to keep China’s excesses from spilling over to our markets. But steel is a commodity and it will find a home somewhere at a price. Thus, the early gains (from the perspective of U.S. steel manufacturers) from the tariffs quickly faded. The President hoped other tariffs would serve to move production back to the U.S. While he can point to anecdotal instances where that has happened, manufacturing output here is weakening and one of the economy’s current soft spots. Indeed, since tariffs are a tax and non-productive, the impact of tariffs or even the threat of tariffs is simply to raise prices and reduce demand. Lower demand at a time when capacity is in excess is a bad combination.
Tariffs alone are hardly the villain. New fracking technology has led to a sharp increase in oil and gas production in the United States. Even without adequate pipeline capacity to move all that can be produced to market, production is now back to record levels and rising rapidly. The rise of alternative energy sources and slower growth worldwide are crimping demand. While prices may be elevated for the moment due to tensions near Iran, the near-to-long term outlook for oil prices is weak if demand cannot keep up with production growth.
Warm weather has expanded crop production. Perhaps heavy rains this spring will result in lower crop yields in 2019 in the U.S. but the damage has been done. Commodity prices for agricultural products continue to be weak.
There is an oversupply of lumber, of semiconductors, of clothes, of smartphones, etc.
The end result of all this is lower inflation. The Treasury, the Federal Reserve and other central banks have reacted by increasing the supply of money. But instead of being spent, the excesses are being redeposited at central bank windows, at least here. Banks can earn 2.35% today on their excess reserves, risk-free. To the extent that comes close to or even exceeds net interest margins, there is limited desire to lend. Unless the Fed chooses to make it expensive for banks to redeposit funds, pouring more money into an economy that is awash with funds isn’t going to spur growth.
One could argue that expanded fiscal policy might help. But here again it matters how the increased dollars are going to be spent. If they simply fund an expansion of entitlements, that simply reshuffles money without any productive benefit. Better infrastructure would lead to better productivity. But Congress isn’t about to do that in front of an election and the current bifurcated Congress may not move forward after the election if the current makeup of government remains intact. The reality is that Washington has been in economic gridlock since the passive of the tax bill in the fall of 2017 and there doesn’t seem to be much of a chance for change anytime soon.
That doesn’t mean the economy can’t grow. It grew about 2% per year in the Obama years when gridlock was the normal state and it can continue to do so again. But it is also clear that 2% growth isn’t going to allow inflation to rise back to 2%. Either the Fed has to accept a lower rate of inflation or its efforts to do some form of quantitative easing is going to have unintended consequences eventually. Too much cheap money encourages dopey decisions. In the early 2000s that meant too many homes got built leading to a collapse in financial markets when financially weak homeowners couldn’t service their mortgages. Reality says every time may be similar but the facts are always different. This time around, excess debt is held by sovereign governments and corporations. Companies have been using “free” money to expand within markets already oversupplied, to fund acquisitions, often at inflated prices, and to buy back stock, often at high prices. While the size of debt loads may not matter when interest rates are as low as they are, any increase in borrowing costs will pinch quickly. That is offered as one explanation as to why the economy slowed more than expected on the heels of four rate increases by the Federal Reserve last year.
Sharply lower interest rates push holders of capital to take more risk since they cannot get desired returns when rates are too low. In financial markets, that pushes money into the stock market, in particular to the high risk side of the market. IPO booms often accompany times of capital excess and now appears to be one such time. Is this a bubble? Only history will tell us that but clearly a lot of companies that aren’t making money and have no prospect of making money any time soon are being rewarded with mind boggling valuations. And more come to market each week. This is a freight train that is going to go over the cliff. I can’t tell you whether it will happen tomorrow or three years from tomorrow.
In 2000, leading analysts were building valuation models based on future expected cash flows that ignored early years of losses. Today’s valuation models are different but they bear uncanny semblance. Present value of future cash flow models depend on a subjective judgment of discount rate and terminal values. Slight changes in either lead to major differences in target prices. As a stock goes up, often very sharply, a slight adjustment to either allows bulls to keep raising target prices. Until, of course, one day it all falls apart and we learn yet again that the one constant is garbage-in, garbage-out.
So, is the market overvalued today? I think it is in parts. Certainly the IPO market is frothy and I would label the prices of many of the hot tech names in sectors like cloud computer, collaborative software, and data analytics as extended, to be polite. Consumer staples, REITs, utilities and pharma names are at high prices but if interest rates stay at or below present levels, these stocks can hold up. However, some might say that is a big if.
We had two valuation corrections last year. Both lasted just a few weeks, were very sharp, but were not long lasting. Within months, stocks recovered to old highs. If the economy remains OK, risks or a debilitating bear market remain low. But valuation matters. The big boost this year-to-date has been entirely due to the sharp drop in interest rates. As I noted at the beginning, the root of these low rates, weak inflation, isn’t about to change. The Fed has little leverage to foster significant growth improvement by itself. Governments around the world need to spend wisely. Unfortunately, right now, the world outside of authoritarian states, have few strong leaders. England has none. Mrs. Merkel’s time in Germany is winding down. Whatever your opinion of President Trump may be, there are few signs that he is going to get a fiscal game plan passed that will enhance economic productivity. The Fed could help by sharply reducing the rate it pays on excess reserves. A high rate may have been justified during the early stages of recovery from the Great Recession but it is counterproductive today.
With stocks now back to highs, the risks are rising. To move ahead further, either earnings prospects have to increase or interest rates have to fall further. Stocks could get one more boost later this week if trade talks between the U.S. and China go well. Right now the most likely outcome is for smiles and a deferment of further tariff increases on our part. But that is an expectation, not a guarantee. Starting next week, the focus will go back to the economy and to second quarter earnings. Neither looks all that buoyant at the moment.
Today, the Sixers’ J.J. Reddick is 35.
James M. Meyer, CFA 610-260-2220
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