Don’t forget as well that we are now in a quiet period before the release of second quarter earnings and most companies are prohibited from executing share repurchase programs until 48-72 hours after earnings are announced. Given the level of stock repurchase programs, that skews the supply/demand balance in favor of the bears. Of course, that balance will flip again by late July and continue until about Labor Day. Thus, in the end, it balances out. But in the meantime, it’s tough to chase against a tape that still worries about what sort of trade war, if any, is about to evolve and faces headwinds while corporations are forced to remain on the sidelines.
This morning, long before the market was ready to opened, futures pointed to another down day. But then word came from Washington, after the House passed a bill 400-2 to strengthen CFIUS regulations, that the White House would abide by the CFIUS rules of engagement and not go further, assuming a conference committee can deliver the law for the President to sign quickly.
CFIUS is an acronym for the Committee on Foreign Investment in the United States. It is an interagency entity of the Executive branch of the government and chaired by the Secretary of the Treasury. It reviews transactions that have the potential to injure the economic and military security of the United States. This is the entity that would stop a foreign company, for instance, from purchasing a major stake in a defense contractor. CFIUS did not want to see the U.S. cede leadership to the Chinese. CFIUS has broad powers and they are being broadened until the pending legislation. In a world where a nation like China will seek any economic advantage it can, CFIUS plays a key role in keeping the U.S. on a level playing field.
Markets responded positively to the news after previously fearing the Trump administration would try to implement its own Executive Orders to stifle trade in a more arbitrary manner. One also has to remember the Trump game plan which is to set the outer limits of debate earlier and then pull back as necessary to reach the ultimate goal. Trump doesn’t want a massive trade war. But he will endure a measure of short term disruption to change the rules of engagement in our favor. Clearly his tactics are unconventional, as least by recent historical standards, and his rhetoric is often harsh and even mean spirited. But, as I remind us all, including myself, often, the stock market doesn’t have an emotion. It isn’t a Republican or a Democrat. It only cares about earnings, economic growth and interest rates. Prices are a composite of future expectations. Clearly, when the rhetoric, back and forth, escalates, the market discounts the risks of bad things happening more. That is what has been going on for the past couple of weeks. Very often the noise is loudest just before settlement. We see that all the time in acrimonious labor negotiations. Thus, it really shouldn’t be all that surprising that the fears related to possible trade wars vacillate a lot at the moment. But, no one really knows the end result yet. Trump and China’s President Xi are both strong minded leaders and neither wants to be seen as backing down ever. That makes compromise much more difficult. Angering our other allies in Europe and North America doesn’t necessarily help our cause although Europe seems to be more willing today to lower some tariff barriers than it was a few months ago.
From a corporate point of view, executives hate uncertainty. Will or won’t there be tariffs and, if so, for how long? Where do we build the next plant? But the point here is that uncertainty may lead to some delay of investment decisions, not something that is good for the economy.
We are approaching earnings season. A few companies that have quarters that ended in April and May have already reported. The majority have seen their stocks fall on generally good earnings. There have been a few exceptions where results were so good that future expectations were guided materially higher. But I want to point out two major areas of concern. The first is currency. In Q1, depending on a company’s mix of foreign business, currency translation could have added as much as 5% to reported earnings per share. But in the second quarter of 2018, the dollar rose. Today, it actually sits a bit higher than it was a year ago. Thus, currency translation was a powerful tailwind in Q1 and a modest headwind in Q2. When companies offered guidance at the end of last quarter, they did so using currency levels at the time they reported Q1 earnings. Changes since then will negatively impact the results of many by 1-5% per share. Analysts should figure that out but many clearly have not done so. Second, while reported inflation remains tame, there have been meaningful increases in wages, oil, timber and other commodities. For companies without significant pricing power, that means a squeeze on margins. Even homebuilders, who have been able to increase prices 5%+, margins are barely holding even because costs are rising as fast as prices. Some older companies that deferred investment spending after the recession are now being forced to catch up. This includes everything from plant modernization, moving to the cloud, or developing an online presence. Simply matching estimated Q2 results is not likely to be rewarded. Any miss will be punished.
Speaking of oil and investment, at the recent OPEC meeting, a collective decision was made to execute a modest increase in production now that markets have tightened. But the increase is modest. For years, the focus has been on the rapid increase in U.S. shale oil production. The U.S. now competes with Saudi Arabia and Russia for world leadership. But shale production has a high decline rate meaning more new fields will have to be development in order to maintain production at current levels. When oil prices were low from 2009 to 2016, the largest oil companies around the world, both privately and state owned, slowed their efforts to discover new large oil fields, mostly offshore. This activity could only be supported by high prices closer to where they are today at $70+ per barrel versus the post-recession average in the $40s. Large oil fields of this magnitude take many years to develop and begin producing. The fields where activity began just before the recession hit are now mostly online but there soon will be a void as there are very few new fields prospectively that will be entering production over the next several years. These large basins have much lower decline rates than shale oil fields but they still decline. Thus, while demand for oil grows about 1-2% per year, or about 1.5 mm barrels, decline rates on existing production may shave as much as 5 mm barrels. Thus, each year, new wells and new fields have to average about 6-7 mm barrels to keep up with demand. Without any major new offshore fields coming on over the next 2-4 years, that is going to be a challenging task.
Today, Tobey Maguire is 43. Director J.J. Abrams is 52. I won’t stoop to tell you which Kardashian sister has a birthday today.
James M. Meyer, CFA 610-260-2220
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