Over the weekend, the only real news was reaction to Trump tweets, something that seems to occupy the media each weekend but something that has little economic bearing and, therefore, little impact on the stock market.
With earnings season winding down, it makes sense to both look back and forward simultaneously. Looking backwards, earnings per share have risen close to 25% in each of the past two quarters, a remarkable achievement. While the tax cuts were the biggest contributor to the growth rate, earnings would probably have risen at a double digit rate even without the benefit of lower taxes. Economic growth in the second quarter was over 4%, international results, while not as robust as earlier in the year, continued to contribute, and inflation remained surprisingly subdued. But one could easily argue that the last six months is about as good as it gets. Lower taxes, expansionary fiscal policy, and easy money overseas are not likely to get much better. The lower taxes have two more quarters to run before their year-over-year impact dissipates. With a deficit now approaching $1 trillion per year and rising, the ability for Congress to continue to add to spending without any new revenue sources is diminished. Never underestimate the willingness of both Republicans and Democrats to keep spending with abandon but it becomes harder and harder to do so as the deficit continues to expand. As for easy money overseas, that too will have to come to an end before too long for many of the same reasons. The U.S. isn’t the only country awash in debt. As interest rates rise and debt service costs increase, some for of fiscal prudence will be necessary all around the globe.
And that brings me to the notion of looking forward. Historically, the period between now and mid-October is the weakest seasonal period for the market. It is a time without much solid economic or corporate news. Third quarter earnings won’t start being reported until mid-October and we will not see much significant economic data until early October. In the interim, there will be an important Federal Reserve Open Market Committee meeting in September at which time a 25 basis point increase in the Federal Funds rate is almost certain. If short term rates rise a commensurate 25 basis points and inflation expectations remain muted, the is a good chance the spread between two and ten year Treasury bonds will fall to near zero. There is even a real possibility that 10 year yields will fall below two year yields, creating what market watches call an inverted yield curve. Normally, longer term rates are higher than short term rates but when the reverse happens, when the yield curve inverts, it is a strong sign that a recession is about a year away. It isn’t 100% true but it is true often enough that the market could become spooked if the curve actually inverts.
That is not the only short term market risk. Tariffs are another one. Trump has now put tariffs on steel and aluminum worldwide plus additional tariffs on $60 billion of Chinese goods. Nations around the globe have responded in kind with a like amount of tariffs on U.S. good. Ostensibly, these tariffs are intended to apply pressure for nations around the world to begin to negotiate to allow better trade terms for the United States. But so far, except for one modified treaty with South Korea, there are no new agreements and nothing seems close at hand. Mexico and American negotiators claim progress is being made but elsewhere there has been little movement. Meanwhile Trump has suggested tariffs as early as September of up to 25% on another $200 billion of Chinese imports. Will the added pressure make China cave? I have no idea. But I do know the impact of 25% tariffs on $250 billion of goods 2
imported won’t be entirely inconsequential. Furthermore, one can expect commensurate retaliatory steps by the Chinese.
November brings the mid-term elections. If the Democrats regain control of the House, expect two years of bickering and gridlock. If Republicans maintain control of the House with a smaller majority, expect little more as the Freedom Caucus will likely keep major legislative advances to a minimum.
Finally, there is the aforementioned deficit. Deficits don’t matter until they matter. Already, annual debt service is up about $200 billion from the 2016 lows and it could easily double in the next two years. This increase only adds further to the deficit. President Trump so far as said entitlement reform is off limits. That makes sense. Entitlement reform can only mean the government reduces support for the poor and elderly, steps that would be politically unpopular whether the initiative comes from the Democratic or Republican side. It has been said that Mr. Trump could shoot someone on Fifth Avenue and his base would still support him. But take money out of the pockets of his base and maybe the reaction would be different. Without some form of entitlement reform, there is little hope that deficits won’t keep expanding.
Thus, we face the end of the super good times where lower tax rates ignite 25% earnings per share growth but the storm clouds keep getting a bit bigger. Valuation is not favorable. Stocks, once again, look a bit expensive. I am not implying the bull market is over. Earnings continue to grow and inflation is still tame, the two most important factors. But I am suggesting that with stocks once again at the high end of the 2018 trading range and a seasonally tough period ahead, now is not the time to be overly optimistic. Tactically, raising a bit of cash might not be a bad idea.
Today, Philadelphia’s Leslie Odem Jr. is 37.
James M. Meyer, CFA 610-260-2220
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