With no new news regarding tariffs, trade, currency wars or the Fed, investors calmed down and resumed buying stocks. With bonds, even long-term bonds, generally yielding 2% or less, even income investors were gravitating to stocks.
Here are some of the facts we know:
- Growth is decelerating all around the world. In the U.S., leading economic indicators are falling, normally a precursor to recession.
- Long-term interest rates around the world are in freefall with only the U.S., the United Kingdom and China sporting positive interest rates all along the yield curve among the larger and developed markets.
- U.S. corporate profits are still rising but barely. Year-over-year dollar headwinds could allow profits to rise starting next quarter but that could be negated by threatened tariff increases.
- Tariffs already instituted over the past 18 months have resulted in a dramatic slowdown in trade worldwide. It has not, however, evolved into a major change in the balance of payments for the U.S. To the extent American companies have altered supply chains, for the most part manufacturing that has left China has gone elsewhere in Asia rather than return to the U.S.
- Consumers worldwide are still vibrant.
- So is the labor market. Unemployment is low as are the level of weekly jobless claims.
- Inflation expectations are falling. But interest rates are falling faster than inflation expectations. Today, the 10-year Treasury yield is very close to inflation expectations. The real cost of money is now negative.
- The lack of yield in the U.S. and negative yields around the world are enticing investors to take more risk. But there is little indication that the low rates here and the negative rates elsewhere are enticing people to spend more. Despite low rates, growth continues to decelerate.
Then there is what we don’t know:
- Will Trump actually implement tariffs against China on September 1? At the moment, most observers expect he will. Bilateral talks aren’t even expected until after September 1.
- Will the implementation of tariffs and the sharp recent decline in rates accelerate the move down in rates by the Federal Reserve, which has its next formal meeting in September? Markets, based on future expectations, suggest a full percentage point cut in the Federal Funds rate over the next year. Some are beginning to suggest the Fed Funds rate goes to zero even without an intervening recession. Why the Fed might do that with a growing economy is beyond my understanding, but that is the direction consensus opinion is developing.
- Sharply lower rates may induce a surge in mortgage refinancing, which will support growth, but they are unlikely to make major changes in other interest-sensitive markets like autos and retail due to factors not related to rates. New environmental rules in Europe will hurt 2020 sales and a modest change in credit card interest rates are unlikely to, by themselves, make a major change in retail spending.
- Perhaps the biggest unknown is the situation in Hong Kong. If the escalating protests evoke a violent response from Beijing that resembles Tiananmen Square, the reaction in financial markets could be sharp and severe. Depending on the severity of possible reactions, monies could leave both Hong Kong and mainland China. While President Trump has tried to stay out of the Hong Kong conflict, any violent reaction could force actions that further divide the two countries and would certainly place a large roadblock on any possible trade settlement. China has a bad set of choices. It can assert itself and crush demonstrations, but it can ill afford to see a subsequent significant flight of funds. I am not making any predictions; politics are beyond the scope of this letter. But the risks associated with a tough situation spinning out of control are real and large. At the moment, markets are not discounting problems but if they occur, the reaction would be very negative. Hopefully, the situation can be calmed down without confrontation. But this is more than a red herring risk.
While growth continues, earnings are still growing, and the outlook still suggests recession will be avoided. Risks have become more elevated, most specifically, the threat of deflation (too much supply!), Hong Kong and an escalating trade war. The problem of too much supply won’t be solved by enticing businesses to increase capital spending worldwide to add to oversupply. How do I know the world has too much capacity? Just look at price. At the moment in the U.S., the only significant categories where prices are rising faster than 2% are rents, hospital services and wages. And in all three cases, the rate of increase is falling. Commodity prices are falling everywhere. The greatest fear is that the whole world gravitates toward a Japanese-like economic pattern of near zero interest rates, rising savings and near zero growth until such time as inflation returns. Central bank policies that want to pump more money at ultra-low rates into the economic ecosphere simply serve to perpetuate the overcapacity and heighten the risk of deflation.
Look at the oil industry. Saudi Arabia and Russia are trying to find ways to restrict production in order to prop up prices. A far better economic solution, which may not be in the short-term interest of either nation, would be to let prices fall to a level that would stifle the drilling of new wells for a significant enough time to rebalance supply and demand. If production falls enough, prices could actually rise. But temporary artificial supply cuts don’t solve a long-term problem. Today, prices could fall below $40 per barrel and not create a shortage assuming Saudi Arabia and Russia produced at normal levels. Politics may not allow that to happen, but the upshot is that the world will remain oversupplied with oil for some time to come and it will lead to a gradual erosion in prices anyway.
So, what’s the solution?
Ken Rogoff and Carmen Reinhart wrote in an often quoted piece that it takes 10 years or so to recover from a financial crisis. The Great Recession was 10+ years ago. But their historical analysis doesn’t add in the immense capacity added by a surging China in the interim. That suggests 10 years might not be enough. As noted, the problem is not lack of demand but too much supply. Will the excess be absorbed in another year or two? Perhaps, but only if the world stops adding supply at a rate faster than the growth in demand. Central banks should get out of the game of promoting growth. They can affect the environment but they can’t, directly, create growth. The threat of deflation, accelerated by overly aggressive monetary policy, accelerates savings more than spending. Governments have to spend more, hopefully on infrastructure that promotes better productivity. Remember that workforce growth time productivity gains equal GDP growth. Our government has been talking about infrastructure spending for years without doing a thing. Unfortunately, there are no signs of any change.
As investors, the best answer is to remain in stocks that either grow fast enough to overcome deflationary forces or that pay and have the ability to raise dividends that exceed meaningfully the yield on 10-year Treasuries. A recession is a possibility but far from certain. Inflation is moving in the direction of deflation but isn’t there yet. Low interest rates keep P/E ratios high, but earnings have to hold for stock prices to benefit. The bottom line is that the consensus outlook hasn’t changed but risks are elevated. Volatility should stay above recent levels. Computer traders, as a result, create short term buying and selling opportunities. Markets with elevated volatility suggest change is in the wind. We have highlighted some of the possibilities. As events fall into place, for better or worse, we will have to be quick to react.
Today, Anna Kendrick is 34. Hoda Kolb turns 55. Designer Michael Kors is 60.
James M. Meyer, CFA 610-260-2220
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