The employment report for October was very strong with about 250,00 new jobs created and the unemployment rate remaining at 3.7%. Wages rose by more than 3% year-over-year but month-to-month the gain was much closer to 2%. There doesn’t seem to be much acceleration in wage growth according to Friday’s data. If there is one fly in the ointment, the large number of new jobs created suggests that productivity growth remains muted. Perhaps, in part, that is due to the retirement of skilled baby boomers while the latest new hires are probably much less skilled. The better part of the young labor pool was hired long ago. Thus, any future gains in production are going to have to be derivatives of technology and automation. There are few signs of accelerated spending in that regard.
With the early October economic data now behind us and most of the earnings reports now out, we should be entering a more quiet market backdrop. Obviously, the volatility generated in October acts as a bit of a coiled spring and it will take time for that to unwind. Normally, the fourth quarter is one that treats equity investors well as everyone looks with optimism toward the next year. Tomorrow, of course, is Election Day and the outcome has suffocated almost all other news in recent days. At the moment, according to the most respected polling data, Republicans should retain the Senate with a very slight majority. They could pick up a seat or two; a lot depends on turnout. Similarly, the odds seem to favor Democrats narrowly winning enough seats to take control of the House. Once again, turnout will be the deciding factor in many of the elections. Should that be the outcome, the conventional wisdom is for two years of gridlock to ensue. A lot will depend on whether House Democratic leadership has any interest in finding common ground with the President. Cynics will say no but, in front of a 2020 Presidential race, perhaps making an effort will be worth something. The picture won’t change if the Democrats win both chambers. Should Republicans keep control of both, the odds for some economically important legislation rise but only slightly. The biggest hurdle will be the desire of a significant number of conservative Republicans to show budget restraint, especially in light of predicted $1+ trillion deficits looming annually. Proposals for a 10% middle class tax cut or a big infrastructure bill, therefore, won’t see the light of day unless proponents find a way to pay for them. In Washington, spending is the easy part. Paying the bill is harder. With just enough true conservatives still left in both the House and Senate, it would seem likely that little will come out of Congress over the next two years regardless of the outcome. Obviously, I am ignoring the range of possible non-economic issues but these won’t have a major impact on the stock market.
We will also find out fairly soon, which of Mr. Trump’s recently proposed actions were true commitments and which were political rhetoric. I doubt, for instance, that 15,000+ troops will spend much time at our Southern border given that they would be legally constrained to support details. As mentioned above, a 10% middle class tax cut depends on how it is paid for. Should Democrats win the House and the Chairmanship of the Ways and Means Committee change, the odds of any further tax cuts become more remote. We will see soon how other proposals made in recent weeks become either reality or fade away. Once the dust settles, the economic focus will turn to two things; Christmas season and Chinese tariffs. Once again, with Mr. Trump, watch the actions and not the verbal threats. Market observers still believe the odds that 25% tariffs will go into effect January 1 against China are still less than 50:50. The odds that they will impact all consumer imports as well are even smaller. But oddsmakers don’t make policy; the President does. There, at least, will be talks between Trump and Xi in late November at the G-20 and Mr. Trump could give China temporary reprieve if it states a willingness to open talks. Remember that he gave North Korea a pass if it engaged in discussions about nuclear disarmament. So far, there has been some behind the scenes talk but little substantive action. The same is true with the EU. Promises of 25% tariffs on cars was pulled back after Trump met with top ECB officials. So far, nothing new has evolved and the tariffs remain on hold. This week, we are set to see new sanctions on Iran but, for now, the President is giving several nations the ability to continue buying Iranian oil. Sanctions won’t be very tough with so many waivers. Many in business hope the same happens with China, that the promise of talks, regardless of how fruitful they are in the short run, will stop further tariff implementation. Should that be the case, stocks could rally strongly into the end of the year. Should Mr. Trump, however, surprise us all and reiterate his tough stance after the meeting and promise to move forward on tariffs, it could be another rough patch.
Looking further ahead, the most important economic questions surround interest rates and economic growth. Obviously, the two are intertwined. Many, indeed most, expect growth to gradually fall from the 4% level of Q2 to something under 3% by the second half of 2019. Supply siders believe growth can still remain at 3% or even higher. Most, however, believe growth rates will gradually fall toward 2.5% or lower unless there is a significant step up in productivity and sustained high levels of capital investment. Interest rates will clearly mirror which path the economy takes. Faster growth invites higher inflation and interest rates. If growth falls back toward 2.5%, inflation expectations could stay muted and bond yields might stay close to where they are today.
Thus, over the next two months, a lot more questions will get answered. We should expect clarity on tariffs, for better or worse. The strength of the Christmas season should set the stage for growth early in 2019 and the near term trend for interest rates. With the election behind us within a day or two, the attendant uncertainties will be answered. That is not to say that our lives will be worry free. We should see wholesale changes in a cabinet that has seen more than a fair share of changes so far. It is quite possible after the election that we will hear Robert Mueller’s report. Who wins the House could determine the path the conclusions of that report take. The debt ceiling was suspended until March 2019 and our gross debt by then will approach $22 trillion. If Democrats will the House, leadership will make demands to allow the debt ceiling to be increased. Finally, a strong dollar is going to play havoc with international earnings at least through the first half of 2019. Somehow, no one has renamed Wall Street Easy Street.
However, in the short run, meaning between now and year end, assuming trade threats don’t get worse, a strong Christmas season and the end of campaign rhetoric should enable stocks to enjoy their usual year end rally. With that said, I think we are now going to find ourselves locked in a trading range with the end of September/early October highs representing the top of the range and last Monday’s lows the bottom. A trade agreement or at least trade peace with China could allow stocks to move to new highs. Conversely, higher interest rates or ratcheting up the trade war could lead to new lows below the bottom of the range. Both, at the moment, are not consensus views. Therefore, I think the most likely outcome is for stocks to drift upward toward the top of the range. If they get there, we will reassess at that time.
Today Odell Beckham Jr. is 25. Tatum O’Neal is 54. Tilda Swinton is 57. Kris Jenner turns 62. I’d like to be a fly on the wall if these four got together to celebrate!
James M. Meyer, CFA 610-260-2220
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