As we have all been expecting and witnessing, growth around the world, including the U.S. has slowed noticeably from its pace of just a few months ago. Part of that is political uncertainty, particularly in Europe. Part relates to the added cost of doing business as a result of tariffs imposed around the world, precipitated by President Trump’s efforts to level the playing field.
The immediate impact of the ECB announcements yesterday on our economy are (1) that it should reinforce the stance from the Federal Reserve to leave our short term interest rates alone until at least the second half of 2019, if not longer, and (2) further strengthening of the dollar as the differential between our growth rate and those of the rest of the developed world widen. This will have a particularly negative impact on earnings of U.S. multinational companies who will be hurt by both weaker growth overseas and the negative translation impact of expressing foreign earnings in U.S. dollars.
The moves by the ECB also resulted in lower rates in our market, a benefit to borrowers but a negative to lenders. Notably, the yield curve didn’t change its shape noticeably. The bond market is still calling for a slow growth environment without much inflation. The odds of recession haven’t changed.
Also yesterday, fourth quarter productivity data came out showing a net increase of just under 2%. Combined with a growth rate of the work force of about 1.5% (depending on whether you believe the payroll or household survey data more), this still suggests overall growth of something close to 3%. However, with inventories building and our economy decelerating, it would be logical to expect productivity in the first half of 2019 to slip back toward 1% or so. All this coincides with our thoughts that the first half of 2019 may be the lowest for growth in some time. But there are reasons to expect improvement thereafter, particularly if tariff pressures can be reduced. In addition, to the prospect of lower tariffs, lower interest rates should be a positive influence on interest sensitive industries like housing, autos and retail. Spring selling season for housing is just getting underway and, despite some poor housing data for the late fall and winter, there are some signs of life over the past 4 weeks or so.
Lastly, this morning’s employment report for February will only add to the confusion. Just 20,000 new jobs were added last month, well below January’s gain of 311,000 jobs. I wouldn’t put too much emphasis, however, on the sharp decline since numbers for both January and February were almost certainly distorted by the government shutdown in January. To the extent some government workers took temporary jobs in January and left them in February, that would increase the January number and decrease the February total. Given the volatility of the monthly employment statistics under normal conditions, I always suggest looking at a rolling 3-month average. That number, 186,000 net new jobs was very close to the consensus estimate for February of a bit over 180,000 new jobs. I would also note that despite the meager gain in new jobs in February, the unemployment rate fell from 4.0% to 3.8%. Finally, the impact of higher wages was evident in the report. Wages rose by 4% annualized in the month, the highest rate of increase since the recession. However, coupled with a 1.9% gain in productivity, the net impact is just about 2%, right on with the Fed target for inflation. With all this said, and given the negative tone in the marketplace this week, the low number will be fodder for sellers of equities this morning.
Of course, stocks look ahead. The current economic malaise should largely be priced in assuming no meaningful further deterioration is about to take place. Stocks rose almost 20% from their lows Christmas Eve to their recent highs last week. Some retracement is to be expected. So far, that has been orderly. But with that said, and as we saw last year both in February and the late fall, selling pressure can escalate quickly. Sudden drops have become almost a norm and any downturn has to be respected. In addition, as we move into mid-March, soon most corporations will have to cease stock buyback programs until their first quarter earnings are released in April. How important is that? In the fourth quarter, corporations spent more money repurchasing stock than they spent on investments within their business. Most stock repurchases are concentrated in 8 months, excluding the 30 days each quarter in front of earnings. In December, not only did the lack of repurchases rob markets of buying power in a tailspin, but tax selling and hedge fund liquidations added fuel to the downturn. This time there will not be any tax selling and only minimal need for hedge funds to fund liquidation requests. Thus, there shouldn’t be outsized selling pressure. That doesn’t mean stocks are immune to a decline larger than 10% but it shortens the odds. If you are nervous near term, watch the VIX measure of volatility. If it remains below 20, any correction should be orderly, maybe in the range of 5-8%. But if downside pressure mounts and the VIX rises higher, a 10%+ retreat could occur leading to some chatter that a full retracement toward the December lows is possible.
As readers of these letters know, I have pegged fair value very close to where we are today. That means stocks at the moment are not at compelling cheap prices although they aren’t very expensive either. But since everyone likes a bargain, one could see some further downside before any correction runs its course. With four down days in a row, it is time to be a bit more defensive than offensive. In good markets, the last hour or so is a trader’s friend. In weak markets, the opposite is true. Be careful of morning rallies without any follow through. My sense is that first quarter earnings will not be all that surprising but I don’t expect many companies to beat forecasts and raise full year guidance very much. As has been the case so many times, the more likely pattern is that the average company with beat existing first quarter estimates by a small amount followed by management commentary that will tone down future expectations. In the end, I don’t expect much change in overall 2019 estimates.
All this suggests we are at the beginning of an orderly correction, one that will reestablish some bargain prices needed to bring in new buyers. Fundamentally, the overriding concern is the outcome to trade talks, first with China and perhaps later with Europe concerning possible tariffs on automobiles. It now appears that the China talks will drag on a bit longer than one might have hoped a week or two ago. The key is the enforcement mechanisms to will protect any concessions China makes relative to respecting intellectual property rights and reducing forced technology transfers. While all economies around the world have felt the impact of tariffs instigated by U.S. policy, no country has felt the impact more than China. But that doesn’t mean China is ready to roll over and comply fully with developed world norms. Presidents Trump and Xi are both headstrong rulers who want to be able to claim victory with any agreement. Finding the right balance to let both “win” isn’t simple.
In the meantime, now is the moment to build your shopping list and perhaps weed out the investments that aren’t meeting expectations. Stocks are only about 2% below recent highs. Raising a little cash now for better bargains later isn’t a crazy idea. With that said, corrections are a normal part of a market’s breathing process. There are moments, in the best of times, when stocks simply are fully priced. Retailers have sales a few times a year and so should the stock market. Don’t overread any correction even if we have a day or two with losses of 2% or more. There isn’t a recession looming a month or two down the road and markets aren’t overheated. It’s just a continuation of a nice pattern of two steps forward, one step back.
Today, Lester Holt turns 60. Monkees drummer Micky Dolenz turns 74.
James M. Meyer, CFA 610-260-2220
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