3rd Quarter 2018 Market View
U.S. GDP, just reported, grew at 4.1% in the 2nd quarter and has averaged 3.1% for the past four quarters. The tax cuts, repatriation, and more friendly business environment has business and consumer confidence at the highest levels in 20 years. The result has been a recent surge in capex spending among businesses small and large.
As the employment rate has surged, resulting in more jobs than job applicants, business has begun to turn to productivity investment. These, along with concerns of debt and trade deficits are the topics for this quarter’s Market View. More significantly, these will be the theme for our investing over the next few months to years.
The global economy is $86 trillion. U.S. GDP is almost a quarter of that. Europe is about 20%, and China and Japan comprise about 22%. The U.S. has about $20 trillion of GDP, and a trade deficit of approximately $500 billion, including $350 billion with China. That means we are delivering money to China and others, knocking 2.5% off our GDP. The tariff situation has been a surprise, but Trump is an arm wrestler and there will be a lot of give and take. Some of it is good. It creates volatility – the old normal in markets. Though volatility is uncomfortable in the short-term, it is likely to increase returns. It allows us to buy good companies a little cheaper, as long as we remain patient.
The tariff noise is creating excuses for some companies like nail makers and Harley Davidson, who use the tariffs as excuses for layoffs or building plants overseas, but for the most part, when combined with the lower tax rates and a territorial tax system (from the previous global system) we can expect a stronger dollar and more companies locating here in the U.S. Further, if tariffs are not a temporary thing, the stronger dollar will negate much of the negative effect and have a minimal effect on the U.S. consumer. The consumer is 70% of the U.S. economy. Jobs are plentiful, wages are rising, and the net worth of the consumer is at an all-time high. There have been many claims of how higher aluminum and steel prices are hurting businesses, but a look at actual prices paint a different picture. Aluminum and steel prices are actually slightly lower than they were at the beginning of the year, though higher than a year ago. Any impact on imported metal is somewhat negated by the stronger dollar and is certainly short-term as there are two aluminum plants and five steel plants in the process of being re-opened in the U.S.
If the Republicans can hold on to the House and Senate, it is possible the tax act will be tweaked again, likely eliminating the 3.8% surcharge on capital gains and dividends and making the personal tax cuts permanent. That will certainly bring a debate over the debt. Without getting caught in a political debate, I’ll just say that wasteful spending is the problem, whether it be an R or a D result. Whoever is in power seems to spend more, but it is not a problem of too little taxation. Pray for the day of term limits and now I’ll return to finance.
In the future we can hope to see private/public partnerships in many infrastructure plans, perhaps even in other areas. This should help keep fiscal deficits in check while providing us with much needed improvements in infrastructure, healthcare and other areas where government has either failed us or, at a minimum, wasted too many resources. A better infrastructure is not just more convenience; it will add to our GDP.
The yield curve flattening and inverting, causing a recession seems to be one of the most talked about concerns these days. Let’s examine the yield curve: Many making that argument focus on the 2-year to 10-year Treasury spread. First, the proper focus should be on the Fed Funds Rate vs. the 10-year. Currently there is a 1% spread (<2% compared to <3%). What makes this Fed tightening different than previous, such as 2000 when Alan Greenspan was the Fed Chairman, is the $2.5 Trillion of Treasury bonds held by the Fed today. When Greenspan raised Fed Funds rates to 5.5%, the 10-year remained at 5.25%. He called it a conundrum – I called his last raises boneheaded. Some point at that inverted curve and blame it for the 2000 recession. That is akin to saying that Catholic churches are responsible for murders since it is a fact that the more Catholic churches in a city tightly corresponds to the number of murders. Of course, it is population size that actually drives both numbers
The President wants a reasonably strong economy in September-October, ahead of the midterm elections. Arm-wrestling with the Chinese over tariffs should cool off by then, as well.
Since 2009, Larry Summers, Paul Krugman and others have maintained that the U.S. economy could do no better than 2% real growth. We have referred to it as a Plow Horse Economy. But after cutting taxes and reducing onerous regulation, last Friday’s GDP report demolished their theory. Though the diehard naysayers will state that net exports were an unusually large boost, they fail to mention that inventories were an equally large drag (largest since 2009). As a result, our calculations forecast a repeat of 4%+ GDP growth in Q3. Keep in mind that in 2000 and early 2008 we were very bearish – we are not permabulls! We are mathematicians and economists and are doing our best to find truth in numbers and the fundamentals so we can find opportunities for investment.
The U.S. economy is stronger today than it has been in ten years. Business and Consumer confidence are higher than they have been in two decades. The consumer is 70% of the U.S. economy. Jobs are plentiful, wages are rising, and the net worth of the consumer is at an all-time high. Gasoline prices have been rising, but Trump is jawboning the Saudis to get oil prices down. If that is ineffective, we should still see lower oil and gas prices by the 4th quarter of 2019. In the 3rd quarter next year, we will see three pipelines open to west Texas, allowing an additional million barrels of oil per day to reach the market (we have a number of companies on our watch list to capitalize on this event).
The tax cuts and repatriation dollars are just beginning to be put to work. It takes business some time to determine the best use of those dollars and they will be deployed over the next several quarters. With more job openings than people looking for jobs, we expect much of that will be invested in robotics, requiring software and semiconductors, making employees more productive.
Companies, large and small, are moving to the cloud for secure storage, creating new and profitable revenues for companies like Amazon, Microsoft, Alphabet, and others. Autonomous vehicles are literally just around the corner – they will make us more productive as we work, rest, or relax during commutes. I expect that we might even see a move from inner-city locations to beyond the suburbs as commutes will be more productive. Artificial Intelligence (AI), Augmented Reality (AR), 5G, the Internet of Things (IOT), and medical innovation are just a few of the many exciting advances that offer new opportunities for investment. The changes today can be compared to the invention of the steam engine and the Industrial Revolution.
There is always a bull market somewhere – we don’t care about the vehicle – just the destination.
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This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.