Mid-year Review: Brexit, US Jobs, US election, S&P 500 Makes Record High


January 18th we wrote:

"The US economy should grow at the middling rate of 2.5% in 2016, with unemployment hovering around 5% as more Americans rejoin the work force, and with inflation in the 0.5-1% range.  In this context, the US Federal Reserve can move slowly to raise rates, or not at all.  Corporate earnings should grow at a modest rate, reversing the negative trend of the last two years caused by declines in the energy sector.  Bottom line, our forecast of gains in US stocks for 2016 remains intact at 5%, 13% higher than Friday's close.  Stocks may sell off a little more in the next few weeks, possible testing the lows of last August, then resume the long term upward trend."

At the end of last December we wrote:

"The world economy is going through a slow patch right now, depressing revenues and earnings for US companies (60% derived from international operations.)  Economists often refer to the US as the "locomotive of global growth."  With an improving labor market, firming wage growth, low inflation and still-low interest rates, sustained consumer spending will keep the US economy growing at least 2.5%/year, and in so doing bring along the rest of the planet.  US stocks are just 4.25% off the record set in May 2015.  We have no doubt new records will be set this year."

So far, the major trends remain intact.  Jobs growth in the US was a robust 287K in June, with an unemployment rate of 4.9% and a modest year over year increase of 2.6% in wages.  Annualized, jobs growth so far this year is about a 2 million annual rate, versus 3 million last year.  Inflation in general rose only 1.0% over the last year, held down by a 10% decline in energy costs.  The Fed may raise rates once, twice, or not at all for the rest of the year.  Q2 earnings for the S&P 500 are estimated to decline 5.6%, the 5th straight quarterly, decline, but projected to gain slightly for Q3 and Q4.  With no earnings growth in over a year, it's no surprise that US stocks remain stuck in a trading range.  Yet, despite MUCH bad news this year, US stocks closed today at a record high, eclipsing the previous high set May 21, 2015, up 6.1% YTD through July 9th.  Stocks are slightly overvalued right now, but may move higher in anticipation of a return to earnings growth in 2017.  

We increase our 2016 forecast on the S&P 500 from 5% to 10%.

Brexit - the British "own goal"

Politicians LOVE making promises to their base, even at the risk of harming the larger country.  In 2013, David Cameron, prime minister of the UK, promised a referendum on Britain continued membership to placate the anti-EU wing of the Conservative Party.  Cameron didn't think he'd actually have to follow through on the promise, thinking worst case that the British would vote to "Remain."  Wrong and wrong!  In the aftermath, Boris Johnson, the Conservative MP leading the "Leave" movement demonstrated that he had no idea what to do next, and pulled out of the competition to succeed Cameron as PM.  Of 5 candidates vetted by the nomination process, the two remaining were:

  • Theresa May, MP, current Home Secretary (similar to the US Secretary of Homeland Security,) favored "remain"
  • Andrea Leadsom, MP current Minister of State for Energy, favored "leave"

The outcome would have been decided September 9th by a vote of the entire Conservative party membership, except that Leadsom pulled out of race earlier today.  As a result David Cameron will step down Wednesday, and May will become PM Wednesday evening. 

Theresa May won 199 votes versus 84 to Leadsom in the nomination process.  May stated "Brexit means Brexit.  No attempts to remain inside the EU, no attempts to rejoin it through the back door, and no second referendum."  But as we noted above, politicians LOVE making promises...  There is a chance May simply refuses to follow through in starting the process of leaving the EU by invoking article 50.

Should the British go or stay? If go, the UK would lose preferential access to export markets in the rest of Europe, but with the pound exchange rate at generational lows (and 12% lower than a month ago) exports could well expand.  Traveling abroad for the British obviously just got a lot more expensive.  London could lose its status among New York and Tokyo as centers of world finance.  That work, and the associated high paying jobs, might well migrate to Frankfurt, Amsterdam or Paris.  North Sea oil, priced in dollars, suddenly contributes 12% more value to the UK economy.  Scotland and Northern Ireland could split off from the UK, rejoin the EU on their own terms. 

It's near impossible to forecast whether the British gain or lose as a result of Brexit, but the capital markets are already voting.  The FTSE 100, clobbered 5.6% on June 24th as the referendum results were announced, is now 4.0% higher than the close on June 23rd and approaching the highest levels of the last year.

Bigger picture: will be prospect of other EU members departing FINALLY cause the European Parliament to take action to address systemic recessionary conditions existing since 2009.  Much of EU economic policy is set by Germany, which currently enjoys 4.7% unemployment rate, a substantial export economy and owns substantial debt of other EU members.  The adoption of the Euro in 1999 substantially benefited Germany, who could lend to Greece, Italy, and Spain at low rates to buy German goods. 

Alas, relying on German imports hollowed out local economies, while saddling those countries with debts that can't be repaid.  In Italy, for example, the national unemployment rate is 11.5%, the youth unemployment rate is 36.9%, the debt burden at 132.5% is the world's third highest after Japan and Greece.  It would be Italy's best interest to leave the EU, revert to the lira (which would sharply devalue just as the pound did last week, boosting exports and halting imports,) and default on half of outstanding debt.

The US Presidential Election

Average Americans are terrified by EITHER Trump or Clinton winning, by worries about Brexit, by worries about international terrorism (ISIS-Orlando, San Bernardino) and domestic terrorism (Dallas.)  We can watch YouTube videos of police officers killing unarmed civilians at average of two killings per week this year.  This era seems like the most violent period of social unrest since 1968.  Over the last 12 months, investors pulled a monthly average of $14.0 billion from US stock funds, $1.7 billion from US Bond funds, $1.2 billion from Emerging Market funds but, interesting, added $3.9 billion/month to International Developed Markets.

David Edwards recently participated in "Challenges of Investing in an Election Year," sponsored by the Financial Planning Association, addressing these topics:

  • What would a Clinton administration look like?
  • What would a Trump administration look like?
  • What are the short and long term implications for the stock market?
  • What tools can investors use to forecast the November outcome?

The replay of the webinar is available here - Edwards' remarks begin at 18:40. 

In thinking about the next presidency, we also have to think about the composition of the House, Senate and Supreme Court.  Unless the Senate allows hearings about an Obama nominee (unlikely) the next president gets to fill at least one Supreme Court seat IF the same party controls both White House and Senate.  If split, the Senate could continue to block nominees indefinitely. 

It seems unlikely, given gerrymandering after the 2010 redistricting, that Republicans lose control of the House in 2016, but the Senate could well flip from Republican to Democratic.  The present composition is 54 Republicans, 44 Democrats and 2 independents who caucus with Democrats.  After the November election, Democrats are expected to control at least 47 seats, Republicans 48, with the outcomes of Nevada, Ohio, Pennsylvania, Florida and New Hampshire currently rated as "toss up."

What would a Clinton administration look like?

We expect that if Clinton wins, the Senate would also be Democratic.  She would be able to appoint at least one Supreme Court justice.  We would expect that Ruth Bader would retire to allow her replacement with a "liberal" justice.  Anthony Kennedy, who also generally sides with liberal rulings, will shortly turn 80.  The current court is generally considered "pro-business," with the 2010 Citizen United effectively allowing unlimited spending by corporations to influence elections.  With the death of Antonin Scalia in February, the court is now divided 4-4 conservative-liberal.

With a Democratic White House and Senate, but a Republican House of Representatives, we expect that the Washington gridlock prevailing since January 2011 would continue.  For better or worse, Obamacare remains in its current incarnation.  Existing federal programs remain funded, but no opportunities for new initiatives.  We would LOVE to see billions spent on upgrading national infrastructure such as bridges, highways, airports and rails, financed by long dated industrial bonds at ridiculously low current interest rates.  No joy.

As a Senator who voted for the Iraq war and as a Secretary of State who watched Libya, Iraq and Syria fall into chaos, Clinton has been bloodied by war.  We would expect her to be cautious extending US military power overseas.

In general, we would expect Hilary Clinton's president to be an extension of Bill Clinton and Barack Obama's administrations.  Considering stocks rose 217.8% under Clinton, 189.6% under Obama, we could live with that.  By comparison, stocks rose 53.2% under George HW Bush (one term) and fell 33.4% under George W Bush (two terms.)  So much for the mythology that Republicans are good for the economy, and that Democrats, particularly socialists like Obama, are bad for the economy.

What would a Trump administration look like?

A Trump Presidency would work with a Republican Senate and House, and a conservative Supreme Court.  The Washington log-jam would break, and legislation would spew forth.  Trump would eliminate the estate tax, slash income tax rates on high income families and corporations.  Trump would erect high trade barriers, impose tariffs on imports from China, but would not touch entitlement programs such as Social Security and Medicare, nor would he slash defense spending. 

According to a well reasoned analysis from Moody's  the US economy would boom briefly with the extra cash flow, but then crash.  At present the US budget deficit is 3.5%, and national debt is $14.06 trillion versus US GDP of $16.65 trillion (84.4% debt-income ratio.)  By 2020, US GDP would grow to $17.12 trillion, but the US debt would balloon to $20.95 trillion - a ratio of 122%.  Once a country's debt exceeds its income, the cost of servicing debt crowds out all other economic activity (see Japan, Greece.)  Moody's projects that 10 year interest rates would rise from 2.4% to 7% (crushing US home values,) and unemployment would rise from 5% to 6.8%.  US corporate earnings would fall, leaving stocks flat to falling.

Presidents need to understand foreign affairs, and Trump has none (no, building golf courses in Scotland does not count as international experience.)  Trump claims to have military "experience" because he spent 5 years at the New York Military Academy in the 1960's, the place arrogant preppies attended after flunking out of New York City private schools.  (Ironically, NYMA went bankrupt in 2015 and was sold to a group of Chinese investors.)  After deferring military service to attend Fordham University and the University of Pennsylvania, Trump avoided the draft by claiming a medical injury - "bone spurs" on his feet.  Trump has expressed great admiration for those notable humanitarians Vladimir Putin, Muammar Gaddafi, Kim Jong-un and Saddam Hussein, possibly because in those countries he could never get sued for bilking Trump University students out of $40 million.

What tools can investors use to forecast the November outcome?

People often look at the national polls in forecasting presidential election.  At present, Clinton has a 4.5% lead in the RealClearPolitics average of national pools:  With four months to go, 4.5% is easily within the margin of error, so you might think the candidates are essentially even.

However, as we saw in 2000, the popular vote totals are not as important as the Electoral College count.  Here's what matters:

  • 538 electoral votes total
  • 270 votes needed to win
  • New York, California sure to go Democratic
  • Texas, Alaska sure to go Republican
  • Election decided in battleground states of: Ohio, Florida, Virginia, Michigan, Pennsylvania, New Hampshire, North Carolina

In 2012, Romney and the Republicans were highly confident of winning based on their own polling.  There was a hilarious moment during the last election when Karl Rove pounded the table denying that Romney had lost Ohio and the election, which Fox News had already called for Obama.  In fact Obama converted a modest popular vote advantage of 50.9%-47.1%to a landslide Electoral College advantage of 332-206.  Third party candidates picked up the remaining 2%.

As of July 11th, Clinton has a head start of 210 electoral votes to Trump with 164. 

12 states are still considered toss-ups, so 164 votes in play.  However, applying the latest state by state polls and eliminating toss-ups creates this electoral college map: Clinton 342-Trump 196, so a better result for Democrats than in 2012, and converging on Obama's 365-173 win over McCain in 2008.

FiveThirtyEight.com massages the poll data differently, but comes up with a similar result. We can also look at the prediction markets - how would you bet, not how you would vote?

Clinton needs 60 votes to clinch. She currently leads in most battle ground states for a gain of 99.  Trump leads only in Georgia for 16 votes.  Clinton has 700 paid staffers nationwide, even in Texas.  Trump has only 70 staffers and fired his campaign manager Corey Lewandowski last month.  Though June 20th, Clinton raised $238 million, spent $196 million (mostly on the primary) has $43 million on hand.  Trump raised $65 million, spent $63.6, and has $1.3 million on hand.  Claims he will write a personal check of $50 million to fund the campaign "when the time is right."

The Clinton campaign and related PACs are spending $500K/week on Trump attack ads in battleground states.  Aside from a small NRA spend, the Trump campaign and allies are spending no money on advertising.  Trump claims he gets so much "free" coverage from the networks (true, about $3 billion worth during the primary) that he doesn't need to buy ads.  However, most of the positive coverage he's getting now is in states he's likely to win.  Clinton's anti-Trump ads are focused in the battle ground states he can't afford to lose.

Bernie Sanders will attend a rally with Hillary Clinton July 12th in New Hampshire, is expected to endorse Clinton and direct his supporters (and their dollars) to her campaign.  Republicans can't decide whether to run from Trump or support him (at arm's length.)  Paul Ryan seems to be struggling with how to handle Trump.  We wonder at what point Ryan decides to sabotage Trump, concede 2016 to Clinton in order to set up another run of his own in 2020.

Slam dunk for the Democrats?

Not so fast!  Clinton's negatives are almost as bad as Trump's.  Many of our clients ask, "How could anyone vote for Clinton?  She's a liar!"  True!  We can be sure she lied about the e-mail server, Benghazi, her speeches to Goldman Sachs, "contributions" to the Clinton Foundation from despotic countries when she was Secretary of State. 

However Trump lies more, winning "Liar of the Year 2015" from PolitiFact.  Of 178 statements evaluated by PolitiFact, a service of Tampa Bay Times and partner news organizations, 160 are rated "Half True" to "Pants on Fire False, while only 18 are rated "True or Mostly True."  Visit the site to see how Clinton, Sanders, Gary Johnson and other leaders rate.  Most Trump supporters don't know that Trump is persona non grata in New York City after a career of defaulting on bank loans and not paying contractors.  His few projects remaining here are branded by the Trump marketing company, but the ownership remains with outside investors.  If he worked for YOUR company, you'd fire him out of self-preservation!

We are not fans of Hillary Clinton by any means, but we feel that at least she would treat the practice of governance like a grown-up.  There's no rationalization we can employ to convinces ourselves that a Trump presidency would be anything but a disaster.

Trump should have flamed out months ago.  Instead, he beat 17 more experienced politicos to become the Republican nominee.  Right now, our portfolios are configured for a Clinton win.  In the past, we've felt pretty secure about our election predictions.  On this one, we won't rest easy on until November 9th.