After 6 months of steady gains that took the NASDAQ and S&P 500 to new record highs in late April , we’ve had two and half weeks of sharp declines. Peak to yesterday’s trough was 5% in the S&P 500 and 7% in the NASDAQ. Stocks are recovering somewhat today. YTD the S&P 500 is up 14.5% and the NASDAQ is up 17.3%. Several clients have called or emailed to learn if there is reason for concern.
Investors are skittish for a number of reasons:
Q1 earnings growth at 5.1% is well below last year’ s 18.9% for Q1 2018
Full year 2019 earnings may grow only 2.2% versus 23.3% in full year 2018.
Saber rattling between the US and Iran popped oil prices to the highest levels in 6 months
The US is threatening to intervene militarily in Venezuela
North Korea, making a mockery of the negotiations of the last year, has resumed missile testing
Trade talks between China and the US broke down last week. Within a few weeks, the US intends to increase tariffs on $250 billion of imported industrial goods from 10% to 25%, and also apply a 25% tariff to $300 billion in consumer goods that were previously exempted.
On Monday, stocks fell sharply as investors digested the unexpected news that the trade talks had ended. If fully implemented, the tariffs would amount to an annual tax burden on American consumers of $137 billion, an average of $1,100 per household. The average household income in the United State is $74,664 and average tax burden is $10,489, so the tariffs would reduce after tax income by 1.47%, pretty much offsetting any income gains from the 2017 Tax Cuts and Jobs Act.
Why can’t Americans simply not buy goods from China? Particularly for consumer electronics goods such as iPhones, there are no alternative short-term sources The expertise to assemble iPhones doesn’t exist in Cupertino, California, let alone Cambodia.
Meanwhile, China will apply 25% retaliatory tariffs to the $60 billion in goods exported from the US to China, but these exports are primarily commodity products such as foodstuffs and chemicals for which there are plenty of alternative sources; Brazil can readily supply soy beans, for example. The 10 years of economic growth enjoyed in the US since the end of the 2008-9 financial growth may come to an end as consumers cut back spending and farm bankruptcies surge.
Watching Donald Trump negotiate with other countries is like watching a YouTube video of a guy punching himself in the groin – just awful. There are significant changes China needs to make to become a fair global trading partner, but applying tariffs does not provide the necessary leverage to obtain those changes. Trump believes that China “needs” the US as an export market, but in fact, China is aggressively seeking new markets in Asia, Africa and South America – easy to do after the US backed out of the Trans Pacific Partnership and allowed China to expand throughout the Pacific Rim.
The United States has a stated objective of spending $1.5 trillion on infrastructure over the next 10 years, but there is no political will to move an appropriations bill through Congress. Meanwhile, China spends about $300 billion annually on domestic infrastructure and another $80-120 billion/year on the “Belt and Road Initiative,” a giant port, bridge and highway project spanning 60 countries across Europe, North Africa, the Middle East and Asia.
The BRI has both economic benefits (by opening new markets to Chinese goods) and political benefits (creating dependencies and influence across half the planet.) The Chinese economy is also shifting from exports to consumer driven, which currently contributes 60% of the growth in Chinese GDP. China can endure short term pain to reap long term gains. As we noted previously, a country that sustained 50 million civilian deaths within living memory (during the Great March Forward) can manage a couple of quarters of reduced economic growth.
President Xi of China obtained the title “President for Life” last year and faces no political opposition. Xi can take his time to make a deal. Trump has to worry about the state of the US economy in 2020. Trump’s approval ratings have never exceeded 46% in 2 ½ years as president and have trended between 40-43% for the last year. No president, in all available records dating back to Harry S. Truman, has polled this badly over the same time frame. Of the three presidents who failed to be re-elected in the last 75 years, election day poll averages were:
George H. W. Bush – 54.7%
Jimmy Carter – 33.7%
Gerald Ford – 51.5%
If the economy continues to growth at 2.5% or better and the stock market remains at elevated levels, Trump will probably be reelected. If the economy falters and Trump loses a couple hundred thousand votes in the five states that will determine the next president (Florida, Pennsylvania, Michigan, Wisconsin and Arizona), he loses. Trump knows this, and therefore will fold on the trade talks sooner rather than later if there is any indication that the economy is slowing. The problem is that by the time Trump realized he’s not “winning” the trade war, it may be too late to prevent a recession.
Stock Market Flashing Yellow
Back on December 24th, we wrote, “After the Worst Week, Month, Quarter and Year in Over a Decade, Why Are We Suddenly Bullish on Stocks?” From December 24th, which was the low for 2018 and the lowest level in two and half years, stocks rallied 26.2% through the new high on April 30th, 2019. That’s about 3 years of average annual returns compressed into 4 months. We invested available cash aggressively in January, but took a more cautious approach with new clients as we got into April.
We also have some new clients from 2018 that are still a third to a quarter in cash (given our cautious outlook over the last year, we’re scaling them into stocks over 12 months.) One client emailed today to ask, “If now is the time to invest that cash?” If stocks fell another 5-7% from current levels (technically a correction) then yes. If not, we’ll wait a little longer. The interest rate environment is benign (Fed on hold for the rest of 2019) but until earnings growth picks up, stocks are on the high side of fair value.