eturns for the first six months were positive, but it has not been a smooth ride. The S&P 500 Index, including dividends for the first six months, was up 2.8%. It is worth nothing that in January this index peaked at 2873, a 7.4% gain from yearend. Notwithstanding the strong domestic economic outlook and prospects for record growth in corporate profits, market returns declined over the next five months. Concerns over trade and the implementation of new tariffs are unsettling investors.
During the first half of 2018, interest rates rose. The U.S. Treasury 10 year bond yield increased from 2.405% at December 31 to 2.860% at June 30, a rise of 45 basis points, reflecting the 50 basis point increase in the Federal Funds target rate by the Federal Reserve Open Market Committee in this period. As a result, the return on the Bloomberg Barclays US Aggregate Bond Index was -1.6% as bond prices fell.
Here is our quick take on the investment outlook.
- The U.S. economy should be especially strong through the remainder of this year owing mainly to higher federal spending and tax reduction legislation. Looking beyond 2018, the rate of U.S. economic growth will decline. There are estimates by the non-partisan Congressional Budget Office (CBO) that U.S. growth will fall back to levels that were expected before the promulgation of tax reduction and spending hikes. This is particularly disappointing because the increase in federal debt to fund this legislation remains and in time will act as a drag on the economy. We see little likelihood of recession before 2020 although various economists are already ruminating over this possibility.
- Global expansion remains firm, although not as robust as earlier in the year. European and Japanese growth are stalled and there are unsettling political and economic issues in selected emerging markets. China's growth rate continues to decelerate.
- Corporate profits are benefiting from the windfall reduction in U.S. corporate income taxes from 35% to 21% as well as from the favorable economic backdrop.
- The principal unknown to the investment outlook is the risk arising from the administration's trade policy. Our take is that current skirmishes will not escalate into mortal combat because it is overwhelmingly in the best interest of all parties to come to an accommodation. Furthermore a good deal of domestic pressure in the private sector is building against the imposition of tariffs. Nevertheless, there will be threats and accusations, and some new tariffs and other restrictions will be implemented.
Although the equity market is up through June 30, valuations on a price/earnings basis are lower than at the end of the year. It is doubtful that trade dislocations resulting from new tariffs will tip the U.S. economy into recession, which could bring about a significant market correction. However, the stock market is not going to rise meaningfully until trade risks diminish and the global outlook becomes more certain.
U.S. Economy Remains Strong for the Time Being.
The U.S. economy grew in the first quarter of 2018 at the disappointing annual rate of 2.0% due to weak personal consumption expenditures. However, the balance of 2018 should see a strong boost to GDP due to the lift from the Tax Cuts and Jobs Act of 2017, which reduced personal and corporate income tax rates, and the Bipartisan Budget Act of 2018, which added stimulus to the federal budget. Table 1 on the next page shows the current consensus forecast1 for the second quarter at 3.4% (Line 1), which may be too low. For the year as a whole, the consensus is 2.9% compared to 2.3% in 2017. Consumer and government spending (L2 & L3) are the principal drivers of higher growth.
It is reassuring to note that despite the spike in demand in 2018, inflation (L5 & L6) will remain moderate, and unemployment (L7) will continue to decline. The main take-away from Table 1 is that the second quarter will likely be the high point of economic growth over the next two years.
The Bloomberg consensus estimates on the economy are generally in line with the forecasts made by the Federal Reserve,2 the International Monetary Fund (IMF),3 and the CBO, among others.
Recently investors have been concerned about the yield curve, the graph of average interest rates in the bond market (Y-axis) by the length of maturity (X-axis). Generally the yield curve slopes upward to the right reflecting normal conditions for borrowing: short-term interest rates are almost always lower than long-term interest rates owing to interest rate risks over time and generally higher credit risks of long-term borrowers. However, when the demand for long-term loans is soft, one indicator of the economy's weakness, it is possible for long-term rates to fall below short-term rates, which are determined mainly by Federal Reserve monetary policy. A widely publicized recent paper argues that an inverted yield curve signaled all nine recessions since 1955 and had only one false positive in the mid-1960s. The delay between the "term spread" turning negative and the beginning of a recession ranged between six and twenty-four months, which could take us into 2020.4
The yield curve is not currently inverted, although the spread between the 10-year Treasury and the 30-year Treasury is unusually small—only 13 basis points at the end of the quarter (Table 1, L13). The Fed, by moving aggressively to raise short-term rates without regard to bond market conditions, may be causing this narrowing of rates. Bond market conditions are currently weak. U.S. junk bond issuance has fallen 25% this year versus last, while investment-grade bond sales are down 18%.5 Although the consensus forecasts in Table 1 indicate that spreads will rebound slightly in 2019, yield curve inversion remains a risk.
Table 1: U.S. Economic Data
|U.S. Econmomic Data, Quarterly Through Q4 2019; Annually Through 2020|
|Quarterly Rates||Annual Rates|
|Line||Q1 2018||Q2 2018||Q3 2018||Q4 2018||Q1 2019||Q2 2019||Q3 2019||Q4 2019||2017||2018||2019||2020|
|Y-O-Y% Change, Seasonally|
Adjusted, Annual Rate
|5||Consumer Price Index||2.2%||2.7%||2.8%||2.5%||2.3%||2.3%||2.3%||2.2%||2.1%||2.6%||2.3%||2.2%|
|6||Core Price Index**||1.6%||1.9%||2.1%||2.1%||2.1%||2.1%||2.1%||2.2%||1.5%||1.9%||2.1%||2.2%|
|8||Budget Deficit % GDP||-3.7%||-3.8%||-4.3%||-4.5%||-4.7%||-4.7%||-4.9%||-5.1%||-3.4%||-4.0%||-4.8%||-4.9%|
|9||Government Debt % GDP||77.0%||76.9%||77.1%||77.2%||77.7%||77.8%||78.2%||79.0%||76.5%||77.9%||79.3%||80.9%|
|10||Fed Funds (Upper Bound)||1.75%||2.00%||2.25%||2.45%||2.65%||2.85%||2.95%||3.00%||1.50%||2.45%||3.00%|
|11||10 Year Note||2.74%||2.86%||3.07%||3.17%||3.26%||3.30%||3.37%||3.47%||2.41%||3.17%||3.47%|
|12||30 Year Treasuries||2.97%||2.99%||3.27%||3.37%||3.47%||3.53%||3.63%||3.73%||2.74%||3.37%||3.73%|
|13||10 Yr-30 Yr Spread||0.23%||0.13%||0.20%||0.20%||0.21%||0.23%||0.26%||0.26%||0.33%||0.20%||0.26%|
|14||EUR / US$||$1.23||$1.17||$1.17||$1.19||$1.21||$1.23||$1.24||$1.26||$1.20||$1.19||$1.26||$1.25|
|* Quarterly rates are seasonally adjusted.||Peaks are highlighted to match this box.|
|** Excludes food and energy prices.||Bond yields and Euro/US$ exchange rates shown
are either at end of quarter or end of year.
|Source: Bloomberg as of July 9, 2018|
The CBO earlier this year examined the question of whether the reduction in tax rates and increased government spending would result in sustained higher levels of economic growth. The CBO concluded that beyond 2020, the annual real economic growth of the United States would actually be lower than the rates contained in its June 2017 forecasts, which were below 2% per annum. One implication is that the CBO does not foresee a recession. Based on the CBO forecasts, the tax rate reduction will not be financed through higher growth leading to offsetting higher tax collections. On the contrary, federal debt is projected to increase by around $1.5 trillion. Federal debt in public hands as a percentage of GDP, around 76.5% in 2017 (L9), is expected to approach 100% by 2030.6 The CBO report questioned the wisdom of reducing taxes and increasing federal budget outlays when the economy was already expanding to realize only temporary, unsustainable gains in real GDP growth.
Global Expansion Continues, but More Slowly.
Earlier this year, the synchronization of positive growth rates in the developed and undeveloped world was unusual and greatly enhanced the investment outlook. However, the outlook at mid-year is less certain. While global growth in 2017 at around 3.8% was somewhat better than expected, no further acceleration is expected in the 2018-2020 period.7 In part, growth is moderating owing to a tightening in global financing conditions related to the withdrawal of monetary accommodation in the advanced economies. In its most recent forecast, the World Bank projected that growth in the Euro Area, Japan, and China will gradually decline from 2017 levels in the 2018-2020 period.8 The outlook in emerging markets is complex mainly due to political factors in individual countries. In our view, the most promising country is India, whose economy is expected to outpace China at more than 7% per annum over the next three years.
Corporate Profits Are on a Tear.
Corporate profits will be very robust in 2018 owing mainly to the reduction in tax rates from 35% to 21%, but also from the bump up in economic growth in the United States, the repatriation of foreign earnings trapped abroad, and a generally favorable global economy. First quarter profits of the S&P 500 companies increased by a whopping 26%, which is in line with Bloomberg consensus estimates for the full year. To the benefit of shareholders, a substantial portion of free cash flow is being allocated to increasing dividends and share repurchases.
Global Trade Risks
It is no exaggeration to state that investors are becoming increasingly "spooked" by the possibility of a trade war. The Trump administration, in dealing with the world, deliberately keeps all parties off balance and unsure of its next actions. This uncertainty has cast a pall on U.S. and foreign corporations and global investors.
The negative trade balance of the United States that is the object of the Administration's concern has been blown out of proportion. In 2017, imports of goods and services exceeded exports by around $552 billion, representing a drag on GDP of only around 2.8%. The point is that the trade deficit by itself is not a serious economic problem for the United States. Despite the deficit, the U.S. economy is performing well.
Table 2 provides data on U.S. tariffs imposed, announced or under consideration in 2018. Tariffs on solar panels and washing machines were implemented in the first quarter. The steel and aluminum tariffs were imposed in June and the first tranche of Chinese tariffs took effect on July 6. The effective date of the second tranche of Chinese tariffs has not been announced. In May, the Department of Commerce began an investigation to determine whether imports of automobiles, trucks and other vehicles as well as parts threaten national security. The premise seems farfetched. The U.S. auto industry is concerned.
Table 2: Trade Balance Data
|U.S. Tariffs Announced in 2018|
|Imported Items||Tariff Rates||2017 Imports|
|Solar Panels & Washing Machines||Varying Rates||$11.6||0.4%|
|Steel & Aluminum||25% St; 10% Al||$58.2||2.0%|
|Chinese Goods, First Tranche||25%||$50.0||1.7%|
|Chinese Goods, Second Tranche||10%||$200.0||6.9%|
|Autos (Under Investigation)||25%||$360.0||12.4%|
|Total U.S. Imports, 2017||$2,903.3||23.4%|
The steel and aluminum tariffs are relatively insignificant but fall mainly on our major trading partners, Canada, Mexico and the European Union. It is worth noting that in 2017 the United States had a positive balance of trade with Canada of $2.8 billion. While there is a $70 billion trade deficit with Mexico, it is entirely offset by our surplus with countries in Central and South America. The supply chain arrangements in NAFTA (chiefly Mexico and Canada) are very complex, which leads us to believe that there is little that can be done near term to reduce the deficit without seriously risking severe dislocations among U.S. manufacturers and farmers. We have a $100 billion deficit with the EU of which two-thirds is attributable to Germany. The United States and the EU will likely negotiate arrangements to reduce this deficit.
The biggest challenge is with China. In 2017, the trade deficit amounted to $385.7 billion or about 60% of the U.S. total trade deficit. The United States has grievances that include: (a) much higher Chinese tariffs on goods imported from the United States compared to U.S. duties levied on Chinese imports; (b) unfair dumping; (c) forced technology transfers; (d) state-directed outright stealing of technology, and (e) other unfair and possibly illegal practices.9 The United States has levied a 25% tariff on $34 billion of imports from China to which an additional $16 billion of goods and services from China will be added at a later date. In addition, the Administration has announced a 10% tariff on $200 billion on additional imports from China, but no details have been provided. China indicated that it would respond in a commensurate manner. As China's total imports of goods and services in 2017 only amounted to $190 billion, the government will likely exact pain in other ways such as raising the cost of U.S. companies doing business in China through increases in taxes and fees as well as imposing punitive regulations.
We expect both countries to back off. In the United States, resistance toward our tariff policy is growing in private industry. A trade war between China and the United States is particularly untimely for China as economic growth is clearly slowing, the Yuan is trading at a low against the dollar, and the benchmark Shenzhen composite index fell 18.5% in the first half of 2018. While the amount of U.S. exports to China, representing only 1% of GDP, is trivial to the U.S. economy, certain companies and sectors such as farmers, manufacturers of agricultural machinery and airplanes, among others, would be severely impacted. Many U.S. companies, including Starbucks and McDonald's, have significant joint ventures in China. Supply chain disruption would be especially severe for technology companies. It is compelling for both countries to settle their grievances.
The Administration's trade strategy is based on national defense considerations, “fairness,” and chronic trade imbalances against the United States. While these are legitimate concerns, they should be weighed against the negative impact the imposition of tariffs will have on the U.S. economy. We have not been able to find one analysis that shows the proposed tariffs will increase U.S. GDP or employment. On the contrary, there are many studies in the public domain by research organizations that attempt to measure the damage—including inflation—the proposed tariffs will cause.10 The lack of clarity involving negotiations, how foreign governments will retaliate, and the difficulty of measuring the dislocations and economic costs are generating confusion, uncertainty and risk for U.S. investors.
The stock market is moderately less expensive today than it was at the end of the year. That is because S&P 500 Index earnings will be greater in 2018 than previously forecasted, and the market is now discounting 2019 earnings, which are projected to advance in the 7% to 10% range. Bloomberg periodically surveys Wall Street strategists to determine their best estimate of the S&P 500 Index at year end (Table 3, Line 1). The current mean estimate for yearend 2018 stands at 2950 or about 9.5% higher than the June 30 level. While we believe the consensus is too optimistic, equity returns for investors should be positive in the second half of 2018.
Table 3: Forecasts
|Investment Strategists of Major Financial Institutions|
S&P 500 Index, S&P Earnings Per Share, US Economic Growth Rates, 10-Year Treasury Bond Yield Data
|Line||Year End Actual||Year End Actual||Actual % Change||Year End Forecast||Estimated % Change||Year-End Forecast||Estimated % Change|
|1||S&P 500 Index (Year-End)||2,239||2,674||19.4%||2,950||10.3%|
|2||S&P 500 Index Earnings||$118.75||$124.51||5.2%||$154.50||23.6%||$175.31||13.5%|
|4||Consensus U.S. Economic Growth||2.3%||2.9%||2.4%|
|5||10-Year Treasury Yields (Year-End)||2.45%||2.40%||3.17%||3.49%||Sources: Bloomberg, Standard & Poor’s, Barron’s|
We can't help feeling that investment risk is larger than the level the Street is discounting. The global approach of the current U.S. Administration is challenging the political and commercial world order that the United States constructed and led in the Post-World War II period. Over the last 70 years, the world has prospered as international trade and investment mushroomed and geopolitical conflicts were contained. The Administration is now challenging longstanding alliances such as NATO, arrangements with major trade partners and allies, and global institutions such as the UN that have served to mediate conflict and disagreements. While some of the premises for reexamining these relationships are justifiable, the Administration seems to be charging forward like a bulldozer in a china shop rather than proceeding on the basis of deep analysis and shrewd judgment. As a result, risks of miscalculation are high and the collateral damage of mistakes could be substantial. In short, the economic and capital market fundamentals suggest that equities will be rewarding investments over the next year, but the conduct of the Administration in dealing with the world could undermine the constructive investment outlook.
Stratigraphic Asset Management, Inc.
- The consensus forecasts are based on Bloomberg surveys of between 65 and 75 economists. GDP forecasts are prone to error, but the general direction and magnitude of change are reliable indicators.
- "Federal Reserve Summary of Economic Projections," June 2018
- International Monetary Fund, United States of America, Staff Concluding Statement of the 2018 Article IV Mission, June 2018.
- "Economic Forecasts with the Yield Curve," Michael D. Bauer & Thomas M. Mertens, Federal Reserve Bank of San Francisco, March 5, 2018.
- How do you explain why the bond market is weak at a time when the economy is very strong? Part of the explanation is that the recent tax act permitted the repatriation of more than $2 trillion of foreign profits previously held captive abroad. This inflow of cash may be affecting borrowing demand. Also the U.S. economy is becoming more service- and less capital-intensive, meaning that business borrowing demand in relation to GDP has declined.
- "The Budget and Economic Outlook: 2018 to 2028," Congressional Budget Office, Washington, D.C., April 2018. The CBO's previous report was issued in June 2017.
- "World Economic Outlook," IMF, April 2018, Pages 240, 254.
- "Global Economic Prospects," World Bank Group, June 2018.
- President Donald J. Trump Is Confronting China’s Unfair Trade Policies, White House, May 29, 2018. www.whitehouse.gov/briefings-statements/president-donald-j-trump-confronting-chinas-unfair-trade-policies
- Trade Partnership Worldwide, LLC, has produced the following studies: "Tariffs on Imports from China,” April 30, 2018; “Estimated Impacts of Tariffs on Motor Vehicles and Parts,” May 29 2018; “Trade Discussion or Trade War?,” June 5, 2018.