Both the positives and negatives of earnings, tax cuts, interest rates, and trade are affecting the market, but is the glass half full or half empty? It depends on what’s being served up by the Federal Reserve, China, and employers. What’ll you have?
U.S. stocks have been on a wild ride lately, with major indexes hitting correction territory in October 2018 before bouncing sharply, all while staying below the September 2018 highs. Volatility has increased. Interest rates have moved higher. Financial conditions have tightened. Investors are concerned about a potential slowdown in economic growth, the side effects of the current tariffs — including what will happen after the recently negotiated 90-day postponement of new tariffs, the chance of a partial government shutdown in early December, and the possibility that the Federal Reserve might move too quickly on interest rates and bring the economic boom to an end.
Up or down, investors should, as always, remain diversified and disciplined.
There are many reasons the market has recently sold off:
- Worries about U.S.-China trade and tariffs.
- These may ease for the short term, now that President Trump and Chinese leader Xi Jinping have promised a three-month trade-war truce at the G-20 gathering in Argentina. The U.S. will wait on an announced escalation of 25% tariffs on $200 billion of Chinese goods, while China says it will increase imports and restart buying a not-yet-agreed-upon amount of agricultural, energy, and industrial products. While the agreement is vague, it does give investors the prospect of a 90-day cool-down. If at the end of this period, the parties are unable to reach an agreement, the 10% tariffs will be raised to 25%.
- The uncertain earnings outlook for 2019 and slowing growth and earnings resulting in negative year-over-year earnings comparisons for companies.
- Higher interest rates.
- A stronger economy tends to push up interest rates, which in turn puts downward pressure on stocks. The yield on the 10-year Treasury note has been climbing, which makes riskier stocks less appealing to investors than safer bonds. It also increases borrowing costs for businesses and consumers.
- Higher labor and wage costs.
- After surging in the first quarter following the cut in corporate taxes, businesses appear to have scaled back investment. Business investment barely contributed to the third-quarter results.
- Slowing growth in the rest of the world reaching U.S. shores.
- Partisan political wrangling likely persisting or worsening, with gridlock, after the results of the midterm elections.
- While returning from the G-20, President Trump indicated he plans to notify Congress he will abandon the North American Free Trade Agreement, or NAFTA, to pressure lawmakers to quickly adopt his replacement deal agreed to by Canada and Mexico in September. Democrats, buoyed by midterm election success, are unlikely to rubber-stamp anything, and peremptorily canceling NAFTA could result in no North American trade bloc, leaving firms with cross-border supply chains in the lurch.
- Government shutdown.
- On Dec. 7, funding was set to expire for several government agencies including Homeland Security, Commerce, State, Justice, and Interior — approximately 25% of the government–and President Trump has indicated he will not sign any new spending legislation without $5 billion in funding for a border wall. Democrats have conceded to $1.67 billion in increased border security. Congressional leaders this week agreed to push the deadline to Dec. 21, with legislative actions on hold during memorials for President George H.W. Bush. Any shutdown would be partial, but the market does not like any uncertainty.
Trade uncertainty, while reduced after the G-20 agreement, will be exacerbated by the possible abandonment of NAFTA. Trade uncertainty is the most notable risk to growth and will continue to have implications for both the economy overall and corporate earnings. The ongoing uncertainty is starting to have an impact on forward-looking economic indicators, including new orders in manufacturing and services.
Though it’s possible that the United States-China trade dispute will be resolved, recent rhetoric indicated a further “digging in” by both sides. The earnings season saw a growing number of companies expressing concern about increasing tariffs, and if those costs are progressively passed on to the consumer, Main Street may start to feel more of the trade pain. Also, at the margin, some companies are beginning to look to other countries to move their Chinese operations. These companies are not talking about moving to the United States. An easing of trade tensions could improve both the economic and earnings outlook and could sustain the recent rally, but the risk of escalation still remains, and the hit to the economy would grow with additional rounds of tariffs. This warrants close scrutiny over the coming months.
Economic forecasters largely agreed that the recent tax legislation would boost growth in the near term, but were split over whether it would increase the economy’s rate of growth over the long term. Second-quarter earnings did receive a boost from the tax cuts, continuing trends from the first quarter. Earnings were up 25% in the second quarter after being up 27% in the first quarter. They are expected to rebound back to 27% for the third quarter, but then weaken to 18% for the fourth quarter. Growth rates are expected to worsen in 2019 as year-over-year comparisons will grow less favorable once the effects of the tax cuts start to fade. Expectations for earnings growth in the first three quarters of 2019 are now well below 10%.
When the Federal Reserve changes the rate at which banks borrow money, this has a ripple effect across the entire economy. As rates rise, consumers put more money towards paying off their loans and thus don’t have as much income for spending or for saving for college or retirement. The cost of borrowing increases for purchases such as a car, a home, or college tuition. In addition, existing debt that is tied to a floating-rate index, such as some home-equity loans, will also rise in cost.
To some extent the same effect hits corporations. Corporate debt as a percent of GDP is at the highest level ever, which is slightly higher than its peak as we went into the Great Recession of 2007-09. With interest rates on the rise, the cost of that debt on balance sheets can become more expensive. When companies must pay more for their debt, they don’t have that cash to pay workers more or buy more inventories to grow. In this way, the higher interest expense could trickle into the job market and slow down the economy. As we have noted in past reports, rising rates affect the cost of the U.S. debt payments. Our country will soon have $22 trillion in debt, and even small increases in interest rates could lead to hundreds of billions of dollars more in debt costs over time. This, in turn, increases our accumulated deficits, putting further pressure on interest rates and our economy.
Higher interest rates could attract overseas capital, thereby causing the value of our currency to rise on a relative basis against other countries. Of course, many factors impact currency-exchange rates, but higher relative interest rates are a key factor. Because our currency is more expensive, higher relative interest rates could raise the cost of our exports, which will hurt exporters, potentially slow down our economy, and slow the recent wage gains.
In late September, as anticipated, the Federal Reserve chose to raise its target range for the federal funds rate by a quarter percentage point to a range between 2-2.25%. This decision was widely expected. Despite Federal Reserve Chairman Jerome Powell’s statement in a Nov. 28 speech to the Economic Club of New York that the Fed’s benchmark interest rate was “just below the broad range of estimates of the level that would be neutral for the economy—that is, neither speeding up nor slowing down growth,” there is still a strong likelihood that the Fed will raise interest rates one more time this year at its next meeting on Dec. 18 and 19. “Consistent with their judgment that a gradual approach to policy normalization remained appropriate, almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations,” the minutes from the Federal Reserve November meeting stated.
While affirming their commitment to a rate increase over the short term, members also noted that actions after that would be dependent on incoming data. “Several participants were concerned that the high level of debt in the nonfinancial business sector, and especially the high level of leveraged loans, made the economy more vulnerable to a sharp pullback in credit availability, which could exacerbate the effects of a negative shock on economic activity,” the November meeting minutes said. “The potential for an escalation in tariffs or trade tensions was also cited as a factor that could slow economic growth more than expected.”
The Fed is also tightening policy by shrinking its balance sheet, which means the market will need to absorb about $400 billion more in Treasury bond supply this year than in 2017. Thus, yields will likely need to rise to attract buyers to the market. That said, when stocks sell off sharply, Treasury bonds tend to rally because they serve as safe-haven investments in times of heightened volatility.
The most important question is: what will the Fed do in 2019? Will they continue their recent automatic one-rate-hike-per-quarter pace or will they be more data dependent and only hike when the data appears to suggest a hike is in order? Over the long run, the Fed is expected to search for a neutral monetary policy, where GDP growth is moving in line with potential output growth, the unemployment rate levels off, and inflation stabilizes around the 2% goal. However, this is very difficult to do.
In the U.S., weekly wages rose at an annualized rate of 3.3% in the third quarter, the Labor Department announced on Nov. 27, which beats the 2.6% increase in inflation over the same period. That’s an improvement from the 2% increase in wages in the second quarter, which wasn’t enough to make up for inflation. Wage gains are typically considered a precursor to inflation. Will the Fed raise rates too much?
For now, the best thing to do is to look at the underlying trend in final demand. It is up 2.9% from a year earlier, which is better than the 2.4% this time last year, as well as the 2.3% rate it has averaged since the recession ended in 2009.
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