by Thomas Dillman
Economic and profit fundamentals remained robust in the U.S. during the first half of 2018, and were generally stable among the larger economies of the world. However, there are a number of macro issues that have buffeted markets this year. Mutual of America Capital Management LLC explores these issues, including the impact of a strong U.S. dollar, tariffs and interest rates, and also takes a look at the prospect for continued economic growth and market expansion in the midst of a bull market nearly a decade strong.
U.S. Economy Continues to Grow
There is no doubt that the U.S. economy accelerated to a new level of output during the first half of 2018. Second quarter Gross Domestic Product (GDP) growth registered 4.2% following a 2.2% rate during the first quarter. Consumption, which accounts for two-thirds of the economy, advanced 3.8%, the fastest rate since 2014. Business-fixed investment, the second largest component of GDP, advanced an impressive 11.0%. Housing remained weak, as it has throughout most of this expansion, and inventories surprisingly declined, detracting 1.8% from overall GDP growth. However, also surprising, net exports added 1.8%. It seems likely that a rush to export U.S. agricultural products to China prior to Chinese retaliatory tariffs were to take effect on July 6 corresponded to a reduction of agricultural inventories in the U.S.1 Final sales, a measure of output that excludes exports and inventories, grew 5.3%, the strongest showing since the first quarter of 2006, two years prior to the Great Recession of 2008-09.
The Institute for Supply Management's Purchasing Managers' Index (PMI) reflects this economic strength, registering scores of greater than 58 in each of the last 12 months (greater than 50 means the economy is growing). Similarly, the Conference Board Leading Economic Index® (LEI) has advanced in every month but two in the last three years.
Keeping Watch on Inflation
Despite such strong growth and an unemployment rate of 3.9%, the lowest in nearly two decades, inflation remains within an acceptable and desirable range to the Federal Reserve. The June Personal Consumption Expenditures Deflator (PCE), the Fed's preferred measure of inflation, came in at a year-over-year rate of 2.2% while the corresponding core PCE, which excludes food and energy, registered 1.9%. The Consumer Price Index (CPI) for July came in a bit higher at 2.9% overall and 2.3% core, but is expected to recede a bit as the year-over-year energy price comparison flattens out.
Inflation on the employment side seems similarly contained. Average hourly earnings for July were up 2.7% on an annualized basis. It has taken three years for this measure to rise from 2% and six years from the cycle trough of 1% in 2012. Normally, recessions are not imminent until this measure hits 4%. Another perspective that supports the notion that wage inflation is not currently a problem is that nonfarm productivity for the second quarter was reported at 2.9%, well above the 2.4% expectation, and the highest rate since the first quarter of 2015. Higher productivity means more output per unit of labor, which results in the cost per unit of labor decreasing, in this case by 0.9%. This does not mean that workers get paid less but, rather, that employers can afford to raise wages without giving up too much profit margin. Thus, productivity is one important key to sustained output and profit expansion and, therefore, continued advances in stock prices. However, this recent data point may be a function of the cycle, not a long-term trend: productivity has been in a secular decline over the past 30 years. Even with the strong 2.9% second quarter, productivity is up only 1.3% over the past year. Acceleration in productivity would contribute to an extension of the current cycle. Note that next June, this expansion, if it lasts, will be the longest on record.
On the earnings front, the first two quarters of 2018 were the strongest for the S&P 500® since 2010 when comparisons were extremely easy following the profit plunge created by the financial crisis. Both quarters showed profit advances in the 25% range, in part aided by tax cuts, but still estimated to be up mid-to-high-teens growth excluding the tax effects. As impressive, nearly 80% of all companies exceeded expectations. Similarly, revenue growth came in at 10%, the highest rate since 2011, with 70% of companies beating expectations.
Global Economy A Mixed Bag
The global economy is not doing as well as the U.S. economy. European GDP, while still expanding, decelerated from a third quarter 2017 peak of 2.8% to the recently reported 2.2% for the second quarter of 2018. Likewise, Japan is down from a peak of 2.7% for the third quarter of 2017 to 1.9% in this year's second quarter, but following a first quarter rate of -0.9%. And China has been forced to alternate between stimulus and restraint to maintain growth while preventing runaway inflation. Officially, China's quarterly GDP has been reported within the mid-to-high-6.0% range for the past several years, but Chinese data is notoriously suspect because it is so consistent and is often not supported by non-official measures of economic activity. The current thinking is that China's growth is also decelerating. However, all these key economies, comprising more than 35% of world GDP, are still growing. The problem is that weakening economic growth makes them more vulnerable to dislocations within the global financial and trading infrastructure.
The combination of the difference between U.S. and non-U.S. growth, plus the vulnerability of non-U.S. economies to essentially U.S.-generated instabilities (e.g., strong dollar, tariffs, sanctions) accounts for the extreme difference in stock market performance between U.S. and non-U.S. markets during the first half of 2018. According to MSCI, U.S. stocks are up 7% while the MSCI All World Index, which includes U.S. performance, is up only 2%. Most national indexes are in negative territory year-to-date, and those that are positive are only marginally so. The only countries with stock market advances greater than that of the U.S. are Russia, Romania, Peru, Thailand, Israel, Qatar, Kuwait, Saudi Arabia, Kenya, Tunisia, Trinidad and Tobago, and Zimbabwe. Collectively, these nations represent 5% of world GDP and even less in total market capitalization.2
Impact of Strong U.S. Dollar
While economic and profit fundamentals remain robust in the U.S. and generally stable among the larger economies of the world, there are a number of macro issues that buffeted markets this year. The strong U.S. dollar, a function of Federal Reserve interest rate increases and accelerating growth in the U.S., is creating economic dislocations throughout the world. The relative weakening of other nation's currencies makes the purchase of goods priced in U.S. dollars more expensive, with energy and industrial commodities constituting a large portion of imports for many countries, especially those in emerging markets, and particularly those with limited foreign reserves. At the same time, many emerging markets have large balances of both sovereign and private dollar-denominated debt that becomes much more difficult to service or pay off when their currencies are depreciating relative to the dollar. The customary response of emerging markets to a falling currency is to raise interest rates to keep what foreign reserves they have from leaving their respective countries and to counter the effects of rising inflation because of the higher cost of imported goods. However, increased interest rates undermine growth. The only partial offset is that a cheaper currency stimulates exports. The most vulnerable emerging market countries are Argentina, South Africa, Pakistan, Brazil, India and Turkey. In the case of Turkey, an already weakening lira was decimated when President Trump implemented punishing tariffs on the country in order to force the government to release an American minister being held on suspicion of espionage and terrorism. So far, a generalized emerging foreign crisis has not emerged. However, if the dollar continues to rise, the countries mentioned above will be under increasing economic and financial stress. And the effects could potentially spread to other more-developed countries to the degree of their banks' exposure to emerging market debt.
Tariffs Take Center Stage
Whereas the strength of the dollar is not a function of deliberate U.S. policy, the Trump administration's protectionist policies of applying tariffs on imported goods is a key part of the President's political agenda to establish a level playing field between the U.S. and its trading partners. This affects not just China, with whom the U.S. has the greatest trade deficit, but also economies that are and have been geopolitical allies, such as Europe, Japan, Canada and Mexico. Trump emphasized that the application of tariffs is not intended to end "free trade" but to make free trade "fair trade" for the U.S. China has used a variety of methods to maintain its trade advantage, including requiring U.S. companies wishing to do business in China to take on a Chinese majority partner and to transfer rights to proprietary intellectual property. Furthermore, China failed to control the dispersion of U.S. intellectual property to other Chinese entities and has done little to clamp down on counterfeiting U.S. products. Up until a few years ago, it was clear that China also manipulated its currency to ensure goods it produced were cheaper than similar goods produced elsewhere. This is why the most aggressive tariff action by the U.S. has been directed at China. But as noted, some tariffs have been applied or threatened against other countries.
So far, the U.S. has levied a tariff of 20% to 50% on imported washing machines and solar cells, affecting China and Europe primarily; a 25% tariff on all imported steel and 10% on all imported aluminum, affecting Canada, Mexico and the European Union (permanent exemptions were granted to South Korea, Argentina, Australia and Brazil); and a 25% tariff on a list of $50 billion of goods imported from China. In addition, the Trump administration has a list of an additional $200 billion of Chinese goods on which a 25% tariff has been threatened but not yet implemented. Beyond that, Trump called for a 25% tariff on another $200 billion of Chinese imports if the other rounds do not yield an acceptable negotiated settlement.3 Separately, he has also called for a 25% tariff on all automobile and auto parts imports to the U.S., which would affect European, Japanese and South Korean manufacturers significantly. Trump and Jean-Claude Junker, President of the European Commission, recently met to discuss Trump's threatened tariffs on European goods. While both parties acknowledged unspecified points of agreement, the discussion did little more than to lower the heat of the rhetoric and defer substantive talks. Finally, the North American Free Trade Agreement (NAFTA), agreed between the United States, Mexico and Canada, and effective January 1, 1994, has been in on-again/off-again negotiations since Trump took office. On August 27, he announced that the U.S. and Mexico had come to an agreement, marking the first substantive success in his fair trade initiative. Canada, excluded from the bilateral negotiations between the U.S. and Mexico, has been put in the position of having to accept the new agreement as is or have punitive U.S. tariffs applied to goods it exports to the U.S. Trump specifically threatened to slap tariffs on Canadian auto and auto parts imports if Canada does not agree. After a week of intense negotiations, no agreement had been reached as of Labor Day. It remains to be seen how Canada will respond.
All of these existing or threatened tariffs, if implemented, would wreak havoc on the complex and sensitive supply chains built up during the past two-to-three decades to accommodate the trend toward free trade. It is impossible to predict how this issue will evolve, but it certainly will reorder the global trading system and cause angst and pain along the way. In the meantime, markets will be affected by the twists and turns of the drama because of its possible impacts on growth and profits. Uncertainty about whether agreements will be reached and the degree of disruption that occurs along the way could potentially affect businesses' willingness to make capital investments and consumers' ability and willingness to pay more for imported goods. But so far, the U.S. equity markets have shrugged off these concerns. During the week of August 20, the current bull market became the longest on record and the S&P 500® closed at an all-time high. The following Monday, the day the U.S.-Mexico trade agreement was announced, the S&P 500® hit another new high and the NASDAQ crossed the 8000 mark for a new record high.
Interest Rates Going Up?
The other key issue affecting market behavior and the overall economic outlook is the Federal Reserve's program to raise interest rates. The consensus expectation is a 25-basis-point increase in both September and December, which would take the Fed Funds rate up to a range of 2.25% to 2.50%. Because longer-term interest rates have not risen as much, the yield curve is approaching a point where short-term rates will exceed long-term rates, a condition referred to as an "inverted yield curve," a situation that has preceded all but one post-WWII recession. When short-term rates are higher than long-term rates, bank profit margins shrink to the point that it does not pay to make loans. Without loan growth, the economy stops growing and enters a recession. The Fed is fully aware of this dynamic. Its goal is to raise rates only to the level of sustainable, non-inflationary growth with full employment. That dual mandate has proven difficult if not impossible for any monetary authority to achieve because it is impossible to know an ideal level with certainty. Thus, the Fed historically tends to overshoot and thereby choke off expansion. As the Fed continues its program of rate increases, the risks to economic growth, profit growth and the bull market also increase. However, the Fed's minutes of their last meeting, and recent comments by a number of Fed members, led some commentators to suggest the Fed is approaching an end to rate increases, or at least will soon pause to assess whether the data show that rates have reached the neutral level at which the expansion can continue without accelerating inflation. Equity and bond markets likely would respond positively to such a decision, at least initially.
We expect the market to continue its advance over the remainder of the year but at a slow pace. Current fundamentals support that outlook. But markets look ahead and discount the future. Next year, the quarterly comparisons of both GDP and profit growth will become increasingly difficult to match this year's results. While growth may continue, it will likely be much slower than this year. Markets do not respond well to deceleration, because it is difficult to know how much growth will slow. And if the Fed overshoots and/or President Trump's tariff initiatives prove extremely disruptive, this expansion could come to an end. So far it has been a great ride, and it may continue if the Fed gets it right and trade wars are avoided through mutually acceptable negotiated settlements. It would not be the first time during this expansion that markets faced what appeared to be insurmountable problems only to be dealt with in such a way as to allow the expansion to continue.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
|1||Chris Low, Chief Economist, FTN Financial, Economic Weekly, August 3, 2018.|
International Monetary Fund, World Economic Outlook Database, April 17, 2018.
Strategas Research, Daily Research Note, August 8, 2018.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.