Stay the Course, Open an Umbrella, or Build an Ark? September 2018
Good Times Roll For Most Companies vs. Potential Storm Clouds Moving In
For much of 2018, the stock market has been in a tug-of-war between policy risks and strengthening economic and corporate fundamentals. In late August most U.S. indexes reached all-time record highs. Stocks and the U.S. economy are doing great now, but are storm clouds on the horizon?
Will tariffs overpower earnings momentum and kill the economic expansion and bull market? Or will the tax cuts prove effective enough to keep corporations delivering record profits into the foreseeable future?
As Kiplinger 8/31/2018 "Though factories are humming right now and the rest of the year looks solid… A few clouds are gathering for manufacturers, all worth paying attention to. Rising interest rates will make borrowing more costly. Stricter immigration policies will make it harder to find skilled workers when labor markets are already tight. And there will be more protectionism from key trading partners against U.S. exports. Tariffs are already acting as a drag, especially the tit for tat with China. The end result: Manufacturing will cool a bit in 2019 as growth moderates in the face of the waning benefit of corporate tax cuts and the looming headwinds."
U.S. Corporate Profits Soared Again in the Second Quarter, Boosted by Tax Cuts and Revenue Growth
Data below from Factset 8/31/2018
S&P500 companies reporting 2nd quarter earnings at a record high of 80% beat earnings estimates with an average growth rate of 25.0%, marking the 2nd highest earnings growth since 2010 (34.1% then) and slightly exceeds the final 1st quarter earnings growth of 24.6%
The 25% earnings growth far exceeded the 19% estimated at the beginning of the quarter. The chaos in Washington, the impact of escalating tariff battles and the higher U.S. dollar, could have had a negative impact on corporate profitability, but they didn't.
All eleven sectors are reporting year-over-year earnings growth. Ten sectors are reporting double-digit earnings growth, led by the Energy, Materials, and Information Technology sectors.
The blended, year-over-year sales growth rate for the second quarter was 10.1% This shows healthy revenue growth not just profits from the corporate tax cuts.
Looking at future quarters, analysts currently project earnings growth to continue at about 20% through the remainder of 2018. However, they predict lower growth in the first half of 2019 of about 7%.
S&P500 profit margins rose to 11.6% in the 2nd quarter, their highest in history.
On 8/29/2018 the Commerce Department said its broadest measure of after-tax profits across the U.S. - not just the S&P500- rose 16.1% for the 2nd quarter from a year earlier, the largest year-over-year gain in six years.
Earnings being one of the most potent drivers of longer-term market performance, the surge in corporate profits has offered substantial support to U.S. stocks.
Tax Cut Benefit
In the 2nd quarter, taxes were down 33% from a year earlier because of the corporate tax cut from 35% to 21%. This amounts more than $100 billion at an annual rate - financed by the huge annual budget deficits expected to reach $1 trillion next year. The tax plan alone is expected to increase the deficit by $1.4 trillion over 10 years, according to a government estimate.
Have Earnings Peaked?
While 2019 profits should still be substantial, they probably will have peaked in 2018. The benefit of the massive tax cut for corporations with the resulting surge in stock buybacks and mergers will have less effect starting in 2019. As predicted, the tax cuts have not yet resulted in significantly higher wages but continue to benefit the most wealthy, since about 84% of equities are owned by the top 10% - and only 54% of Americans own stocks including in their retirement plans. Source: marketwatch.com & Time Rising transportation costs, supply constraints, tariffs, and higher interest rates will soften profits, unless price increases can keep up the profit levels.
The Widening Income & Wealth Gap Political Risk
The widening income disparity is fueling the political divide between the far right and left extremes, with fewer politicians in the middle to be able to make deals and get bills passed in Congress.
While investors are doing very well, wages are only growing half as quickly as a decade ago, even with the continuing lower unemployment rate which has been declining steadily under both Obama and now Trump. In the OECD Employment Outlook 2018, a compelling case is made that productivity growth that is a prime driver of wages is being driven not by workers, but by technology.
The most affluent Americans continue to show confidence in the economy, boosting spending on new homes, designer clothing, and other luxury products while shrugging off emerging threats to the long-term U.S. economic expansion. One of the nation's largest builders of high-end homes, reported a 30% rise in profit in their fiscal quarter ended July 31.
U.S. household net worth surpassed $100 trillion in the second quarter, thanks to rising home and stock values, according to a Federal Reserve report. Much of that is concentrated among high-end households.
Trump considers another tax cut - for investors
As investors, we welcome more tax cuts. It would continue to increases the wealth gap where globally the U.S. has one of the widest gaps between the wealthy and the rest of the population.
The Treasury Department is considering a tax cut for the wealthiest Americans through a change that would not need approval from Congress. The proposal is to allow capital gains to be adjusted for inflation that shields more of it from taxation. The use of executive power on such a significant change to the tax law would be highly unusual and could be vulnerable to a legal challenge.
Despite the fact that almost half of all households owned stock shares either directly or indirectly through mutual funds, trusts, or various pension accounts, the richest 10% of households control whopping 84% of the total value of these stocks. Source: Time.com
Again, as investors we welcome the proposal but as Marketwatch 8/5/2018 reports: "America’s 1% hasn’t controlled this much wealth since before the Great Depression. The gap between the rich and the poor in America has ballooned over the last several decades. A family needed (in 2015 which is the latest data) an annual income of $421,926 to be part of the 1% nationally. Meanwhile, the median net worth of Americans currently hovers at $68,828 per household (mostly in home equity)."
Worker wage growth slows while companies spend billions to boost stocks
Businesses are spending nearly $700 billion on repurchasing their own stock so far this year, according to research from TrimTabs. Corporations set a record in Q2, announcing $433 billion worth of buybacks — nearly doubling the previous record, which was set in Q1. Stock buybacks could exceed $1 trillion this year for the first time ever, according to analysts at Goldman Sachs.
A group of senators wrote to the SEC asking the agency to review the rules around buybacks. "The explosion of stock buybacks has funneled corporate profits to wealthy shareholders and corporate executives instead of workers ..." they wrote.
As a wealthadvisor.com headline reads "‘Eye-popping’ payouts for CEOs follow Trump’s tax cuts" which is fueling luxury sales and homes.
Inflation wiping out wage growth
U.S. workers’ paychecks are worth less than they were a year ago, the Labor Department reported, as modest wage gains have failed to keep pace with inflation. Inflation rose 2.9 percent from July 2017 to July 2018, the Labor Department said, while average hourly pay increased 2.7 percent over the same period. The lack of real wage gains comes despite a strong economy, with sustained growth and an unemployment rate of 3.9 percent — one of the lowest levels in decades.
On 9/7/2018 reported August job growth jumped to 2.9% year-over-year although it seems unrelated to the tax cuts, rather the shortage of skilled labor in a tight job market. On 9/6/2018 PBS did a story on a Wisconsin private manufacturer desperate to find 20 more skilled workers to run automation equipment in his plant. One solution was a training program for prison inmates to be trained on hi-tech equipment and many companies no longer requiring drug testing since need trained workers so badly. This in addition to having to offer higher wages.
Since 2000, only the top quarter of wage earners have seen any true increase in their pay once you account for inflation, Pew reports. For the middle class, it’s been years of stagnation. Source: thegezette.com
Automation replacing certain old economy workers
In 1956 there were about 980,000 autoworkers in Detroit. By contrast, today the largest three tech companies combined employ only about 230,000 worldwide. These tech companies have some of the largest market capitalizations in the world. Their value rests not on people but in intellectual property designing robots and other technology that increases productivity faster than people - and need fewer engineers to develop them vs. car assembly workers who are now largely replaced by robomation vs a few decades ago.
On a global basis - based on the latest 2015 OECD study the U.S. had one of the largest shares of working adults who qualify as low-income per capita. The only countries with a higher ratio of low income were Spain and Greece, each with only a slightly higher proportion of adults earning a low income than the U.S.
Many other countries have extensive programs to train unemployed and underemployed workers to develop skills for higher- income jobs. The U.S spends only 4% on skill building and worker placement programs, putting it at the lower end of OECD countries. Sweden, for example, spends 7 times that of the U.S., has less inequality and higher wage growth than in the U.S.
For a deep dive look at automation vs workers see my extensive White Paper pdf file at dhutch.news/RobotsVsHumans
Fed Chairman Powell 8/25/2018 comment highlights:
1) U.S. economy has strengthened substantially.
2) Strong economic performance will continue.
3) Will "do whatever it takes" on inflation.
4) Gradual rate hikes "remain appropriate."
Trump claims credit for the 2nd quarter 4.2% GDP growth and is hailing his own economic and trade policies, saying he is “taking our economy to incredible new heights” in spite of fears of damage from the escalating trade disputes he has provoked.
Many economists expect the second quarter figure to be an aberration. About 0.6% was from large prepurchases by China of soybeans to beat the tariffs, 0.6% was from 2017 tax cuts and the 2018 spending deal. Goldman Sachs projects a 3% growth rate for the third quarter and then continuing declines in the growth rate to less than 2%. Source: businessinsider
While Trump does rightfully get credit for some 2018 GDP growth due to the tax cuts, regulatory reform, and the huge budget deficit, critics like Mark Shields point out:
"In November 2016, when Trump got elected, he convinced enough voters that the country was at the brink of desolation and destruction. We, at that point, had — were in a point of 89 consecutive months of economic growth, 80 months, a historic high in the country, of job growth consecutively. He somehow was able, at a time when longevity was an all-time high, graduation rates were at an all-time high, pollution, other than greenhouse gases, were at an all-time low — I mean, it was — it was really a good era. And yet he was able to say, this is the worst time in America, it’s the darkest moment. He does — the president does either get credit or blame. And I would just point out to him, as a cautionary note, the last time the economy grew at a faster rate was third quarter of 2014, when it grew — Barack Obama was president. It grew at 5.2 percent." Source: PBS News Hour transcript
Housing Market Slowdown
Already increased mortgage rates are slowing the housing market with consumer confidence tracking near 18-year highs, strong corporate earnings and soaring retail sales haven’t translated into gains across the housing market.
New-home sales sank to a 9-month low, the Commerce Department reported 8/23/2018. For 2018, shares of most big builders stocks are down by double digits. (WSJ 8/29/2018) Many builders are slowed down by lack of construction workers, especially with fewer skilled Mexican workers unable to get into the U.S.
Average home prices in major metropolitan areas of the U.S. have slowed for three straight months. Some of the weakness may be temporary; analysts hope that a buoyant labor market, plus strong consumer confidence, will help offset the recent rise in mortgage rates.
NAFTA Status Unclear
Trump has called NAFTA the "the worst trade deal the U.S. has ever signed," yet in the tentative agreement with Mexico relatively minor changes were made. The Mexican agreement calls for 75 percent of automotive parts to be made in the NAFTA region, up from the current requirement of 62.5 percent. The requirement is expected to shift production of some automotive parts to Mexico from China. In addition, the deal requires 40 to 45 percent of auto content to be made by workers earning at least $16 per hour.NAFTA Status Unclear
This will likely result in the relocation of some automotive production from Mexico to the United States, but could also result in an increase in Mexican automotive wages. In addition, the agreement limits exports of Mexico-made vehicles to the United States to 2.4 million annually, with any volumes above that level subjected to tariffs. Source: gmauthority.com
Mexico and Canada are currently the biggest suppliers of US car imports, worth a combined $89 billion annually. There's no doubt the auto industry would feel a massive amount of pain if tariffs are enacted.
One of the biggest points of contention is concessions on agriculture, with the U.S. looking for Canada to end its steep tariffs on U.S. dairy products, which President Trump claims hurt U.S. farmers. But Canadian Prime Minister Justin Trudeau has promised to protect the dairy industry of his nation.
“The government of Canada will not sign an agreement unless it’s good for Canada and good for Canadians,” Minister of Foreign Affairs Chrystia Freeland said on 8/31/2018.
Another principal issue is auto trade, with Trump having threatened to impose new tariffs on Canadian-made cars coming into the U.S. “If we don’t make a deal with Canada, that’s just fine. I say, affectionately, we’ll just have to tariff those cars coming in.”
Are Investors Going to Get Gobbled by Turkey?
See my extensive report at dhutch.news/Turkey
Trade Wars - Just for Bargaining or a Major Risk to the U.S. economy?
Some economists estimate a full-blown trade war could wipe out the benefits of the recent tax cuts. Source: CNBC Closing Bell
The trade war between the U.S. and much of the world - especially China - is like two slowly sinking cargo ships, unless an agreement is reached.
On March 1, Trump announced his intention to impose a 25% tariff on steel and a 10% tariff on aluminum imports. That sent shock waves through markets and the Dow dropped over 400 points. In a tweet the next day, Trump asserted, "Trade wars are good, and easy to win."
Stephen Moore - Former Senior Economic Advisor, Trump Campaign and supporter of free trade - agrees the Trump strategy "is risky and is precarious, but I believe that at the end of the day China will come hat in hand and make some concessions and at the end of the day we wiind up with freer trade with lower tariffs, but we are still early on in this game." GPS CNN 8/19/2018
On the GPS report, it was also pointed out that Germany and other Europeans have the same complaints about China. So this could have been a great time to join together and say enough is enough. Instead, Trump has started trade wars with most of our European allies, Canada, and other former economic friends.
Steel and Aluminum Tariffs
While the U.S. steel industry itself employs about 150,000 steelworkers, about 6.5 million workers are in steel-consuming manufacturers reports Moody's.
The domestic steel industry has emerged as an early winner, but others may be hurt by retaliatory tariffs.
On August 16th a large steel company committed $750 million to revitalize its flagship plant to gear up for increased domestic demand. The plant employs 3,800 workers. However, no new hires are expected. The five-year project will include new production equipment and technology (so fewer workers needed) Source: Chicago Tribune
Commerce Secretary Wilbur Ross agreed to waive the tariffs if companies could show that the steel wasn’t readily available in the US, or if it didn’t threaten America’s national security. The agency has since been flooded with more than 30,000 requests for exemptions, and some of the decisions suggest the administration is picking favorites.
In July, the Commerce Department had approved a tariff exemption for the US subsidiary of a sanctioned Russian metals company with ties to Russian President Vladimir Putin. Despite past objections from US steel producers, this Russian company was allowed to purchase 6.6 million pounds of imported aluminum, untaxed.
The construction industry publication Construction Dive August 30, 2018 reports:
"In July, a Commerce Department official said the department had approved 267 exemption requests and denied 452. That left more than 26,000 applications submitted but not yet reviewed.
"One of the companies denied a tariff exemption was (a major pipeline construction company). In its application, the company said there were only three steel manufacturers in the world that could supply the steel it needs to construct the $1.2 billion, (vital US pipeline) and that they are all located outside of America. A pipe company based in Florida opposed the exemption request and said it could supply the project with the appropriate pipe, even though it did not meet (the pipeline builder's) process specifications.
Other manufacturers have announced plans to move jobs overseas in response to the tariffs that will be too costly for some companies to remain in the U.S.
Thousands of companies are seeking exemptions worth billions of dollars and affect manufacturing and investment decisions nationwide. But this process appears to be running on an ad hoc basis, with little transparency and bending to political pressure from well-connected lobbyists and Administration officials. Source: Vox 8/29/2018
Barons reports; "Rattled investors should maintain perspective. President Trump has been softening his stance on tariffs since announcing them. So long as any retaliatory tariffs are proportional, they will be modest relative to the size of the economy, and for most companies, gains from recent tax cuts will more than makeup for a higher raw-materials bill.
"With luck, the whole thing could blow over quickly with little damage, because many companies lock in metals prices months in advance. Or it could yet devolve into a trade war."
Subsidies for Farmers
Trump is paying out $12 billion to farmers to lessen the blow resulting from his trade war. Most of that aid has been set aside for farmers who grow soybeans. Their prices reached historic lows after China imposed a tariff on the legume.
The $127 million set aside for direct payments to dairy farmers would cover less than 10% of their losses, Jim Mulhern, - President of the National Milk Producers - said in a statement.
"NCGA - National Corn Growers Assn - has understood from the beginning that this aid package would neither make farmers whole nor offset the long-term erosion of export markets. But, even with lowered expectations, it is disappointing that this plan does not consider the extent of the damage done to corn farmers," said North Dakota farmer Kevin Skunes in a statement.
Secretary of Agriculture Sonny Perdue said the initial round of aid "buys time for the president to strike long-lasting trade deals to benefit our entire economy."
The Deficit Risk
Investors need to continue to invest in U.S. debt, which may demand higher interest rates. The Treasury predicts that IOUs in the second half of 2018 will be flying out to an extent not seen since those dark financial crisis days - a cool $769 billion. Some current projections have the deficit topping $1 trillion next year. Source: nasdaq.com 8/27/2018
See my extensive report Fear and Loathing in the Bond Market with Alternatives pdf at hutch.news/Bond-Risk-Alternatives which includes the added problem of the Fed reversing its quantitative easing, which will require additional Treasury debt funding in addition to the need to fund the current budget deficit.
Investor Action Strategies
Bonds May Not be Part of Ark Safety- The recent rise in the 10-year Treasury to near 3% and the surge in LIBOR rates may signal the trend to long overdue higher interest rates and resulting losses in bond values if not held to maturity – locking in below-market income. Therefore, we do not recommend most bonds. If a bond has a duration of 7 years, it would be expected to lose 7% in value for each 1% increase in interest rates – absent other factors.
The outlook for equities at least for 2018 and probably 2019 is on balance favorable but with risks. A well-diversified portfolio should span geographies as well as sectors of the market.
Since 1950 the stock market has done fine even with rising interest rates, provided the annual growth in earnings exceeds the 10-year Treasury yield.
“Participation Yet Protect” equity growth strategies: This helps maximize potential market gains with a widely diversified portfolio. Instead of “dumb” index funds with no stock selection based on individual company outlooks, or similar ETF’s (only make sense for traders, not investors), we suggest managers with long-term track records of outperformance compared to the category they invest in, and compared to the risk taken (Alpha vs. Beta in investment terms) – not just raw returns.
We may also recommend alternatives without stock or bond market exposure for more cautious income, or participation in part of equity gains without downside risk backed by a strong insurance company - All guarantees are based on the claims-paying ability of the insurance company.