by Hubert Marleau, Market Economist, Palos Management
The U.S. Stock Market and the U.S. Economy as of May 23, 2019:
Investors are wrestling with a wide variety of potential escalations like the US-China trade spat which could turn into an economic cold war, the Trump-dispute with Huawei which could become a G-5 broadside discharge, the controversy in the South China Sea which could result in a geopolitical showdown.
The North Korea nuclear ambitions could turn into a diplomatic stalemate and the US-Iran quarrel could evolve into a military conflict.
Risky assets react strongly to these sorts of hawkish shocks, decreasing the relative predictive advantage that seasoned investors and private economists usually have over the gunslinging ignorance of the crowd. The abject creation of these headlines can notably affect in a jiffy market sentiment and economic confidence, making what comes next difficult to forecast.
Pullbacks and corrections stemming from these sorts of things are mostly short-lived; but they take on a life of their own. From hereon, investors may have to swallow more sudden and sharp stock price movements than in the past.
Jason Zweig, a famous writer with the WSJ, argued in a recent piece that large price changes are becoming more common than they used to be. He wrote that: “according to Dow Jones Market Data, the Dow-Jones Index has fallen by at least 2% in a single day 1011 times since 1896, That comes to about to once every 33 trading days on average.”
Given today’s price level and frequency of external outbursts, investors should expect the Dow-Jones stocks to fall by at least 520 points more often than once every six weeks or so.
These kinds of knee-jerk price movements are usually produced by contagious narratives that may not appropriately reflect what investors should care about. As a matter of fact, headline stories do have their own identity.
They are random occurrence, independent of what is really going on internally in the economy. Market volatility, like we are increasingly experiencing, creates an opportunistic environment for both traders and investors.
Smart and attentive traders can profit handsomely by reacting fast to violent market gyrations while fundamental investors that have a sense of long-term value can skillfully take advantage of nervous price settings.
It is much more important to concentrate on what is really important—the inflation and recession risks-- because they can have a longer and more devastating effect on stocks prices than random-like exogenous events.
At this time, it’s perceived that the inflation risks might be tilted to the downside and the recession to the upside. Yet, neither risks have a high enough chance of success to justify protracted fear—just prudence.
I recognize that escalating geopolitical tensions are trimming a notch or two off the economic expansion. Yet, the underlying strength will likely persist because the U.S. is neither brittle when it comes to growth or frail when it comes to inflation. I’m therefore not ready to hit the panic button. Why?
Businesses are jockeying productivity by cleverly taking advantage of the benefits that it brings. It’s the premise upon which I base my optimism in spite of the longevity of the recovery. The deterioration in productivity has reversed.
As mentioned several times in previous commentaries, improvements in productivity gains started in 2016, acquired vigor in 2017 and 2018 and became evident in Q1 of 2019. Higher productive capacity is good for growth, inflation and interest rates.
I believe that it explains why investors are ready to buy the dips. Billions worth of cash flows to stocks after every dip, suggesting that the productivity gains might be holding down the probability of a recession in the next 12 months to less 20%.
It will facilitate the economy to achieve a reasonable level of business activity, tend to raise profit margins, attract young people into the workforce, and improve the trade balance.
While the history of the 1990s shows how productivity growth can pop to an annual rate of 4.0%, my temperament and reasoning dictate conservatism. Yet, I maintain that a cruising annual speed of 2.0% for productivity combined with a 0.25% labour force expansion would bring about a satisfactory growth result.
If my thesis holds true, it will provide the economy with what is necessary to keep inflationary pressures at bay-- near the target rate of 2.0%- even if wage rates were to rise at an annual rate as high as 4.0%.
Recent numbers from the BLS show that companies are holding down their unit labour cost. They are falling more than expected, dropping 0.9% in Q1, leaving them up only 0.1% on a year-ago basis. Unsurprisingly, the GDP implicit price deflator, the broadest measure of inflation, increased at the annual rate of 0.65% in Q1.
All measures of inflation data for April fell short of expectations. Surveys and financial markets show that neither believe that recent lower readings on U.S. inflation is transitory. According to a recent NY Fed survey among consumers, the one year outlook on inflation fell by the most in two years in April.
At the time of this writing, the Cleveland Inflation Nowcasting model has an estimated annual rate of increase of only 1.2% for the June quarter.
It would definitely ease the work of the monetary officials. Putting all the recent data points together for the first half of 2019, one would now get 2.25% in GDP growth and 1.1% in GDP inflation. That’s a pretty good situation for the Fed.
Interestingly, the shape of the real curve is forcing the futures market to predict a 66% chance that the Fed officials will cut rates in 2019. As if by magic, it appears that the aforementioned market predictions come more from a general belief in stagnant inflation than a major fall-out in growth.
The yield curve for Treasury Inflation Protected Securities (TIPS) is positive through the piece—23 bps for one year duration, 45 bps for five years, 57 bps for 10 years, 63 bps for 20 years and 94 bps for 30 years.
I suspect that the reason for this occurrence is that investors have become accustomed to how the Fed bails out the market from too much turmoil and the economy when consumer confidence and/or business sentiment falls apart.
An accommodative Fed offers the market a cushion. Thus, there’s little reason, in my judgement, to expect the Fed to imminently change its assumed bias in keeping the economic cycle going.
I recently attended the Marleau Lecture Series on Economic and Monetary Policy at the University of Ottawa.
The lecture was on what could be an “Optimal Monetary Policy” set-up and given by the Regis Barnichon of the Federal Reserve Bank of San Francisco. I concluded from his well-thought-out presentation that the Fed has bias towards growth.
P.S. The twisted plot of the current trade drama is as complex as the “Games of Thrones”. But as in all denouements, the story unravels quickly in the last few chapters.
A featured article in Barron's by Reshma Kapadia argued that while a trade war between China and the U.S. looks more and more like an impasse which would re-calibrate all sorts of expectations, such a scenario is unpalatable for both sides.
On one side, “the U.S. is heading into the 2020 election season. Trump will want to talk up a strong economy and a bullish stock market.” On the other side, “the Chinese leaders will want to stabilize their economy as the Communist Party celebrates its 70th anniversary in power.”
Although they remain in a negotiating mode before additional tariffs take effect, I’m not anticipating a clean resolution. The two nations have similar strategic interests and objectives, but with very different political and economic systems.
It probably means that a deal will never be completed. However, they will try to coexist to save face until companies fully reassess where they will make goods, access completely how they will live with tariffs and figure out the best technology in which to invest, and the best place to do it. This process has already started.
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