Let’s start with some observations to “set the table.”
Let’s first focus on facts and then we’ll get to opinion:
1) Q1 earnings for S&P 500 companies rose 24.4% year over year (YOY), 8% ahead of Wall Street expectations
2) Q1 revenues for S&P 500 companies rose 8% YOY, 1.3% ahead of analysts’ expectations
3) Capital expenditures increased 21% YOY in the first period of 2018
4) The U.S. unemployment rate fell to 3.9%
5) U.S. retail sales were +5.9% in May YOY
6) The Personal Consumption Expenditure (PCE) Index, the Fed’s favorite inflation index, came in at +2% for March, hitting the Fed’s long-established target
7) The 10-year US Treasury yield rose above 3% – first time in a long time
8) The Fed raised the Fed Funds rate by 25 basis points to a range of 1.75% – 2% and signaled that there might be two more rate increases in 2018
9) President Trump met with the G7 in Canada
10) Kim Jong Un, leader of North Korea, and President Trump met in Singapore
11) China’s GDP grew 6.8% in Q1
12) China’s leader Xi announced new measures to open the Chinese economy, allowing more foreign participation in financial services and ownership in auto joint ventures
13) UK GDP rose 1.2% in Q1
14) Eurozone GDP grew just 0.4% in Q1
15) The European Central Bank (ECB) will reduce its massive bond buying beginning in September of 2018 and perhaps halt it by year-end – but interest rates will be kept flat through the summer of 2019
16) President Trump withdrew the U.S. from the Iran nuclear deal, while all other parties remained committed to it
17) Trade tariffs were implemented by the U.S. against Canada, the Eurozone, China and Mexico.
Several points above “paint” a US economic picture which appears quite robust. We are about to enter “earnings season” for the second quarter and analysts expect corporate income to grow approximately 20%. For all of 2018, the pundits look forward to S&P 500 company earnings expanding some 23%. Higher capital expenditures would suggest CEO optimism; higher retail sales, consumer optimism; higher interest rates, Fed optimism. Other parts of the world (China, the Eurozone and the UK) are growing – some faster than the U.S., others not so fast. There also is the potential for global risk reduction, as a result of the meeting in Singapore between President Trump and Kim Jong Un, the first ever between these two heads of state. Perhaps peace will break out on the Korean peninsula, perhaps not. But it is a start to a conversation. Finally, there are several points above which would suggest political tension. The unilateral pullout of the US from the Iran “deal” while other signatories stayed the course, the activation of the first of a potential series of trade tariffs against allies and competitors alike and, by all reports, the none too friendly G7 meeting in Canada – all would suggest that there is a good bit of “pushing and shoving” and discontent amongst supposed friends. There indeed are a lot of balls in the air! Investors have enjoyed the “economic points” but are a bit anxious about the unpleasant “political points”. We would continue to urge investors to focus on the “economic” rather than the “political”. The economic reflects what is going on corporately and individually. So long as the economics stay strong, then the markets should be reflective of those conditions. The political could affect economics. But politics is whimsical and politicians capricious. Until the politics really begin to affect the economics, it is best not to project that result, lest one be caught out.
Above is a chart which well demonstrates that every year since 1980 there has been a “down draft” and the average of those setbacks has been 13.8%. But even with those retrenchments, the S&P 500 ended the year positively 76% of the time and the average increase was 16.7% – pretty goods odds, we would suggest.
BELIEVING IN DEMOCRACY, OR NOT……
We are fast approaching America’s birthday and a recent survey conducted in 2018 by a German polling firm, Dalia Research, caught our eye. The survey interviewed 125,000 people in 50 countries around the world – some rated “free” by the U.S. organization Freedom House and others “not so”. When asked “do you feel that your government is acting in your best interest?” 64 percent of respondents living in democracies said “rarely” or “never”. In non-democracies 41 percent said the same. People in Saudi Arabia, Egypt, Turkey and China, all countries considered “not free’ by Freedom House, most rarely gave that response. Of the 10 nations that had the highest percentage of responders saying their voices were rarely or never heard, nine are democracies, according to Dalia.
We find these comments sobering and reflective of the detachment so many people feel with regard to politics, politicians and policies. However, this is not the first or the only time in America’s history that there has been disquiet among so many. One only has to go back to the late 1960’s and the early 1970’s to revisit the assassinations of Bobby Kennedy and Martin Luther King Jr., the race riots, the aftermath of the Vietnam War, and Watergate to remember that the U.S. has been “through the wringer” before, survived the turmoil and went on to thrive. America’s Founding Fathers devised a governance system with many checks and balances to distribute power among three distinct branches of government, with each branch having its own rhythm of governance so that power would never devolve to just one. When downcast, one should think about the genius of our political forbears and have faith that the American democratic experiment is still strong. It has been tested numerous times by many people and has never been found wanting.
THE CUSTOMER IS ALWAYS RIGHT, ESPECIALLY A BIG ONE….
As a rule, a trade war is never good. We are not here going to delve into every facet of the “war of words” and possible trade war that is being broadly discussed. Rather we are going to simply analyze the Chinese trade imbalance. Generally speaking, the U.S. exports (sells) approximately $130 billion of goods to China and imports (buys) approximately $500 billion of goods. In “round terms” there is a deficit of approximately $370 billion. Both the U.S. and China are threatening tariffs on one another’s products if a trade war begins. So, what would the Chinese tax? Well, what do the Chinese import from the U.S.?
The above chart, sourced from the Congressional Research Service, outlines the major categories. Aerospace products (think Boeing) are a huge import as are motor vehicles (think GM and Ford). Boeing products could get taxed (they are not as of this writing) but that would leave only one other supplier to China, Airbus, as the aerospace business is essentially a duopoly. By raising prices (via tariffs) on Boeing product the Chinese government creates a “price umbrella” for Airbus to also raise prices to Chinese airlines – not sure about how good that strategy is. Ford and GM have built cars for years in China. They also import vehicles and parts. Forcing GM and Ford to raise auto prices in China might hurt the companies and their employees. One thing China does not want to do is create unemployment in China. Semiconductors are a significant import for China because they go into a lot of products that China exports to the world. We would think that again China would be reticent to tax semiconductor imports. Look at the recent example of the U.S. banning sales of semiconductors to ZTE, a major Chinese telecom company. That action shut down ZTE. So, what is essentially left for the Chinese to tax are commodities: oilseeds, grains and energy. The problem here is that American commodities are like others from elsewhere – an American soybean is like a Brazilian soybean. If U.S. farmers lose part of the Chinese market to Brazil, some Brazilian soybean customers, no longer supplied by Brazil, will become US soybean customers. Commodities are fungible. There may be some market disruption, but customers will be replaced, as long as demand is strong. So simply, we do not think the Chinese are in a strong negotiating position with trade tariffs as their primary weapon against the U.S. Some analysts have suggested that the Chinese might use “interference” as another tool against American companies operating in China. In other words, use bureaucracy to slow down needed regulatory approvals or conduct needless surprise company audits – i.e. make it more expensive and less profitable for U.S. companies to do business in the Middle Kingdom. However, this idea has been denied by the Chinese government. According to the South China Morning Post this past Thursday, President Xi Jinping declared China open for business to a gathering of top American business executives including David Solomon (President of Goldman Sachs) David Abney (Chairman of UPS) and Albert Bourla (COO of Pfizer Inc.). Again, hurting foreign investment in China would probably create unemployment – a taboo. We said before that we think deals will be done and we continue to believe so.
PREDICTIONS FOR 2018
1) Inflation will rise above 2%, using the Fed’s favorite measure. – Still believe, not quite there yet
2) U.S. GDP >+3% & international GDP growth will accelerate. – Still believe – some think Q2 U.S. GDP >+4%; international doing OK, but some worries over trade tariffs
3) U.S. unemployment will decline to 3.6% & ex-U.S. unemployment will decline. – Still believe
4) U.S. corporate profits +12% with higher profit growth ex-U.S. – Yes – Q1, +24%, Q2, +20%
5) The dollar will drift lower. – Trade worries have sparked some dollar strength
6) The U.S. bond curve will get “flatter” but not “invert.” – Yes
7) Investment spending will rise again. – Yes – Q1 capital expenditures +21%
8) Republicans will take a “political beating” in the midterms. – Still believe
9) Consumer confidence in the U.S. & abroad will stay strong. – Yes – still strong
10) Equity markets will do well, while bond markets will stagnate. – Bonds have stagnated, but so have stocks due to “political worries”
A FINAL THOUGHT
The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.
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