It’s the Economy, Stupid
To keep Clinton’s 1992 presidential campaign on message, Clinton’s lead strategist, coined the phrase “the economy, stupid”. Many later expanded that phrase to the more familiar “it’s the economy, stupid.” In comparison, for many workers and business owners, today’s growing U.S. Economy seems “smart” not “stupid.” In contrast, the trade wars lead to recoining that campaign message into “it’s the politics, stupid.” Before dealing with the politics of trade negotiations, let us examine the “smart” side of the economy.
Businesses—Enjoying the Results of Lower Taxes and Reduced Regulatory Growth
Small Business Optimism
A recent small business optimism survey by The National Federation of Independent Business showed peak levels of optimism (see Figure 1). Interestingly, note their optimism spiked right after the 2016 election.
Source: National Federation of Independent Business
Corporate Profits Show Their Own Enthusiasm
S&P 500 corporations reported record second quarter after-tax profit margins of 11.2%. Admittedly, lower corporate tax rates contributed meaningfully to that number. Of the improved after-tax margins, sixty percent came from corporations we labeled, in our last commentary, the “superstar firms.” The following graph from Goldman Sachs research shows that contribution (see Figure 2).
The Rise of S&P 500 Margins is Entirely Drive by Tech And Adjacent Tech
Can Superstar Corporations Maintain Their Profit Margins?
Our last commentary also pointed out that the labor share of income for “superstar firms” continues to decline. Therefore, these firms should deflect increasing wage pressures better than firms that do not benefit from the power of rapid technological development. With their substantial cash positions, higher
interest rates also should not meaningfully affect their profitability. However, their global operations make them sensitive to short-term changes in the strength or weakness of the dollar. Overall, barring a major economic slowdown, “superstar firms” should be able to maintain their stepped up profit margins. No doubt, other S&P 500 corporations, outside of tech, would likely see their profit margins erode from the possibility of higher wage and interest costs.
Consumers — Favorable Trends
The declining unemployment rate represents the headline number importantly influencing consumer attitudes. Most economists expect the unemployment rate to decline from its already low 3.9% rate. Perhaps less noted but as important, the U-6 unemployment rate — discouraged and marginally attached workers as well as those part-time workers seeking fulltime jobs — dropped to its lowest level — 7.5% — since 2001.
Improving Total Earnings
Average hourly earnings in July increased a modest but improving 2.7% YoY. From a macro view, combining that increase with the 2.2% YoY increase in total hours worked results in cash earnings increasing nearly 5% when compared to a year ago.
Higher Quit Rate—Strong Employment Outlook
The strong employment outlook gives workers the confidence to quit and seek better employment opportunities. As evidence, the June quit level showed a nearly 7% increase over a year ago (see Figure 3). The total non-farm quits reached a level not seen since early in the last decade. Interestingly, on a recent Bloomberg Radio edition of Surveillance, an economist indicated that those who quit and found new jobs usual gain a 4-5% increase in earnings.
Improving Household Balance Sheets
The improvement in household balance sheets can be shown by the fact household net worth reached 680% of disposable income — a historic high. At the same time, household liabilities declined to 105% of disposable income from the high during the financial crisis of 136%. With lower interest rates, mortgage and consumer debt payments dropped to a near historical low of about 10% of disposable income. Simply put, consumers show good financial health.
Still, Consumers Exhibit a Conservative Savings Rate
Despite their favorable financial position, consumers remaininfluenced by their experience during the last “great” recession. This caution showed up in the government’s recent revision of the personal savings rate that more than doubled from 3.3% to 7.2%. Most of the increase came from undercounting interest, dividends, and business owners’ profits (see Figure 4). Such savings sources usually accrue to upper-income households. Households at that level usually show a lower propensity to consume then would be the case for lower-income consumers. However, if the economy remains buoyant, we would expect to see upper-income households open their wallets further to spend on luxury goods but even more so on services. Baby boomers, who may be “goodied out,” would likely focus their spending on high-end services such as dining out (see Figure 5) and travel.
Source: Wall Street Journal
Retail Sales —Food Services And Drinking Places
Source: FRED — St. Louis Federal Reserve
It’s the Politics, Stupid
Two Political Leaders May Prove Key to Economic and Investment Outlook
In our view, the positive U.S. economic environment, as reflected in this commentary, would likely result in even stronger financial markets if not for the trade wars. The most important trade conflict arises between China and the United States. This leaves investors trying to determine what motivates just two men — the presidents of the United States and China — not an easy task. As a result, the basis investors use for traditional economic and financial analysis may prove less valuable.
Trade Resolution—Where Does the Leverage Reside
Investors can speculate on what might drive these two men finally to reach some agreement — or not. Currently, the U.S. and China will meet this week in Washington to attempt to begin resolving their disagreements. The positive U.S. economic environment compared to the less certain outlook for China
(see Figure 6) may encourage the U.S. to attempt to use that advantage. At the same time, if the U.S. plays bull in the China shop, so to speak, it will likely further increase the pushback from the Chinese.
If not resolved as we move into 2019, the U.S. Presidential election will initially come into focus. No doubt, as he prepares to run for a second term, resolving the trade dispute will gain even more of the President’s attention. At that point, not facing an election, Chinese president-for-life Xi might gain some upper hand.
One of our prior commentaries cited an academic study that showed equity markets traditionally show a spurt after each mid-term election. Beyond that potential spurt, one key investment issue after the elections will be how far the current economic momentum will carry into 2019. In our view, the
stimulative impact of both tax reductions and additional fiscal spending will likely begin to wane in the second half of next year. At the same time, we continue to expect the Fed’s normalization policies will then begin influencing economic activity as they become more restrictive. The uncertain political
events including trade wars and Brexit, scheduled for next March, will also weigh on markets. Based on the direction we foresee for these potential issues next year, we continue to favor a portfolio evenly balanced among growth stocks, short duration fixed income paper and alternative investments.
In contrast, if investors wish to assume most trade issues will be resolved by year-end, then a somewhat more aggressive equity mix would be appropriate. For example, meaningfully raising U.S. tariffs, all things being equal, likely leads to a stronger U.S. dollar. Instead, if trade issues can be resolved, the U.S. dollar would likely weaken. Then, with that change, the composition of the equity mix would likely shift. More specifically, a refocus on U.S. global rather than predominately U.S. oriented companies would result. In addition, with a weaker dollar trend, specific emerging market equities would likely regain their attraction.
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