Second Quarter 2019 Client Newsletter

The ‘Rocketship Economy’

Today marks the 50th anniversary of the Apollo 11 Launch.  The Apollo program employed the services of the most powerful machine ever built – The Saturn V Rocket.  This massive vehicle stood 363 feet tall and weighed over 6 million pounds.  The express intent for designing such a craft was to deliver three lucky (or insane) crew members into lunar orbit.  By the conclusion of the Apollo program in 1975, the Saturn V successfully delivered 10 crews into space.  Six of those ten missions included moon landings, and all of them ended with a safe return to earth for the crew.  The Saturn V rocket was clearly a very successful tool in achieving President Kennedy’s 1962 goal of placing a man on the moon.

Just as the Saturn V was a tool for delivering astronauts to the moon, the economy can be thought of as the principal tool for delivering a steadily improving standard of living to society.  Although, when judging economic success there are far fewer total failures or absolute triumphs.

The title of this newsletter originates from statements by President Trump a few weeks ago.  He lamented that were it not for the overly restrictive interest rate policy of Jerome Powell and the Federal Reserve, we might be experiencing a ‘Rocketship Economy.’  

For this quarter’s newsletter we will discuss the components that might facilitate or impede what could be described as a ‘Rocketship Economy.’

Monetary Policy

In Brief – Global Central Banks are typically in one of three stances: Restrictive (higher rates), Neutral, or Accommodative (lower rates).  Over the past 12 months, market expectations have reversed from a panicked perception of restrictive policy to a sense of inevitable accommodation.  The hope is that lower short-term rates will feed through in a positive way to the underlying economy.  But the catch-22 remains:  If accommodative monetary policy is in response to weakening economic growth, should we unquestionably cheer accommodative policy?  Put another way - Have you ever hoped for a cold so you might get to take some robitussin?

Over the past 8 months, the outlook for monetary policy in the United States has experienced the largest shift in expectations since the Taper Tantrum of 2013.  In October ’18, the expectation and messaging from the Fed was for a continuation of the rate hike program that began in 2015.  Since then, growth has deteriorated, and the Fed is now messaging a rate cut.   The Fed funds chart below shows the trajectory of short-term rate policy over the past 60 years.  You’ll notice that falling short term rates typically occur in response to recessions (shaded areas).  

The European Central Bank (ECB) and Bank of Japan (BOJ) continue to implement the unprecedented policy of negative interest rates.  And as of today, $12,400,000,000,000 worth of fixed income instruments carry a negative interest rate.  Negative interest rates are the equivalent of you paying me to cut my hair, they aren’t supposed to make intuitive sense. But they do show the degree to which central banks are successfully suppressing interest rates.

After a brief period of synchronized global growth and attempted policy normalization, global central banks have returned to a very accommodative footing.  The lower rate outlook has served as a security blanket for markets, but the fundamental impact will take time to filter through to the data.

Earnings & The Economy

In Brief – Corporate earnings enjoyed a tax-cut and deregulation-fueled boom throughout 2017 and most of 2018.  Since September of 2018, earnings expectations have turned decidedly less exuberant and are now expected to be unchanged or even slightly negative in 2019.   Since corporate earnings are derived from both domestic and foreign sources, they are generally a good proxy for overall global growth.  That global growth picture is dominated by two opposing themes: 1) The US Consumer is as strong as ever and 2) The global manufacturing/industrial economy is stagnant at best, and recessionary at worst.

The global economic and corporate earnings picture can be summed up in an outline of The Good, The Bad and The Ugly.

• The Good – The US Consumer remains the strongest and most reliable force in the economic picture.  People have jobs, are seeing larger paychecks, and are spending.  Also, various reads of consumer confidence/comfort have recently hit cycle highs.
• The Bad – Capital spending and various measures of CEO/business confidence are lackluster.   These gauges of business sentiment are generally linked to the uncertainty cast by unpredictable trade policy.
• The Ugly – Global manufacturing has been a major source of weakness.  We use the Global Purchasing Managers (PMI) index to judge the trajectory of manufacturing.  You’ll note the trend has been substantially negative since January of 2018 and the recent reading below 50 signals a contraction

When you put all the pieces together, the US Economy is very close to firing on all cylinders.  In the chart below, JP Morgan rates the ‘temperature’ of 11 areas of our domestic economy. A ‘hot’ reading indicates a positive and/or improving data set.  

If it weren’t for global weakness and a lack of business confidence, you would likely see 8 of 11 indicators in the ‘hot’ classification.  Instead what we are left with is a very mixed picture.  

Fiscal Policy

In Brief:   Government spending is increasing, while receipts have decreased relative to the increasing taxable base.   That is the textbook definition of accommodative fiscal policy.  Looking forward, there appears to be little political will for additional programs such as infrastructure or a relaxation of tax rates for individuals.

When evaluating fiscal policy, it is important to take both spending (outlays) as well as income (receipts) into account.  Any uptick in outlays represents additional gov’t spending, while a dip in receipts represents either a reduction in the taxable base (recession), or a cut in the tax rate for individuals or corporations.  The chart below shows the aggregate amount of US gov’t outlays in red, and receipts in blue.   

Receipts have been stagnant over the past 3 years, while outlays continue to set new highs.  The Tax Cuts and Jobs Act of 2017 helped keep revenues from rising, while consistently increasing social and defense spending have kept upward pressure on outlays.   

Going forward, we see very little political will to cut spending levels in the aggregate, or meaningfully adjust tax rates.  The major risk in this late stage of the expansion is that any sort of economic slowdown will likely exacerbate an already stretched deficit spending situation.   Then again, major shifts in fiscal policy tend to come 1-2 years after presidential elections… and we just so happen to have one of those in a mere 476 days.

The potential negative impact of gov’t regulation and anti-trust actions on ‘Big Tech’ could also be included in this section.  But we’ll save that for a future note.

Trade and Geopolitics

In Brief – Restrictive global trade policies are by far the biggest obstacle to a so called ‘Rocketship Economy.’  Increased friction in global supply chains pressures corporate margins, while uncertainty about the trajectory of trade policy delays business investment and capital spending.  We are currently in a period of increased nationalism and brinkmanship.  This shift away from globalism has been tolerated by markets because it is seen as a means to realizing a more level playing field for our companies.  If that objective is met, and free-trade proliferates globally – that would be a very good thing.  In the interim, uncertainty persists.

One year ago, the US placed a 10% tariff (tax) rate on over $200 billion in imported goods from China.   At that time, we were in the process of producing our 2Q2018 newsletter, where we noted that in relation to global aggregate trade volumes, the effective tariff of $21 billion/year was unlikely to derail global commerce.  

Analyzing the impact of any tariff policy comes down to three basic components: 1) Tariff rate as a percent 2) the size and composition of the goods that will be subjected to the rate and 3) the duration for which the rate will be applied.  If any one of these components is immaterial, then the policy won’t have much bite.

After a full year of tariffs, the US Gov’t has collected roughly $21 billion in duties.  While that sounds substantial, it is less than 1% of the total value of all goods imported by the US ($2.1 trillion).  Additionally, a majority of that $21B was collected on intermediate goods.  

Intermediate goods are used to create the finished goods that are eventually sold to end consumers.   When these inputs cost more, companies must decide to either absorb that cost, or pass it along to consumers in the form of higher prices.  Based on recent reads on corporate margins and inflation, it appears that companies, on balance, have decided to absorb these incremental costs.

The often-threatened increase in the tariff rate (25%) and base (all Chinese goods imported by US) would disproportionately target consumption and capital goods.  Tariffs on that scale would be much harder for companies to absorb and would likely jeopardize the strength of the US consumer that we noted above.  For that reason, heightened rhetoric on this front must be taken seriously. 

Conclusion

If business and consumer spending are the fuel that power our potential ‘Rocketship Economy,’ monetary and fiscal policy are the weather and the launch conditions.  While we agree with the President that growth is being held back from its potential, we would not place 100% of the blame on Mr. Powell.  Sure, monetary policy could be more accommodative.  But by historical standards, the current stance of monetary policy is exceptionally accommodative, especially in the 10th year of an expansion.  In our opinion, as long as trade policy remains a dark cloud on the horizon, it will be tough for the global economy to lift off.

If you have any questions or would like a more in-depth review of your accounts or our outlook, please let us know.