Market valuations are high. Current consumption is being financed by debt. The housing data is mildly positive, but has been impacted by “rebuild” issues in the wake of natural disasters. Corporate balance sheets are strong and laden with cash. The world’s major economies are doing well and central banks are beginning to tighten policy led by the U.S.’s Fed. Q4 real GDP growth looks to come in above 3% (third quarter in a row!). Every major investment house is forecasting another great year for equities in 2018. So, what could possibly go wrong?
Fully 50% of this year’s 5,000 point gain in the Dow are due to five stocks; 80% due to 10. Clearly, this was not very broad based. The trailing PE ratio is 22.6x (a year ago, this was 21x). The forward PE ratio is 17.5x including the estimated additional corporate earnings from the tax rate reduction to 21%. This remains 2 points above historical norms and represents a full standard deviation. The Shiller cyclically adjusted multiplier is 32.9x, only higher in 1929 and 2000. Including the earnings from the tax cuts, this multiple is still an astronomical 30.8x. Even a 10% correction won’t bring valuations back to their historic averages.
Under the new tax code, everyone’s tax rate is reduced except for singles with incomes between $157,500 and $425,000. They have a tax increase. Most of the high paying jobs those singles hold exist in high tax states like CA, NY, WA, MA… Those higher income individuals who live in those states may also have to pay higher taxes because the new tax law eliminates or severely limits the federal tax deductibility of state and local taxes, and mortgage and other interest payments. So, the jury is still out as to whether or not the newly passed tax legislation will be, on net, a positive or negative for economic growth. Clearly, some will benefit, but others will not.
During the Q4 selling season, some noteworthy trends emerged. Excluding autos (which are in a downtrend), retail sales rose 4.9% between November 1st and Christmas Eve, vs. 3.7% a year earlier according to Mastercard. That’s the good news! In November, spending growth was greater than income growth by a 2 to 1 margin. The Amazon effect produced 50% off sales at most major retailers. Such sales likely did two things: 1) crimped profit margins; 2) pulled demand forward. You can tell demand has been pulled forward because the purchases were mainly debt financed. Credit card balances at commercial banks rose more than 18% so far in Q4. Normal is 5%-6%, and exceptional is 8%. In addition, the savings rate, normally near 5% or higher, has now dropped to 3%. It is really hard to get it much below that given automatic payroll contributions to 401(k) plans and contributions to IRAs. It is a good bet that bonuses and the small increase in take home pay due to lower withholding will be used to pay down the credit card debt in Q1 and Q2, and/or be used to replenish savings.
The Business Sector
The just passed tax legislation appears to be beneficial for corporations, especially for those with the bulk of their sales in the domestic markets. The cash repatriation and 100% depreciation allowance in year 1 are there to spur capital expenditures (capex).
Most of the offshore cash belongs to the large tech companies, all of which already have large domestic cash hoards. Over the last couple of years, we have seen the majority of corporate cash deployed for stock buybacks, dividends and acquisitions. In fact, the result of the cash repatriation legislation of 2004 was that those large tech cash holders only recalled 9% of their cash, and, in 2011, the Wall Street Journal labelled the tax holiday a ‘failed’ policy.
It would be foolish to think that no new capex will result from the depreciation or cash repatriation provisions of the legislation. But, given current corporate cash conditions and the state of the consumer, it isn’t likely to be what was touted. One has to wonder if any new capex resulting from the tax legislation will simply be just another pull forward.
Real GDP for Q3 ended up at +3.2%. And, no doubt, Q4’s GDP will also be in the 3% range. The good retail season (debt financed) along with the “rebuild” from the impacts of the Q3 hurricanes all but guarantee that result. In addition, the “rebuild” will continue in Q1 and Q2, if not beyond, due to the two major CA fires, each of which destroyed several thousand expensive homes and other structures. That “rebuild,” while it looks like GDP growth, is not sustainable growth. It is an asset substitution, usually from an insurance company’s loss reserves (a balance sheet item) to the homeowner who spends to either buy an existing structure or to rebuild. The result will be a positive impact on Q1 and Q2 GDP, but the growth won’t be organic or sustainable no matter what Wall Street says.
When you adjust for 50% retail discounts, 18% increases in credit card debt, and the drawdown in the savings rate, this doesn’t appear to be the 3% growth economy the GDP implies. It probably isn’t even a 2% growth economy. When you have really sluggish underlying growth which has to be stimulated to bring forward demand, the economy becomes susceptible to a policy mistake, either fiscal, monetary, or both.
In the wake of the signing of the tax legislation, the Trump Administration is ready to move on to “infrastructure,” another campaign promise. Visit any western industrial country, even China, and you will marvel at how far behind the U.S. infrastructure is, especially in transportation. No doubt, new technology, especially in autonomous vehicles, will have a future beneficial impact on using existing infrastructure. But, there is no doubt that existing U.S. infrastructure needs a lot of attention, including water and sewer systems, bridges, the electrical grid, airports, etc. This looks to be fairly low hanging fruit. But, even attention to such existing infrastructure needs will still take several quarters, with the initial legislation likely to be a protracted Congressional affair, and then there will be the studies and permits. So, spending on infrastructure is not really likely until at least 2019. There is also the question as to how this gets paid for – more debt and deficits, or increased taxes?
New infrastructure is an issue unto itself. Ten years after the passage of the Interstate Highway legislation in 1956, 20,000 miles of highway had been built. Today, it takes 10 years or more to build a single mile and at a mind-blowing cost/mile. (For example, it took 25 years to rebuild the Oakland side of the SF Bay Bridge after the 1989 earthquake, and at a cost of $7+ billion.) So, don’t expect the construction portion of new infrastructure projects to have an impact on the economy anytime soon.
From a market perspective, the real wild card for 2018 is the Fed and the other major central banks. Policy tightening is definitely in the cards, and that, alone, may cause some market indigestion. The European Central Bank (ECB) will begin tapering their Quantitative Easing (QE) program in January, and there will be a new ECB President. A German will likely be appointed with the market then expecting a more rapid move toward tighter policy. The better tone to the Brexit talks along with higher inflation than expected in the UK is pushing the Bank of England towards higher rates. Then there is the Bank of Japan. Heretofore, that central bank has been the only holdout to the tightening move. But, now, they have signaled an initial move toward less accommodation.
Regarding the Fed, let’s not forget a new lot of inexperienced policymakers will take the helm in February. Importantly, on net, the all-important Federal Open Market Committee (FOMC), the rate setting committee, will be composed of three more hawks and three less doves. This implies an upward bias to short-term rates from what the market currently expects. The Fed, itself, tells us that there will be at least three rate hikes in 2018 and an additional two in 2019. The rate hike forecast is based on the “dot plot,” a compilation of the views of the individual members of the FOMC, not on any official policy position.
The truth is, the Fed really has no clue as to how many rate hikes there will be and when. They are driven by the forecasts from econometric models that are built on historical data. The underlying assumption of such models is that the future economy will behave similar to the economy of the past. We are all aware of the rapid changes in our economy since ’09. It is unlikely that today’s economy reacts the same way as the economy reacted in the 1960-2009 time period, which represents the bulk of the data in the Fed’s models. Inflation, of course, is the prime example of how the economy’s reaction function today is different than it was in the tight labor markets of yesteryear.
Worse, the Fed’s track record in tightening cycles is atrocious. In past cycles, the Fed raised rates until something went wrong. Typically, it stops and reverses only after a calamity occurs. The following is a list of such calamities. In each case, the Fed was tightening and had to reverse course:
Latin American Debt Crisis: early 1980s
Flash Crash: 1987
S&L Crisis: 1990
Asian Meltdown and LTCM: 1997
Financial Crisis: 2008
What makes anyone believe that their timing in this cycle will be different? What is different today that will make them know when to stop, especially since today’s economy doesn’t behave the same as it would have pre-’09?
As we pass the 102nd month of this expansion (average post-WWII expansions are 58 months in duration) with the unemployment rate near 4%, there is still no inflation in sight, no matter what the Fed says. Even the economists at Goldman Sachs, who see the unemployment rate falling to 3.4% in 2019, don’t see core inflation reaching the Fed’s 2% objective until 2020. With rates rising, debt skyrocketing, and a much changed economy, the odds of a policy mistake from a central banks still dependent on the pre-’09 reaction functions appear to be high.
We don’t know when the markets will correct, but we do know that they will. Incomes in the underlying economy have not kept up with spending, a situation that, by definition, can’t last. Think back to 2007. Which, if any, market prognosticator foresaw the oncoming financial meltdown? Certainly, not those at the Fed, like Chairman Bernanke, who, just a few months prior to the meltdown, pronounced that the mortgage market was healthy. If you had money in the markets in ’08, had you known and believed someone not caught up in the Wall Street hype who could see the issues in subprime mortgage credit, you could have been saved a lot of financial pain.
Will 2018 be like that? Probably not. No one knows. But, today, there clearly is too much debt, the cycle is long in the tooth, valuations are sky high, and, the Fed is tightening. At the very least, volatility is going to rise. A market correction is long overdue.
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information.