Heartburn, Not a Heart Attack Heartburn, Not a Heart Attack

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

Not long ago, many investors were kicking themselves for not investing more when the stock market was cheaper. But when stocks fall, like they did last week, many investors have a hard time buying for fear stocks may go lower still.

Who knows, maybe they’re right. We have no idea where stocks will close today, nor at the end of the week. Corrections (both small and large) happen from time to time. In hindsight, many claim they knew it was coming, but we don’t know anyone who has successfully traded corrections on a consistent basis – we certainly won’t try.

We’re also skeptical when analysts try to attribute corrections to a particular cause. It’s a basic logical flaw: post hoc ergo propter hoc. Because the correction happened after a certain event, that event must have been the cause. But important news and economic events happen all the time. Sometimes the market goes up afterward, sometimes down, and similar events at different times have no discernible impact.

Now some are blaming the Federal Reserve, and specifically statements from Chairman Powell, for the downdraft in equities. But, according to futures markets, the outlook for monetary policy has barely changed. The markets are still pricing in a path of gradual rate hikes and continued reduction in the size of the Fed’s balance sheet.

Let’s face it, fretting over the Fed is as old as the Fed itself. In recent years alone, we faced the “Taper Tantrum” and calls for a fourth round of quantitative easing. And remember when the Fed first raised rates and then announced it would reduce its balance sheet? Each time, analysts predicted the apocalypse was upon us – that a recession and bear market were right around the corner. How did those calls pan out?

Exactly, they were wrong, and this time looks no different. QE never lifted stocks, taking it away won’t hurt; and interest rates are still well below neutral. The biggest pain has been felt by those who followed the false prophets of doom.

The odds of a recession happening anytime soon remain remote, we put them at 10%, or less. And a recession is what it would take for us to expect a full-blown bear market. In other words, the current drop is just heartburn, not a heart attack.

We’ll publish a piece next week about our exact forecast for economic growth in Q3, but it looks like real GDP rose at about a 4.0% annual rate. Profits are hitting record highs and businesses are still adapting to the improved incentives of lower tax rates and full tax expensing for business equipment. Home building is still well below the pace required to meet population growth and scrappage (roughly 1.5 million units per year). Household debts are low relative to assets and debt service payments are low relative to income. These are not the ingredients for a recession.

That’s why we love Jerome Powell’s response to the recent gyrations in the market. Many pundits were calling for him to back off his tightening and his “hawkish” language, but he didn’t take the bait. He’s focused on monetary policy, and the economy and won’t be pushed around by hysterics or market gyrations. The S&P 500 fell about 6% from its intraday all-time high to Friday’s close. This isn’t earth-shattering, and the Fed shouldn’t respond. Investors need to stop obsessing about the Fed. Instead, they should focus on entrepreneurship and profits. The fundamentals are what matter.

Meanwhile, some investors are concerned about President Trump tweeting or speaking out on the Fed and monetary policy. If this were any other president, we’d be concerned, as well. But we all know Trump isn’t the kind of president to hold his opinions close to the vest on any topic. If he thinks it, he says it. Please take his comments on the Fed in that context. That certainly seems to be what Jerome Powell is doing.

The bull market in equities that started in March 2009 isn’t going to last forever. But we don’t see anything that’s going to bring it to a screeching halt anytime soon.

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The Growing Deficit

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

The U.S. federal government reported last week that it ran a deficit of $214 billion in August, the fifth largest deficit for any single month in US history.

The Congressional Budget Office thinks these numbers are consistent with a budget deficit of about $800 billion for Fiscal Year 2018, which ends September 30. If so, that would be the largest annual deficit in raw dollar terms since FY 2012. This deficit is roughly 4.0% of GDP, which would be the highest since FY 2013.

For many, this growing deficit is a dagger to the heart of the tax cut enacted in late 2017. They say the tax cut was irresponsible. However, economic growth has picked up because of the tax cut, and growth is the key to higher fiscal receipts down the road – in fact tax receipts are still hitting record highs.

Between 2010 and 2017, the U.S. passed two large tax hikes, yet the deficit was still $665 billion in FY 2017, which was not exactly a model of fiscal purity. As a result, we call “politics” on all those now fretting about deficit spending only when a tax cut is involved.

It’s important to recognize that the tax cut has, so far, reduced revenue compared to how much the federal government would have collected in the absence of the tax cut. But, total federal receipts are likely to end the current Fiscal Year up slightly from last year and at a record high. Next year, according to the CBO, revenue should be up 4.6% and at another record high.

In other words, the tax cut didn’t lead to an outright reduction in revenue, it just slowed the growth of revenue. Spending is the problem. Total federal spending will rise about 4% this year and is scheduled to rise about 8% next year. In spite of an acceleration in economic growth, government spending is rising faster than GDP.

While this is a long-term problem, it will not turn the U.S. into Greece overnight. No fiscal crisis for the nation is at hand. Last year, net interest on the federal debt amounted to 1.4% of GDP. The Congressional Budget Office projects that net interest will hit 2.9% of GDP before some of the tax cuts theoretically expire in the middle of the next decade.

That is a large increase, but net interest relative to GDP hovered between 2.5% and 3.2% from 1982 through 1998. The U.S. paid this price and the economy still grew more rapidly than it has in the past decade. The U.S. didn’t become Greece.

Compare two economies of equal size. One spends $500 billion, but with zero taxes, the other spends $2 trillion, but taxes $1.5 trillion. Both have $500 billion deficits, but the first economy would be more vibrant and could finance the debt more easily. It’s not that deficits don’t matter, but deficits alone are not a reason for investors to run for the hills.

And when deficits are partly caused by more federal spending on interest payments you know who will hate it the most? The politicians.

Here’s why. Politicians like to deliver things their constituents are grateful for, things that make voters more likely to vote for them rather than someone else. Tax cuts help politicians get more votes, at least from those who actually pay taxes. Government programs can also help incumbents corral votes. Pass out government checks and you can get more votes, too. But bondholders have no gratitude for politicians when they receive the interest they’re owed on Treasury securities.

Higher net interest payments will eventually “crowd out” future tax cuts and government programs, making it tougher for incumbents to get re-elected. As net interest payments rise, more politicians will start obsessing about the deficit again, just like in the 1980s and 1990s.

The true threat to long-term fiscal health is spending. If left unreformed, entitlement programs like Social Security, Medicare, and Medicaid will take a ceaselessly higher share of GDP, leading to a larger and larger share of American production being allocated according to political gamesmanship rather than individual initiative, in turn eroding the character of the American people.

Unless we change the path of spending, last year’s tax cuts - and the boost to economic growth they’ve already provided - risk getting overwhelmed in the long run. But, for investors, this isn’t an immediate problem. After all, deficit fears have been around for decades and equities still rose. Stay bullish, for now.

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California Ramps Up Privacy Protection

A new law may spur other states—or the feds—to give you more control over your online data.

By Lisa Gerstner, Contributing Editor
August 30, 2018
Kiplinger's Personal Finance

Kiplinger’s spoke with Aleecia M. McDonald, an assistant professor at Carnegie Mellon Univer­sity’s Silicon Valley campus who researches internet privacy and security. Read on for an excerpt from our interview:

California’s new law, which goes into effect in 2020, is supposed to improve online privacy for consumers. What are the key points? Consumers will be able to know more about the information companies have collected about them, request that companies delete that information, and download or transfer the data for their own use. Consumers will also have the right to know when their personal information is being sold to a third party, such as an advertiser, and to opt out of that sale in many cases.

Will opting out be free? Companies can’t refuse service to customers who exercise that right, but they can charge customers the amount of money they would have collected from third parties for selling the data. The law applies to large companies and data brokers, so your local dentist or pizza shop could still sell your unlisted cell-phone number without notice or without allowing you to opt out.

Will other states follow California’s lead? It is entirely plausible that other states will either adopt the California law or modify it slightly. I wouldn’t be surprised if a state such as New York, which has an attorney general’s office with a strong consumer focus, passed a law like this one. And privacy is not a red state or blue state issue, so Montana and Vermont, for example, could easily pass privacy laws in a single year. Facebook and Google have reportedly been meeting with federal policymakers to talk about developing a privacy law. But a federal law may be weaker than state laws and may preempt them.

What changes will consumers see? Some companies may provide notices on their websites to everybody—not just Californians—about the personal information they’re collecting. It’s easier to write the code that way. California will require a button on websites allowing you to opt out of your personal data being sold. Non-Californians may see the button on some sites, too.

How else can consumers protect their privacy online, regardless of where they live? Look for privacy-friendly alternatives to the tools you use. DuckDuckGo is a fantastic search engine that doesn’t collect or share your personal information. The Privacy Badger browser add-on blocks advertisers and other third parties from tracking your activity—and you don’t need a PhD to figure out how to install and use it.

US Stops Subsidizing Global Growth

     For decades the United States has, directly and indirectly, subsidized global growth.  For example, after World War II, the U.S. provided direct economic aid to Western Europe with the Marshall Plan, while also helping to rebuild Japan.  And since then, we have provided never-ending direct aid to foreign countries, which has been a constant political football.

     But in the economic scheme of things, the biggest subsidies of all have been indirect.  For decades the U.S. has held trade tariffs below those of most foreign countries.  And until recently, the U.S. has maintained a corporate tax rate significantly above the world average.  At the same time, the U.S. hindered, through regulation, its production of energy.

     According to the World Trade Organization, before the Trump tariffs were put in place, the U.S. had an average tariff of 3.4%.  Canada had an average tariff of 4.0%, the EU 5.1%, Mexico 6.9%, China 9.8%, and South Korea 13.7% - all higher than the U.S., which means the playing field was tilted in favor of foreign countries.  The U.S. was subsidizing them.

     In 1993, America lifted its federal corporate tax rate to 35%, from 34%.  When combined with state and local corporate taxes, the average rate was 38.9% and held there until the Trump tax cut in 2017.  In 1993, the average worldwide corporate tax rate was roughly 33% (about 6 percentage points below the U.S.) and by 2017, the average had fallen to 23% (about 16 points below the U.S.).  In other words, at the margin, businesses looking to invest globally had an incentive to invest outside of America.

     The slowing of energy production in America became a direct subsidy to those who produce energy.  Russia, Saudi Arabia and the Middle East, Venezuela and Mexico all benefited as the U.S. bought most of its crude oil from overseas.

     But things have changed – in a huge way.  The geopolitical implications of this are coursing through the world right now.  In some places, like Venezuela, it’s an economic crisis.  In others, like China, it’s reflected in slowing economic growth.  And if anyone doesn’t understand the relationship between fracking and the fact that women in Saudi Arabia will be allowed to drive, they aren’t thinking hard enough.

     But, more to the point, cutting the U.S. corporate tax rate to 21% and boosting tariffs on select countries and products is removing a huge subsidy to growth for the rest of the world.  The U.S. is the dominant economy in the world and when it stops subsidizing foreign countries, who have not followed free market principles, economic pain spreads.

     The U.S. has become not only the largest producer of petroleum products in the world, but a net exporter to some regions.  And output keeps going up.  This is altering the balance of world power in a huge way.

     The impact of all this is to put pressure on other countries to come back to the table and talk about more equal trade.  It also forces countries that previously were able to have high income tax rates, huge government budgets, and lots of red tape to rethink their fiscal policies.  The global establishment have never been under attack like they are today.  The world order is changing for the better.

     This means the U.S. economy and its stock markets are in better shape relative to others.  However, if these pressures really do lead to more freedom and less political interference in economic activity, the world could end up seeing a boom like it did in the 1980s, when Reagan’s tax cuts led other countries to follow suit.

     While news shifts rapidly, the pressures we outlined above already seems to have pushed Europe, Mexico, Canada, and China to negotiate on trade.  We think this will eventually lead to lower tariffs, not a full-blown trade war.  After all, because the U.S. is removing a subsidy to these countries, their growth will suffer relatively more.  They have an incentive to follow better policies.

     No one knows exactly how this will turn out, or whether the establishment will fight back and find a way to resist change.  But, for now, the U.S. is benefiting from an increase in investment and growth due to better policies.

 

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"Distractophilia"

“Distractophilia” is defined as, “One’s obsession with focusing on mostly irrelevant matters, while creating a diversion from what is important.”  Ladies and gentlemen, that is exactly what Andrew and I have been writing and talking about for months upon months.  The distractophilia list is immense: China, overvaluation, higher interest rates, Russia, yield curve, trade wars, NAFTA, Turkey, and on and on.  Meanwhile, the mother’s milk of secular bull markets is earnings, and earnings continue to improve and will likely do so for many quarters to come.  Moreover, the stock market is a leading economic indicator and will tell us months in advance what’s in store for the economy going forward.  


That reminds us of a quip we have used many times over the past 48 years.  To wit: “The market itself determines the relative importance of all factors more accurately than any speculator can hope to interpret them.”  So wrote Don Guyon in the seminal book One Way Pockets, the book Merrill Lynch’s legendary retired market strategist Bob Farrell says is the best stock market book ever written!  And to be sure, NOTHING has really changed since then, because human nature has not changed.  Investors and traders can buy and sell based on their own interpretation of the news events of the day, but the market action itself determines the true and the most accurate interpretation.  In other words, if the investor, or trader, isn’t in sync with the stock market, he/she is going to suffer losses!  So when the stock market speaks, if you want to make money, you had better listen!


Clearly the stock market has spoken and has been “speaking” since the undercut low of February 9, 2018 (2532 and we were bullish).  Since then, the S&P 500 (SPX/2896.74) has gained over 14%!  
 

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Capitalism Works, Don’t Change It

Brian S. Wesbury – Chief Economist

Robert Stein, CFA – Dep. Chief Economist

Strider Elass – Senior Economist

     “Wealth creation” versus “the redistribution of wealth” is an age-old political/economic battle.  And once again, Senator Elizabeth Warren - among others - has capitalism in the crosshairs.

      Adam Smith defended capitalism in 1776.  Karl Marx attacked it in the 1800s.  William Jennings Bryan attacked it; Grover Cleveland defended it.  FDR attacked it; Ronald Reagan defended it.  And, today, the battle goes on, with many Democrats openly promoting socialism.

      Elizabeth Warren wants her own “new deal”, employeeelected board members and companies responsible to communities over shareholders.  She complains about “shorttermism” – quarterly reporting that makes companies only worry about the bottom line in three-month periods.  Even President Trump has weighed in; after talking with the CEO of Pepsi, he has suggested six-month reporting cycles.

     We don’t disagree that some companies make decisions to “hit” quarterly earnings targets.  Many believe privately-held companies often make better long-term decisions because they aren’t kowtowing to analysts.  But, Warren Buffet downplays his quarterly reports and the stock market hasn’t punished Berkshire Hathaway.  And don’t think private companies ignore their monthly, or even weekly, results.  They don’t.

      We’re not arguing that freedom shouldn’t be applied.  If companies want to report every six months, let them. But, our bet is that the market wouldn’t like that.  Investors deserve timely information.  Even today, companies are free to say “we aren’t managing to quarterly data.”  Let the market decide what matters.  Let companies experiment.  But more information, not less, is almost always better. 

     Over the years, political attacks on companies for shorttermism have come and gone.  We find this disingenuous.    Washington DC, and many state capitals, make a complete mockery of fiduciary responsibility.  Budgets haven’t been balanced in decades, and after eight years of economic recovery (and even before the recent tax cut) the budget deficit in 2017 was still over $650 billion.  Not even Keynes would stand for that.

     And Congress isn’t on a quarterly reporting cycle.  Politicians report to the people in 2-, 4- and 6-year cycles.  Yet,Congress can’t balance its budget, or in many recent years, even produce a budget.  We find it fascinating (to put it nicely) that politicians who have shown such incredible fiduciary irresponsibility would even attempt to reform a system – The Capitalist System – that has produced unfathomable wealth and higher standards of living for so many.  Before the nation debates a takeover of corporations by political fiat, maybe Congress should get its own house in order. 

     Senator Warren has proposed The Accountable Capitalism Act.  Her Act would allow “stakeholders,” which include employees, and unstated others, to sue companies if they think they are not sharing profits equally with other stakeholders.

     This is a terrible idea.  Corporations provide products to consumers, and profits are simply a sign they are doing it effectively.  As long as there is freedom for capital to move, for people to change jobs, and for investors to choose what to invest in, then the system holds no one hostage.  As long as contracts are fairly enforced, the system remains equitable.

     Profit signals opportunity.  Profit signals growth.  Some are complaining that corporations are returning too much of their profits to shareholders, but without these investors there would be no company in the first place – and far fewer jobs.  In fact, today there are more unfilled jobs in America than there are unemployed Americans.  In other words, workers have choices and companies must work hard to attract labor.

     Senator Warren, and others, complain that profits are up while wages are stagnant.  In her Wall Street Journal Op-Ed, she said “In the early 1980s, large American companies sent less than half their earnings to shareholders, spending the rest on their employees and other priorities.  But, between 2007 and 2016, [they] dedicated 93% of their earnings to shareholders.”

      The data doesn’t support this.  Real average hourly earnings fell 7.3% from January 1980 to January 1995, while they rose 7.3% from December 2006 to December 2017.

     Profits are the lifeblood of capitalism.  Reporting them, earning them, and returning those profits to shareholders creates more investment, more wage growth, and more wealth creation.  Politicians can’t balance a budget.  Why would a sane electorate give them even more control of private wealth?

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Investment Strategy: "Charts of the Week"

It can be very easy to forget that the stock market is a market of thousands of individual stocks doing their own thing. While major averages like the S&P 500 are helpful and can give a rough idea of how the overall market is behaving, they also have some limitations due to the way they are constructed. The Dow Jones Industrial Average, for example, is price-weighted, so stocks with a higher price have more of an impact on the performance of the index than stocks with a lower price (which doesn’t really make much sense). Meanwhile, the S&P 500 is market-cap-weighted, which makes more intuitive sense than a price-weighted index like the Dow, but it also means that the biggest stocks in the market are always going to have a disproportionate impact on what happens with the index itself (that’s just the way math works). Due to this effect, a lot has been made recently of the fact that only a handful of stocks are responsible for the majority of the S&P 500’s gains so far this year. And yes, this is a fact, as the data below show, but the danger here is that too many people seem to be misinterpreting the information as this has been a narrow market or that only a handful of stocks have been going up, which is not the case at all.

As of about mid-day yesterday, six stocks in the S&P 500 – Netflix, Amazon, Microsoft, Apple, Alphabet, and Facebook – had collectively contributed 5.09 percentage points of the S&P 500’s 6.21% price return year-to-date, or about 82% of the returns overall. At first, this sounds horrible and scary and might lead one to believe that we’re secretly in a bear market that no one told these six companies about. Yet, once again, this phenomenon says much more about the way the S&P 500 is constructed than it does about the breadth or health of the stock market. The six aforementioned stocks also happen to be five of the six largest companies in the market by market cap, with Netflix a still significant 35th in market weight. If these stocks have a good year, as they mostly have so far in 2018, it should come as no surprise that they are having a significant effect on cap-weighted indices like the S&P 500. It’s like being surprised that the 3-4-5 hitters in a baseball lineup are driving in a disproportionate number of runs! 

What follows is a breakdown of the “big six” stocks by both 2018 year-to-date price performance within the S&P 500 and their current market cap (as of mid-day yesterday):

• Netflix (NFLX): 3rd in performance; 35th in market cap

• Amazon (AMZN): 6th in performance; 2nd in market cap

• Microsoft (MSFT): 56th in performance; 4th in market cap

• Apple (AAPL): 72nd in performance; 1st in market cap

• Alphabet (Google) (GOOG): 104th in performance; 3rd in market cap

• Facebook (FB): 254th in performance; 5th in market cap

What jumps out initially is that, other than Netflix and Amazon, the rest of these stocks haven’t performed as great as most probably believe when considering that, collectively, they are responsible for 82% of the S&P 500’sperformance this year. The latter four aren’t even in the top 10% of S&P 500 stocks, return-wise, and Facebook is actually underperforming the S&P 500 by a fair margin.

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Along For The Ride

Self-driving cars potentially will cause a disruption reaching well beyond your local car dealership.

Implications for investors could range from shifts in urban planning to the way insurance policies are handled, and from health care to the price of real estate.

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For more on this topic, check out the “Along for the Ride” website for fascinating new videos on battery advancements, safety, shipping, truck platooning, and the race for the lead in the coming world of autonomous vehicles.

"Along for the ride"

The Economic Surge

     Paul Krugman, Larry Summers and Bob Gordon have some ‘splainin to do.  Where’s that “secular stagnation?”

     Since 2009, they, along with many others, have said the US economy is stuck at 2% real growth.  Their theory got traction after 2009, as the U.S. saw what we called a Plow Horse Economy.

      But, we never believed slow growth was permanent.  The real problem was the size of government – too much spending, too much regulation and excessively high tax rates were holding the economy back.  We believed the idea of “secular stagnation” was another Keynesian red herring, designed to hide the damage government was doing and fool people into accepting slow growth as something that couldn’t be fixed.

      But after cutting tax rates and regulation, Friday’s GDP report demolished their theory.  Real GDP grew at a 4.1% annual rate in the second quarter, and is up 2.8% in the past year.   And although some analysts pointed out that net exports were an unusually large boost in Q2, they ignored that inventories were an unusually large drag (the largest drop since late 2009).  As a result, our initial forecast for real GDP growth in Q3 is 4.5%, even faster than was just reported for Q2.

      So now some of the same people who said the economy couldn’t grow any faster are saying that the acceleration in growth is just temporary, due to tax cuts.  While we certainly agree that tax cuts boost growth, we think the change is more than temporary, particularly due to the cut in the corporate tax rate and the move to full expensing of plant and equipment.  Not only has real GDP growth picked up, “potential” GDP growth has accelerated, as well.

      Potential growth is a term economists use to mean how fast the economy would grow if the unemployment rate remains steady.  We calculate it by using “Okun’s Law,” named after economist Arthur Okun, President Lyndon Johnson’s chief economist.  Okun’s Law says that for every 1% per year the economy grows faster than its potential rate, the jobless rate will drop by 0.5 points.

     Working backward from the unemployment rate declines of recent years shows that potential GDP growth has picked up.  From mid-2010 thru mid-2017, Okun’s Law said potential real GDP grew at just a 0.6% annual rate.  But in the past year, potential GDP has risen to 2.0%, and signs suggest it’s moving higher.

     Maybe this is a statistical fluke that will fade away over the coming years, but it sure looks like something changed a year ago. Deregulation and tax cuts are boosting growth, and the Keynesians are back to the drawing board.

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