The old saying is that stock markets must climb a wall of worry, and we have certainly seen that wall-climbing play out over the past several years. Every day, it seems, we can open the pages of the newspaper (or more likely, check our online news feed) and find headlines expressing anxiety over every downward squiggle in U.S. stock indexes apparently relentless march up and to the right of the chart.
When that march was interrupted by more than a squiggle during the decline in the last quarter of 2018, of course, it prompted deeper anxiety and soul-searching about the economic underpinnings of the rally. (Such corrections always do.) The job of an investor in such moments is to assess neutrally whether the fundamental thesis is still in place, and not to respond emotionally; and our job is to select from the chaos of conflicting data and news what we believe are the most important events, trends, and indicators to assist you in that neutral assessment.
We believe the thesis that supports a continuing bullish view of the U.S. and of many global stock markets is still in place. There are data supporting that thesis, and there is also a larger context — a framework and direction for current government policy that let us understand where the data are coming from, and how likely they are to remain positive.
So what are those data — and what is that bigger context, as we see it?
Positive Data Fuel the Rally
Last year at this time, we created a framework for assessment that we called the Recession Watchers Guide, in which we outlined some of the key data points that we follow as we assess the risk and proximity of a recession and a bear market. The data we mention below continue to flash green.
GDP Growth
We say frequently that corporate profits are the mother’s milk of stock prices, and economic growth is the mother’s milk of corporate profits. According to the advance estimate released by the Bureau of Economic Analysis on April 26, first-quarter 2019 real U.S. GDP rose quarter-over-quarter at an annualized pace of 3.2%.
Slow Growth? The “New Normal†Wasn’t So Normal After All
Source: Bureau of Economic Analysis
Stepping back from the data, we see that the former view of a permanently lower new normal of economic growth promoted by some economists and pundits over the past several years, was mistaken; the new trend that has emerged after 2016 is markedly higher. To put that trend in further context, consider how ecstatic any European politicians would be if they could consistently hit a real GDP growth rate of 4%. (They might think they were in a reboot of The Twilight Zone.)
What drove the good GDP growth in the first quarter? First and foremost, net exports trending up — exports up, and imports down. Imports of goods declined at the most rapid rate since the depths of the Great Recession, while exports continued to rise robustly. The second-biggest contributor was gross private domestic investment; third was personal consumption expenditures.
The improvement in net exports is policy driven. Again, while our capacity for enduring political drama continues to be stretched every day we look at the news, it is the important policies being enacted outside that circus limelight that are really significant for investors to watch. By all means, if following the daily kerfuffle gives you joy, go ahead, but it is largely irrelevant from an investment perspective, which is why we consider ourselves basically apolitical.
What are the policies that are pushing GDP data in the right direction for markets?
Accelerating declines in net exports of goods and services have been a drag on U.S. economic growth for decades, and that trend is beginning to be reversed, both practically and psychologically, by the U.S. administrations tougher stance toward trade deals
Net Exports Have Been a GDP Drag For Decades
Shaded areas indicate U.S. recessions
Source: Federal Reserve Bank of St Louis
Note that the most precipitous phase in the decline of net exports began in the mid-to-late 1990s, as Chinas exports grew, and the decline accelerated still more markedly after Chinas accession to the World Trade Organization under the Clinton administration.
It is likely that the trade negotiations currently underway with many of the U.S. trading partners, including China, will result in continued improvements to net exports and their contribution to U.S. GDP growth. This improvement registered in the first quarter was not a flash in the pan.
Another of the elements that boosted GDP growth in the first quarter, and that is even more likely to be a new, emerging trend than a one-off blip, is private domestic investment. This, we believe, is emerging as a consequence of the tax reform enacted last year. That tax reform did result in a tax break for the vast majority of individual taxpayers in the U.S. (on average, individual taxpayers Federal taxes declined by 25% in data released by H&R Block at the end of March).
However, the real significance of the reform was the cut to the headline corporate rate to bring it more into line with the U.S. developed-world peers, and a change which allowed business investments to be written off as expenses immediately, rather than spread over a period of many years. These changes mean that businesses are incentivized to invest in improving and expanding their offerings. We have noted many times in these pages that one of the most important drivers of economic growth is improvement in workers productivity — and that is exactly what will be enabled by the fresh investment in plant and equipment encouraged by the new tax law. This is a change in incentives that we believe will yield economic dividends long into the future.
Consumer Spending and Confidence
We noted above the contribution of consumption expenditure growth to overall economic growth in the first quarter. On that front, we note that consumer confidence, one of the key variables we described in the Recession Watchers Guide, has bounced back after a predictable volatility-driven dip in late 2018 and early 2019, and remains on the higher trend it established in mid-2016.
Source: Bloomberg, LLP
Consumer spending kept pace, with March purchasing notching the best gain in nearly a decade.
Inflation and the Fed
Notably, inflation remains contained, with March core inflation coming in 1.6% above the same month in 2018, missing projections. We noted recently in these pages that around the world, central banks have “stepped dovish that is, they have either eased policy or communicated their intention to ease policy, emphasizing their sensitivity to signals of economic and market weakness. This includes the U.S. Federal Reserve, which as we write has held rates steady again, and according to consensus, is unlikely to raise them further this year. Thus, monetary policy continues to be accommodative, which will help to support stock prices.
Investment implications: The situation in the U.S. remains goldilocks. Growth is strong, for reasons that are likely to be enduring. The pessimism of a low-growth “new normal†economy is rapidly fading. Exports, investment, wages, consumer confidence, and consumer spending are all doing well. Inflation remains low, increasing the likelihood that Fed policy will remain accommodative for some time. Recession warning signals are not flashing red. In this context, we remain bullish on U.S. stocks — especially those with growth characteristics who can increase profits in the longer-term trend of increased capital spending and productivity enhancements.
