Market Update

Posted on April 13, 2018 by Gemmer Asset

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It was a decent week for the global equity markets with broad based gains. The S&P and developed EAFE index both advanced +2.0% while small-cap U.S. equities modestly outperformed. Commodities performed well given the over +10% rally in crude oil. Interest rates ticked higher and intermediate-term government bonds lost -0.3%. Low quality high-yield bonds performed strongly, though, with a +1.2% gain for the week.


Conflicting Themes


In our latest quarterly letter, which will be going out soon, we outline three themes we think are going to be key for the rest of the year. Each is important in their own right. Taken together they offer a mixed bag for both the global economy and the markets.


Theme #1 – Tax, Budget, and Corporate Earnings Tailwinds


We have talked extensively about the tax and budget changes and the implications for growth. Essentially, much higher fiscal spending this year and next should provide an important tailwind for growth. Estimates from respected sources are that the boost could average +1% or more in both 2018 and 2019.


Of course, this comes at the expense of larger deficits. According to the Congressional Budget Office’s projections, the tax cuts will increase the federal deficit by $242 billion this year and $292 billion next year. These are non-trivial numbers in a $20 trillion economy. The CBO projects that the debt to GDP hits roughly 80% by 2020 and close to 100% by 2028 (see below)




Of course, this assumes no recession. Throw in a downturn in say 2020 or 2021 and we’ll blow through these numbers, but that is a problem for another day. More fundamentally, are these debt trends sustainable? Certainly they are over the short-term (next five years). Where debt will become a problem is when interest payments swamp the budget. The CBO estimates that interest payments as a percent of tax revenues could hit 17% by 2028. While much higher than today’s level, we’ve seen these numbers in recent history.




For the time being the fiscal picture should be supportive of growth. And this should be positive for earnings. The can will be kicked as always.


The other major tailwind comes from earnings. It should be one of the strongest in years. Analysts expect S&P 500 profits to rise 18.4% in the first quarter. That would be the biggest profit rise since the first quarter of 2011. Given the tendency of companies to report results above Wall Street estimates, those numbers might be expected to come in even higher. For example, first-quarter profits should rise by 24% if results achieve the median out-performance of the past eight quarters.


This comes at the same time that valuations have improved markedly. As J.P. Morgan notes:


“…based on forward consensus EPS estimates, S&P 500 now trades at only ~16x (ex-cash ~15x), which is below historical median. This puts the current valuation lower than anytime seen during last five years (even lower than 2014-2015 when outlook for equities appeared to be much more bleak with potential hard landing in China, rising USD, sharp decline in oil prices, and less favorable business policy).”




Theme #2 – Percolating Inflation


It is easy to tell the inflation story. Economy running at full capacity, throw in a big dose of fiscal stimulus, season with some tariffs, and BINGO, you get rising prices. Those who have been around long enough look back to the 1960’s (highlighted in the chart below) and speculate that we are on a similar path. Once unemployment falls below the key threshold of 4% price inflation is right around the corner.




Skeptics take a more jaundiced view. They point out that union membership was much higher back in the swinging 60s.




Surely this plays a role? Furthermore, we are still dealing with the after effects of the financial crisis. Credit growth remains anemic, running at basically half the level it did back in the 1960s-1980s. Without credit growth it’s tough to generate excess demand. And you need excess demand for inflation.




Who’s right? We suspect it depends on your time frame. We think inflation percolates higher short-term and the Fed hikes two (possibly three) more times. However, any increase in inflation will be capped by structural factors.


Theme #3 – Politics


This is an obvious one and captures everything from the Mueller investigation to trade policy. We have little to offer on the former, but on the latter we can at least take a stab at an answer. In essence, we agree with Bank Credit Analyst’s view:


“Trade protectionism is an obvious risk to (our) sanguine cyclical view. BCA has long argued that globalization is under threat from the combination of rising populism and the end of America’s role as the world’s sole superpower. However, the retreat from globalization will occur in fits and starts. Just as investors were overly complacent about protectionism a few months ago, they have become overly alarmist now. Both the U.S. and China have a strong incentive to reach a mutually-satisfying agreement over trade…”


We are already seeing hints of a compromise. Even before Trump’s tirade, China’s tariffs on U.S. cars and other imports were scheduled to be chopped this year to levels similar to that of the U.S., and foreign ownership limitations on the auto and aircraft manufacturing industries have been scrapped. The financial services industry is now wide open to foreign competition. Beijing has pledged to change its behavior regarding IP protection and technology transfers. These are substantive and significant steps. Will they be enough? We wouldn’t be shocked that both sides at some point declare victory, take credit for what was already planned, and move on.


Do We Really Have Another Election This year?


Any way you cut it we have a lot of elections in this country. Of course every four years we have the big Kahuna, but you must also throw in all the local, regional and state elections. And this year’s mid-terms are going to be a doozy.


Historically at least, there is a tendency for the incumbent party to lose House & Senate seats during the mid-terms. From 1934 the average loss has been 27 House seats and 4 Senate seats, as you can see below.




But this year is shaping up to be something unusual because it isn’t just Paul Ryan who’s choosing not to run again. Even at this early stage there are a record number of Republicans (and a growing list of Democrats) who are not seeking reelection in November. Just take a look at the graphic below!!




It is going to be a very interesting year politically.


Averages Are Misleading, Especially When it comes to Housing


How much do you need to earn to buy the average house in America? Of course, it depends where you live. Kansas requires just $43,160. But a study that pulled from Zillow’s recent sales puts California at $120,120, as you can see below.




But even this is misleading. The calculation for California assumes you are buying the average home in the state for $499K. I don’t know about you, but I don’t often see many $500K homes in the Bay Area. The average price in Walnut Creek (homes plus condos) is right around $900K. This means you’d need a salary of $216K/year. Go further south to San Jose and the average price is roughly $1.23MM. Now you are talking of needing an annual salary in the high $200,000!!


And then of course you could pick up this gem in San Jose. A real house (sort of) clocking in at all of 1066 square feet for just $799,000. Unfortunately, no usable bedrooms or baths, but then again, it basically burned down a couple years ago.




Such a deal!!


Have a good weekend.


Charles Email Sig




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