Byron Wien: No Recession in Sight
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This business expansion has gone on for nine years and most investors think we have to be near the end. In baseball parlance you hear talk that we are in the seventh or eighth inning; nobody seems to believe we are in the second or third. Jamie Dimon of J.P. Morgan has said at a conference we’re in the sixth, which got a lot of attention. Those who are cautious on the outlook talk about how corporate cash flows will be inadequate to service long-term debt obligations. They also raise macro issues like the large U.S. budget deficit, declining American competitiveness, worsening relationships with our trading partners, Middle East instability, a slowdown in Europe, difficult 2019 earnings comparisons and displacement of white collar employees by artificial intelligence.
We believe that the current business cycle has at least several more years left to run. The major signs that would herald the beginning of the next recession are not yet in place. Unemployment is low and likely to decline further; wages are rising, but not sharply; the Federal Reserve is tightening, but real interest rates are zero; inflation is moving higher slowly; the yield curve is not inverted; profits are increasing; and the leading indicators are still rising. Until some of these indicators change, the expansion is likely to continue.
Policy makers will try to keep the expansion continuing as long as possible. I believe that they recognize that if we get into a recession, we do not have the traditional tools to get out of it. The usual pattern for the U.S. economy when it is in recession is either for the Federal Reserve to lower interest rates from a high level to stimulate business activity or the Keynesian method of providing fiscal stimulus. At this point, even though we are presumably late in the cycle, interest rates (Federal funds) are still low and a year from now, even with continued rate increases every quarter, they are still likely to be less than 3%. Lowering them from there would not likely bring on a surge in the economy because the real rate of interest would only be a still low 1%, not much different from zero, where we are now. The two-year / ten-year spread is, however, tighter. In terms of fiscal spending, the Trump Tax Cut and Job Creation legislation is likely to increase the U.S. budget deficit from $700 billion to $1 trillion, making it about 5% of gross domestic product. This is the highest we have experienced in peacetime. A Republican Congress is unlikely to want to increase the budget deficit from the current level even if real economic growth slows back below 2%.
Our bullish thesis will likely be tested this summer. Mid-term election year stock market performance is notoriously bad. Historically, the market has corrected an average of -18.9% from peak to trough leading up to the election, based on data going back to 1962. But July in particular is typically the most painful month, as history shows it is the month when the market loses its gains, turning negative in the year to date column. Over the years there have been many theories attempting to explain the weakness seen around mid-term election, none particularly good, but still the pattern seems to persist. The summer months may be rough but we are optimistic for year end, and stick with our S&P 500® target of 3,000.
There are several more fundamental reasons for further short-term weakness. Any bull market is always vulnerable to a 10% correction, and even though we already had one in February, we did not do enough damage to investor optimism to create a foundation for the next important move higher. Now we are getting some deterioration in the fundamental economic background that may make investors somewhat more cautious. This probably started with the decision of the Trump administration to withdraw from the Iran nuclear agreement. The plan was imperfect, but it obligated Iran to cease its production of nuclear material for a decade, and our major allies who participated with us believed the country was generally in compliance. Our decision angered our partners, reinforced their view that the United States was increasingly insular and added to Middle East instability. While it brought Israel and Saudi Arabia closer together, it also enabled Iran to support various hostile conflicts in the Middle East in Gaza and Syria. The decision to move the American embassy in Israel from Tel Aviv to Jerusalem virtually eliminated the possibility of a two-state solution to the détente between the Palestinians and the Israelis and added to the uneasy political condition in the region. A two-state solution was probably a long shot anyway, because the Palestinian Authority was demanding a right of return and the Israeli settlements in the West Bank represented a logistical problem.
The sharp drop in the price of crude relieved some inflation pressure and contributed to the drop in Treasury yields. I believe, however, this move is temporary. Both Russia and Saudi Arabia need the revenue from higher oil prices and I expect the price to move higher over the next two years as demand exceeds current supply and the industry continues to underinvest in the development of new resources. Venezuela will be producing less, hydraulic fracking in the U.S. may be limited by a lack of pipelines and environmental considerations and Middle East instability may limit production from other countries in the region.
When President Trump cancelled the Singapore meeting, I still believed talks between the United States and North Korea would take place. Both parties had too much to lose if they did not meet. Kim Jong-un would be deprived of the prestige he would gain from bringing Donald Trump to Asia to negotiate and the President would lose the opportunity to create a non-nuclear Korean peninsula (although I think the Nobel Prize would elude him). The most favorable outcome possible would have been a suspension of further nuclear development by North Korea but continued maintenance of their present stockpile of nuclear material. Expecting to achieve more from the negotiations was not realistic. The talks on June 12 carried risk, and if they went badly, the financial markets would not have responded well. As it turned out, the outcome was weak on specifics, but Trump was able to return to the United States and say that the likelihood of war with North Korea had been eliminated – and that’s what everyone wanted to hear.
Recent data out of Europe indicates some softening of the major economies. Purchasing Manufacturing Indexes in Europe are rolling over. Anti-European Union sentiment appears to be building in Italy where a flimsy coalition between the Five Star Movement (populist) and the League (right wing, anti-immigrant and anti-Euro) has been formed. What the two parties have in common is that they both want to cut the pension eligibility age. The presidential veto of Paolo Savona, a Euro-skeptic, was designed to reassure the world that Italy was committed to maintaining its European participation, but instead the move seemed to highlight Italy’s dysfunctional political situation and its heavy debt burden ($2.3 trillion). The League wants a 15% flat tax and Five Star wants a guaranteed monthly income of $900 which could add close to $200 billion annually to Italy’s already large budget deficit. Italian government bond yields have risen sharply as the coalition has taken shape.
Italy is not Greece. Greece was relatively unimportant to the world economy, but Italy is the third largest economy in Europe (16%) and the ninth in the world. Italy, coupled with softer economic data elsewhere on the Continent, raises the question of whether the synchronized global expansion is continuing. One should note that in the more than 70 years since the end of World War II, Italy has had 64 governments, so the current one may not last long. In no case, however, do I expect Italy, at least in the near term, to drop the euro as its currency. Almost three quarters of Italian voters supported staying in the Union.
The European Union is unlikely to break up because of Italy. Mario Draghi has delivered on his promise to do “whatever it takes” to save the alliance. He has expanded the balance sheet of the European Central Bank and, even though he talks about ending accommodation by the end of the year, he is unlikely to do that with Italy in trouble. The ECB is buying Italian bonds to hold down yields and providing loans to support local banks. In the end, Italy will have to restrain its spending, but this is likely to create significant unrest and cause political change. Any attempt at austerity will make jobs hard to get and hurt the party in power. On top of this, the immigration problem is adding to instability. Europe’s problems started with populism and Brexit; they are continuing. The Union must work more cooperatively to prevent disintegration. Emmanuel Macron and Angela Merkel are taking the lead in this effort. Others should join them in their noble project.
While post–financial crisis Spain has become one of the great recovery stories of recent times, now it has held a no-confidence vote and Prime Minister Mariano Rajoy has lost his leadership position to a pro-left coalition which, as in Italy, includes a right wing group, this one from the Basque Country. Rajoy was a reformer who cut taxes and gave corporations more flexibility in hiring and firing workers. Spain grew at more than 3% last year, but the new government’s policies will make that level hard to sustain.
The decision of the Trump administration to implement tariffs on steel, aluminum and certain manufactured products has provoked Europe, Mexico and Canada and put the North American Free Trade Agreement in jeopardy. Most of Canada’s primary aluminum production is shipped to the United States. Given that abandoning NAFTA would result in the loss of several hundred thousand American jobs, I thought that it was more likely that the pact would be modified rather than scrapped. The Administration’s taking of actions that isolate itself from our trading partners rather than trying to improve the relationships through negotiation is hard to understand. The effort to justify certain trade restrictions on the basis of national security considerations seems contrived. Our European allies were already wary of the U.S. because of our withdrawal from the Iran agreement. The tariffs make matters worse, but so far the dollar amounts involved are small. German and French officials describe their relations with the Administration as being “at a low.”
In the case of China, where the U.S. does have a number of legitimate grievances, a tough position is warranted. President Trump, however, doesn’t want to sour what he believes to be a good relationship with Xi Jinping. China is destined to be the largest economy in the world. As if there weren’t enough to worry about, few of us are thinking about China’s military build-up, not only in the South China Sea, but also in the Indian Ocean. The latter violates a 2016 United Nations ruling. In 2015 President Xi Jinping told Barack Obama that China did not plan to militarize the Spratly Islands, where they now have missiles. Defense Secretary Jim Mattis recently cancelled an invitation by China to participate in exercises off Hawaii because of its military build-up. While most conversations on China are focused on the on-again, off-again trade dispute, an understanding that one-third of global shipping, nearly $5.3 trillion worth annually, passes through the newly militarized South China Sea is critically important. For these reasons, a sensible approach is for the United States to try to have a working rather than an adversarial relationship with Chinese leadership. This is only likely to be achieved through judicious compromises. Let’s hope the Administration is prepared for that.
Geopolitical factors as well as the continuing health of the world economies are critical to the continuance of the expansion of the United States. Business done abroad accounts for more than 40% of the earnings of the Standard & Poor’s 500. If overseas economies slow down or geopolitical events interrupt the continued expansion of the world economy, then the current positive cycle in the United States may come to an end earlier than we now expect. Short of that, the conditions that historically have brought on a recession, an overheated economy, rising inflation and higher interest rates, do not appear to be in prospect. Actually, a somewhat slower global economy may contribute to a longer U.S. business cycle because pressure on interest rates and inflation would be diminished. Right now, the United States equity market is assuming that all of these macroeconomic and geopolitical events will be resolved favorably. That seems somewhat unrealistic. For that reason, although I still think earnings will drive stocks to new highs before year-end, I am cautious over the next few months.
We are making a small change in the Radical Asset Allocation. We are reducing Europe Equities from 10% to 5% and adding to cash, making that 10%.
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The views expressed in this commentary are the personal views of Byron Wien of Blackstone Advisory Partners L.P. (together with its affiliates, “Blackstone”) and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Wien as of the date hereof and neither Mr. Wien nor Blackstone undertakes to advise you of any changes in the views expressed herein.
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