Byron Wien: Sifting through the Clutter
We all complain that so much is happening so fast these days it’s hard to keep up. The plethora of events that could have a negative impact on the financial markets is being ignored in the United States, however, and investors seem to be assuming that everything going on will somehow be resolved favorably. The S&P 500 index is up 15% so far this year in spite of a world-wide economic slowdown and political turmoil in the United States, the United Kingdom and almost everywhere else. To reflect on the major issues facing the markets and their possible resolution, however, is useful. In the end, I expect that earnings and interest rates will be the determining factors and that geopolitical issues will cause temporary angst but not have a lasting effect on market performance.
At the beginning of the year we anticipated that the S&P 500 would be up 15% in 2019. As the year began, the index was selling at less than 15 times earnings and investor sentiment was clearly negative. These were near-perfect conditions for, at the least, a strong market rally. Now the index is selling at 18 times trailing earnings and sentiment is optimistic, which would suggest that equities might have a more difficult time between now and year-end. If the events I discuss below don’t work out favorably, we can expect some market turbulence going forward. To start, perhaps considering a few important developments that have gone right in the last few months would be worthwhile. The Federal Reserve has decided to pause on its policy of raising interest rates and shrinking its balance sheet; the government shutdown has ended; there is some better economic news out of China, which is the primary engine of world growth; and inflation has remained low almost everywhere. There are some signs that the second half might be better for the U.S. and Europe.
So what are the issues worth a look? Here are a few: the yield curve inversion, the Affordable Care Act, Brexit, the 2020 election, friction in the Democratic Party, the Chinese threat to American competitiveness, the timing of the next recession, Federal Reserve policy this year, the direction of oil prices, European growth, the dollar, government debt at all levels, climate change and why have we had no inflation in major developed economies.
I will try to cover most of these issues while providing some analytical support for my views, but this is primarily an essay designed to express the opinions of Joe Zidle, our Chief Investment Strategist, and myself (designated by “we”) or just myself (designated by “I”). Each section is covered in a deliberately provocative way to spur you to respond mentally with your own view. The positions described are those of us in Blackstone’s strategy group and do not reflect the opinions of the firm itself. Each is covered briefly; any one of them could well be the main subject at a monthly essay in the future.
Starting with the inversion of the yield curve, the three-month yield moved briefly above the 10-year, but that is no longer the case. The 10-year yield is 2.56% and the three-month is 2.42%. The two-year yield is 2.40%, so that spread is also not inverted. Even if it were, the inversion would have to be 15 basis points over a period of ten weeks for it to provide a true bearish signal. Even if it gave a warning, we still might be as much as one to two years away from a recession, although the market would anticipate trouble sooner and react negatively. We maintain our conclusion that the next recession will occur in 2021 or later, but the S&P 500 has already achieved most of its gains for 2019.
On the Affordable Care Act, we believe it is here to stay. Legal attempts to declare it unconstitutional will fail; attempts in the Senate to roll back parts or all of it will not get traction. With all of its flaws, I believe the Act will be broadened over time and extended to more people. Recent polls show that voters are supporting an expansion of entitlement programs and the sudden popularity of the Green New Deal would suggest the country, which stood center/right at the last presidential election, is shifting to center/left. I do not believe we will move all the way to Universal Health Care and a single payment system. The cost would be too great and the insurance lobby would resist the change vigorously.
While the current Brexit situation is confusing, the drift toward a “soft” outcome is clear, but there is a strong argument on the other side. Recent polls show 50% of the U.K. population in favor of remaining in the European Union and only 42% in favor at leaving. The polls were wrong in 2016 and perhaps they are wrong now, but the situation is different. In 2016 the U.K. was growing at 2% and it is now only growing at close to 1.4%. In 2016 older, Euroskeptic people in Britain resented being subordinate to policymakers on the continent; younger people were less bothered by this issue and many didn’t vote. Today, younger people there are having trouble finding jobs. Restoring Britain to its historical glory is an irrelevant abstraction to them. Economic opportunity is much more significant. If a referendum were held today, we think the vote would be to remain. Parliament seems to recognize that, and it is drifting toward a soft Brexit. Theresa May’s willingness to involve the Labor Party in the final policy position is indicative of her intention to get a Brexit deal done by the end of October. On the continent, there is growing sympathy for a soft Brexit as a way to bolster a slowing European economy, but there are hard Brexiteers there also.
While it’s too early to speculate on the 2020 election, the lack of criminal findings related to the president improves Donald Trump’s chances of having a second term. Since a sitting president could not be indicted, there were probably not ever going to be any criminal findings. What Trump has going for him is that the report will be a dim memory when the 2020 campaign heats up. He already had a lot going for him. He had cut taxes and dismantled regulation, thereby confirming that there is a more businessfriendly environment in Washington. His meeting in Singapore last June with North Korea’s Kim JongUn defused the threat of nuclear-tipped missiles being hurled at South Korea, Japan or Los Angeles. His willingness to leave the recent meeting in Vietnam when Kim’s demand for a complete lifting of sanctions in exchange for a minor concession on North Korea’s nuclear program showed that he would rather come home empty-handed than agree to a bad deal. People respect him for that.
On the Democratic side there are too many candidates, making it difficult for the electorate to focus on the suitability of only a few people. Bernie Sanders, Elizabeth Warren, Kamala Harris and perhaps some others may be too far to the left for many voters, but the party platform, when it emerges, is likely to incorporate some of their views. To me, Joe Biden seems likely to be chosen as the best compromise candidate, but he has the problem of his age and unpopular positions in his past voting record. His delay in declaring his candidacy has put him at a disadvantage in building staff and dealing with unfavorable press coverage of his relations with women. Charisma, youth and social media effectiveness will be important, which works to the favor of Beto O’Rourke and Peter Buttigieg. Reviewing the whole field, I don’t see anyone who could beat Trump, and if the economy is doing well in eighteen months, I expect he will prevail. If we were in a recession by then, Trump will be in trouble, so the state of the economy is critical.
I continue to believe that Chinese competitiveness is the most important issue facing the United States and we are not taking it seriously enough. China is already the largest economy in the world on a purchasing power parity basis and will be the largest in terms of gross domestic product by the 2030s. Moreover, because of its commitment to research and development, where it is already spending more than the United States on digital and biotechnology, it could be the leader in innovation by 2025. This would challenge American products and services in the world markets. China’s Belt and Road Initiative of increasing its influence globally by investing in the infrastructure of countries in Asia, Europe and Africa is continuing to move forward while the United States is becoming more insular and pulling back from multilateral alliances. While China has built up too much debt in its relentless pursuit of growth, those who have been expecting a hard landing are still waiting. There is evidence that its domestic stimulus program (3% of GDP) is offsetting its plan to reduce leverage in the banking system.
An authoritarian government has great flexibility in postponing disaster. I worry that China is investing too much in inefficient state-owned enterprises, although the private economy seems to be improving anyway. Continued growth is dependent on the United States reaching a trade deal with China reasonably soon, but the probability of that happening is high. As my old Morgan Stanley partner, Steve Roach (now at Yale) points out: there will be some unresolved structural issues, namely “intellectual property rights, state-sponsored industrial policy, forced technology transfer through venture arrangements and innovation,” but the reciprocal tariff escalation threats will quiet down. We are still positive on China.
At the end of 2018, with the market having erased its gains for the year, many observers believed that a recession would occur within the next two years. Our position was that the earliest a serious slowdown would take place was 2021. For us to be right in that view four events need to happen: (1) a soft Brexit deal would have to be ratified by the U.K.; (2) a trade agreement would have to be worked out with China; (3) the Federal Reserve would have to refrain from raising interest rates and shrinking its balance sheet; and (4) the downward slump in the world economy would have to show signs of improvement. The first three of these are currently trending favorably. Recently, there have also been some positive economic signs around the world. In the United States there are some stronger data related to housing (mortgage applications), which has been an important laggard, and the price of oil and copper have been rising. The Purchasing Manager Index has turned positive in Europe, and there are signs that the Chinese economy is improving, which should help the economies in the rest of the world. Copper has proven to be a bellwether for world growth.
We also believe that Donald Trump is determined to avoid an economic slowdown as he campaigns for a second term. He will do everything possible to keep the economy growing above 2%, exclusive of inflation. If we get into a recession, we won’t have the usual tools to get out of it. The Federal Reserve is not likely to be accommodative and, with the budget deficit already running above $1 trillion, Congress is unlikely to pass stimulative fiscal programs to increase that number. The concept that deficits don’t matter, or Modern Monetary Theory, which holds that countries can run large deficits as long as they can print their own currency and investors will buy their bonds, will be drawn into the debate, but if the economy is faltering, policy steps will be taken to keep growth at a satisfactory level. I am not saying that there will never be another recession. I am only pointing out that efforts will be made to defer its coming as long as possible. When we do have one, we are likely to be working our way out of it in a slow growth mode for a long period of time.
On the rise in oil prices, which is favorable for energy earnings and the market, the price of West Texas Intermediate has gone from $45 to $63 a barrel this year, an increase of 40%. There are several reasons for this, but according to David Foley, the head of Blackstone’s energy group, production cuts by the members of OPEC and Russia have played a primary role. World growth, even though it is not at the pace of last year, has helped and finally Venezuela and Nigeria are producing at a lower rate.
The dollar has been flat this year against most major currencies and we expect that condition to remain. The Federal Reserve is not likely to tighten further. The U.S. economy continues to expand, but at a modest rate. Operating rates are 80% and there is plenty of spare capacity, so foreign capital is not needed for the building of new plant or the acquisition of additional equipment. The stock market is no longer cheap and interest rates are low. All of these conditions discourage foreign capital flows. We expect the dollar to stay at its present level against major foreign currencies for the rest of this year.
While there is likely to be continued debate about climate change, I do not expect any major legislation to come out of Congress to deal with the problem. A carbon tax is the most we should hope for. I do believe the problem is real and temperatures are gradually rising which will result in an increase in the level of the oceans surrounding our country. There will be more flooding and more unpredictable weather, but so far these have created little sense of immediacy among our current leadership. The U.S. only accounts for 15% of world carbon emissions, so even if we go to zero, the problem will still be with us. If the Democrats gain broad control in 2020, we are likely to see more action on this front, but the near-term impact on the economy should be gradual. A greater use of nuclear is powerful positive option, but right now that seems like a political impossibility.
One of the most significant imponderables of the present economic framework is the low level of inflation. With strong growth, rising deficits, low unemployment and an expansive monetary policy, almost every economist has expected inflation and interest rates to rise, but they (and we) have been wrong. The usual deterrents to inflation are globalization and technology, and both have played an important role. Improvements in agriculture and hydraulic fracking may be holding back food and energy prices. We expect low inflation to continue and that is an obvious positive for the financial markets.
Putting all of this together, the conclusion is that there is a favorable fundamental background for the financial markets. We continue to believe earnings and interest rates will be the critical factors. On a dividend discount model basis, which projects the level of the market based on earnings and interest rates, the S&P 500 could trade well above 3000, but other valuation models rate the index more fully priced. Low interest rates have resulted in a very high equity risk premium. Earnings yield, however, is well above the 10-year Treasury percentage return. Trying to balance all of these factors, our conclusion is that there is limited opportunity in the overall developed markets right now but, while the possibility of sharp corrections is always there, the probability of a bear market any time soon is small.
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The views expressed in this commentary are the personal views of the author and do not necessarily reflect the views of the Blackstone Group 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 the author 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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