Wednesday, April 25, 2018

Why Does Feeling So Good, Hurt So Bad?

Every time I turn on the TV these days, I get the distinct impression that the world is ending shortly. I do not think I can recall a time when the economic conditions in the U.S. were at the almost pristine levels they are today. You would think everyone would be happy considering we are almost at full employment, economic growth is strong and there is a worldwide economic boom. However, if you read the financial reports or watch the evening news, they would imply quite the contrary. So rather than chime in on the superficial discussion of whether or not I like Melania’s shoes, I am going to discuss the true economic data that clearly illustrates the positives rather than the negatives. I do not intend to tweet or snap this information and have opted to just leave it here for you to peruse at your leisure.

Before I get to the more exciting and interesting information of late, I will report on March of 2018. This month was basically a whipsaw of a market, moving back and forth between investors and day traders. There was not a lot of new information one way or the other. The traders were convinced they could force the market lower, but investors tried to prove otherwise. For the one month ended March 31, 2018, the Standard & Poor’s 500 Index was down 2.5%. For the one-year period, it is up 14%. For the year-to-date, it was down 0.8%. The Dow Jones Industrial was down a healthy 3.6% for the month of March and for the year 2018, down 2%. Yet, for the one-year period, it is up 19.4%. The NASDAQ Composite was down 2.8% for the month of March but is up 2.6% for the year 2018 and up 20.8% for the one-year period ended March 31, 2018.

As always, I would like to give you the bond index as a comparison for 2018. The Barclay’s Aggregate Bond Index which was up 0.6% for the month of March and is down 1.5% for the year 2018 and for the one-year period reflects an almost non-existing gain of .9%. As you can see, all of the major market indexes for the one-year period had very high, double-digit gains while the bond index barely broke even. You do not need to be that astute to observe that bond investing in a rising interest rate environment is clearly an upstream swim, and not something we recommend.

Partner, Eddie Wilcox's kids Harper and Lucy at Marineland

Before I start my tedious economic analysis of current events, I think an overall picture of the general economy and the stock market is warranted. For the fourth quarter of 2017, the GDP was revised up to 2.9% from the previously reported 2.5%. Final sales numbers are up a robust 4.5% and Americans filing for unemployment has reached a 45 year low in the month of March. As mentioned many times in the past, more Americans working creates higher GDP and a better lifestyle for them and their families.

Fourth quarter earnings for the S&P 500 jumped 21% year over year. Every quarter for the year 2018 is projected to be increasing from a low 20% to a high 20% ratio year over year. Never before have corporate earnings been forecasted to increase so much. Those who would attempt to argue that the only reason these increases are occurring is due to a one-time tax decrease do not seem to understand that for at least the next 10 years, these tax cuts will be in place. While there will not be a huge percentage increase in 2019, the absolute increase of earnings in dollars will continue to be extraordinarily strong.

In the geopolitical events of the month, it is clear now that North Korea has blinked and wants to make peace on some level. While we have all been tolerant of North Korea in the past, it looks like they are now willing to accept the fact that their economy is in shambles and their nuclear implementation will not be tolerated by the western world. So, there’s one geopolitical event that you can take off your worry list….

It is also apparent that China has had a change of heart regarding exports. As illustrated more in depth below, they need us significantly more than we need any sales to China. While export duties on certain products will presumably hurt, overall, those amounts are significantly immaterial to the U.S. economy.

I think every student of basic economics was taught to believe that free trade was very important in the world’s economy. I, to this day, believe that free trade is one of the most basic principles of building international trade. However, economists are also taught that any obstacles to free trade are a bad thing. Clearly, economists are not trained to be creative thinkers. While I agree with the concept of free trade, there are in fact times it could have a negative effect on the U.S. economy. One of those times is with foreign government owned businesses.

For example, China’s government owns all of its steel manufacturing capacity. Therefore, their companies do not compete on an equal playing field with U.S. manufacturers of steel. They do not pay taxes, nor do they have medical benefits or other expenses that any corporation in an open capitalistic democracy would have. Despite the fact that President Trump quickly dismissed the tariffs on Canada and Mexico, where the vast majority of our steel is manufactured, great volatility of the markets was displayed when the President announced a tariff on steel and aluminum shipped into the United States. Economists were all over the financial news expressing complete dismay that anyone would propose tariffs in an otherwise free trading economy. Clearly, those economists have either failed to review the data or are just so naive that they cannot believe that any tariff is worthwhile.

Let’s explore the actual facts. According to the U.S. Census Bureau, in 2017 the United States exported an estimated $130 billion to China. However, in the same timeframe China imported $506 billion into the United States. As you can see, the goods shipped into the United States far outweigh the goods we export to China. Currently, it is thought that the GDP of China is at $14.5 trillion. Therefore, you can divide the numbers to see that the exports to the United States are 3.5% of the GDP in China. To compare, the U.S. GDP is now considered to be $20.2 trillion. Any learned economist alarmed that we would lose these sales clearly does not understand the true economic effect of a small percentage of the GDP in the United States.

So, what happened almost immediately? China wavered, as I’m sure you suspected. Today, the U.S. charges an import tariff on cars built by China at 2.5%. However, China was charging a 25% tariff on any car built in the United States and shipped to China. So, what almost immediately occurred, China agreed to lower the tariff for new cars shipped into China to equal the 2.5%, putting trade on an equal footing.

The most important thing to remember about tariffs is that talk is much easier than implementation. There has yet to be a single tariff carried out since the effective date is not until May 31, 2018. It is assumed widely that even if the tariffs were imposed, they would not be levied until the end of 2018. It is not like we are talking about an immediate implementation of these dreaded tariffs, but rather a long process of implementation and negotiation which I assure you will be negotiated along the way. For the financial markets to essentially wipe out $10 trillion in value over something as small and trivial as this discussion, tells you that these are traders and not investors.

In pursuit of some sort of reasonable discussion on the subject, I can’t emphasize enough that the Chinese needs our imports a lot more than we will ever need their exports. Without imports into the United States, China’s economy would suffer a serious recession and negative financial future. If the Chinese were to retaliate by putting huge tariffs on our imports into China, this would have a negative economic effect. There are only a few countries in the world that build airplanes. If China were to impose a tariff on Boeing shipping planes into China, the effect would be very negative on the Chinese airlines and the effect on Boeing would be practically nonexistent, as there are many lined up to buy their planes.

For all of you that continue to wrongly argue that China will no longer buy our debt, and therefore destroy the U.S. economy, remember that China has to control their currency against the U.S. dollar. One way of doing that is to buy U.S. debt to hedge against their currency. To do otherwise would mean extreme volatility in their currency and a likely negative effect on their commerce. So even though the markets reacted violently to the downside of the announcement of proposed tariffs, it should be known that all the negativity will be reflected on China, not the United States.

Ava's 1st grade school pictures

To summarize the tariff issue with China, a little real-world economics would be beneficial. The United States absolutely, unequivocally and without question, needs steel manufacturing in this country. To not have any steel manufacturing in this country would be a national security risk unparalleled in our history. We do not want to pay higher prices for products, but for the common good, maybe we could absorb some of those increases and force manufacturers to once again build plants and employ people in the steel manufacturing industry in the U.S. It is now believed by an economist that the cost of steel to produce one car will increase its price $150 per car. I for one am more than willing to pay that $150 increase to preserve manufacturing in the U.S.

For some reason there are so many people that read this blog that are totally misinformed when it comes to China. I guess because of the incredible publicity they got before they standardized trade with the United States, it was believed that the Chinese economic machine was totally indestructible. However, the truth is a lot more informative than the myth.

In fact, as a percentage of GDP, China has a higher percentage of debt than the United States. It is believed that they have close to $14 trillion in national debt just about equal to their GDP. Worse than that, their banking system is a joke in international commerce. During the crisis of 2008, the Chinese government forced banks to loan money to companies to keep the economy moving. Often times these companies were shadow entities owned by the government themselves. Since the banks in China are not regulated, no one reports their financial results. It is now believed that there are close to $476 billion of bad debts on the banks’ books in China. Since there is no regulation of the banking system, no one really knows whether these debts are good or bad and since the Chinese government controls who is foreclosed on and who is not, I guess we will never know. It is however believed that if a proper recording of these bad debts was made, the Chinese banking system would be effectively insolvent.

There is also the constant rumor of what is called “shadow” banking industry. It is now believed that maybe $20 trillion is tied up in the shadow banking industry. What this means is are their loans to various company’s governmental agencies and other entities favorable to government that will never be repaid. All this is to say that if China were to lose it’s 5% exports to the United States, it is likely it would be in severe economic trouble. You have to recall that 20% of all exports out of China are to the U.S. Losing even a small fraction of these exports could tilt China’s $14 trillion in national debt and trigger an economic crisis in the country. Does anyone with any type of common sense think that China would take that risk?

One of the interesting conundrums of investing was demonstrated last week when the banks reported their earnings for the quarter. Overall their earnings were nothing short of remarkable, but as is the perplexing part of the current market, virtually all of the stocks traded down after the news. I think we have a lot to learn from the earnings of banks, despite the day traders finding these numbers insignificant.

JP Morgan Chase, one of the premier banks in the U.S., reported earnings of $8.7 billion for the quarter, up from $6.4 billion the previous year. I am not sure how anyone can observe that a 35% increase in earnings for the year over year is immaterial. We are talking about real money here!

Also, the banks acknowledged that credit quality was excellent and their charge-offs on consumer debt were at some of the highest standards in years. Even with the good news, stocks traded down at subsequent trading sessions. Bank of America earned $6.92 billion for the quarter which was 30% higher than the previous year when they earned $5.43 billion and yet the analysts attempted to classify those earnings as poor quality. I don’t know about you, but I find an increase of $1.6 billion for a quarter far from poor “anything”.

There was a great deal to be learned from these banks earning announcements. One was that consumers were more financially sound than they had been in years. Secondly and maybe more importantly, all of these banks are sitting on tremendous reserves of capital, making the banks of the United States not only the strongest banks in the entire world, but also the best capitalized group of banks in the history of the U.S. financial system. I do not want to appear to be Pollyanna-ish about economic reality, but I just cannot feel any way other than extraordinarily positive on the strength of the U.S. economy.

One thing that seems to be missed by the investing day traders is that banks now have enormous amounts of capital to invest in and lend to expanding companies. One of the major reasons the economic fallout occurred in 2008 was banks were inadequately capitalized and did not have the financial assets to lend to companies. Every day in my business, I hear from bankers indicating they would love to make more loans, they just cannot find customers to lend the money to since the economy is so strong.

The reason that customers do not want loans has nothing to do with their business being bad. It has everything to do with their business being good. Clients do not need to borrow any money since they have adequate capital and can internally fund their business. It is a rare time in economic history when corporate America has excess capital and does not need to borrow. When I survey my clients and ask how business is and how things are going, they all express overwhelming optimism for continued success for years to come. If there is a group more concentrated in the doubter’s camp, it is corporate business owners, so when they become optimistic, you may rest assured that it is based on hard economic facts and not conjecture.

Here is an excellent illustration of just how absurd this push/pull between traders and investors has become. This morning before the stock market opened, Google announced that their net profits for the quarter were $9.4 billion. Please note that I am talking about the quarter and not for the full year. Their full year earnings are projected to be close to $35 billion for the year. Almost immediately after this announcement, Google traded down 5% for reasons unclear to me as an investor. Obviously, the traders saw something I did not see. What I did see was that earnings were up 74% from the prior year, which in anybody’s classification would be quite excellent. Just so you have a level of comparison, Google made more net profit this quarter than GM, Ford, GE and IBM made profits for all of 2017 combined. It seems like traders could really not care less about fundamental economics and care a lot more about misleading investors.

In summary, we learned a lot during March, even if we were not successful financially. We learned that corporate America is extraordinarily profitable and is likely to continue that way through 2019. We know the economy is strong and that GDP is forecasted to be close to 3% for all of 2018 which would be the first time in over two decades of strong economic performance. However, we also found out that stocks and emerging markets are actually trading cheaper in Europe than in the United States. With the strengthening in the price of oil, emerging markets once again are highly profitable at unprecedented levels. For all the problems in Europe, they have become recently more capitalistic in their desire for higher profits and I fully expect them to fulfill those goals.

The main reason GDP continues to go up in America and looks good for the future is that we have reached virtual full employment in this country. The most important component of increasing GDP is putting spending power in the pockets of consumers. With almost 4% unemployment, we now have more people working than ever in the history of this country. Yes, there is a very low participation rate among all workers in the workforce, however, my opinion is that it is due to choice, not available jobs.

There are currently more jobs than there are employees, mainly due to the lack of usable talent. Once trained and educated in these new high-tech jobs, those employees will also become employable. I really do not see how the economy could take a major turn down until the unemployment rate starts to trend up and recession is in the forecast. Currently there is little to no recession likely in this country until the end of 2019 or beginning of 2020. We are long term investors and with a projection of at least 2 years of profitable operations, I fully expect the market to continue to trend higher during this two-year span. You need to be investing now in order to enjoy that upswing.

As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.

Best Regards,
Joe Rollins