After the sharp decline in December and equal recovery in January, investors can be forgiven for believing that the financial markets are back to normal after a slight hiccup.
While there are parts of the market and economy that are cruising along, the reality is more complex. There is a feeling among some of the more exotic investments that time is not on their side. To wit, last week the price of bitcoins dropped to a level that was less than the cost of producing them.
Also, at the World Economic Forum in Davos, Switzerland this past week, where the wealthiest converge to reassure the public and themselves that all is right with the world, there was the aggressive promotion of firms like Uber, Lyft, and software companies of several stripes to prime the market for their public stock offerings, probably sooner rather than later. This stood in contrast to a year ago when wealthy investors were reluctant to go public when the perceived value of these enterprises was skyrocketing.
I once knew an investor who believed that a sharp increase in the number of initial public offerings was the sign of a market top. Conversely, the low number of public offerings was symptomatic of a market bottom. The idea behind the strategy was one of supply and demand. New issues increased the supply of stock, while fewer shares of stock offered led to higher prices, given the long-term demand for shares.
The concept was formed long before the days of stock buy-backs, private equity, and other forces that weigh on one side of the equation or the other. Still, the concept bears observing, especially as more companies come to market. Remember that for each buyer there is a seller. When several companies come to market at once, it may be a sign that insiders see either lower levels of growth or greater competition. Or, the owners believe that with higher interest rates to pay in the future, it may be better to sell than to share profits with the lenders.
This brings up a second observation. According to earnings forecast, some companies will generate less profit in 2020 than in the last twelve months.
Earnings declines over the next two years seem focused on the industries like retail banking, where in some cases the cost of funds is rising faster than the ability to charge for the same. This scenario has the effect of squeezing interest income. Other industries that are forecast to feel the heat are some real estate enterprises, retail, restaurants, and the like. Judging from the earnings estimates published thus far, it seems that cost pressures may make economic growth more difficult to translate into profit growth. This is especially true of labor-intensive companies. Demographic trends are pretty much set, and any respite from immigration reform is not on the horizon.
While the federal government shutdown has been canceled, at least for the next three weeks, it gives Congress a window of time to iron out contentious issues regarding immigration and national security (issues not resolved for 60 years), there are other dates to note in the near future aside from the threat of another shutdown February 15.
March 1st is the “hard deadline” in our discussions with China regarding tariffs. Without an agreement by that date, the U.S. is to impose a 25 percent tariff on all imports from China. Logically, one would expect the Chinese to impose the same tariff on goods imported from the United States.
There are two bones of contention. First is the imbalance in trade that China has offered to rectify by 2026. The second concerns the theft of intellectual property. Outside of court, this is difficult to prove. It is not clear if the U.S. administration is insisting on compensation for past acts of intellectual property theft, guarantees against future theft, or what.
It is true that China has insisted on access to a company’s intellectual property as a condition for setting up a manufacturing facility in China, usually as a joint venture with a Chinese firm. However, acceptance of the terms was voluntary by the company. It was considered a cost of access that was worth paying. If you wanted a presence in the Chinese market, you had to pay the price. Stated terms going in can hardly be considered intellectual theft.
Also on March 1st or thereabouts, the federal debt ceiling will need to be raised, providing another legislative free-for-all. Then, March 29th is the deadline for the United Kingdom to decide whether or not to exit the European Union. Along with the unforeseen, this should be a lively spring.
In truth, there is no reliable way to know how the economy is doing. All the departments of the U.S. governments associated with data collection have been shut down for the past five weeks. Without data, any assessment of the economy is a guess.
With the government reopening soon, we will hopefully have data in short order on what has transpired in December, January, and February. Most assessments have been fairly benign, but with a total of two million people unpaid or out of work (800,000 civil servants and an estimated 1.6 million contract workers), the effects are perhaps more substantial than realized. Estimates by economists have called for up to 0.5 percent cut from this year’s GDP number. On the other hand, the large numbers of people retiring may make the next downturn easier on workers who stay, meaning there will be the need for fewer layoffs with so many voluntary retirements.
Inflation is higher than stated. The government indexes on inflation, delayed with all other economic data, are too oriented to goods and not enough to services. Also, unemployment rates are a function of those willing to work. The data is not being tabulated, but it appears that unless we liberalize immigration, wage pressures will result in higher inflation. There are simply not enough workers to go around.
There is a sense that the Federal Reserve may have been more lax on interest rates while the shutdown was in session, to avoid a financial problem when the government was not up and running.
If this is true, funds should become a bit tighter in the coming weeks. With the passage of some time, data will tell us what we need to know.
The Stock Market
The market, in general, is coping with the slowdown in the economy. Parts of the market will have a harder time coping than others. Specifically, there seems to be a sense that higher interest rates and more restricted credit will bear down on some high-flying investment concepts. If a couple of new stock offerings go badly, the market could take on a different tone than the present.
Warren M. Barnett, CFA
January 28, 2019