The stock market continued to grind higher as an expanding economy and strong earnings growth outweighed concerns about trade wars and fragile politics both here and abroad. During the second quarter, the Gross Domestic Product in the US grew at a rate of 4% while corporate earnings surged by 25%. This economic expansion is predicted to continue for the remainder of the year.
A significant factor driving economic growth is the tax cut passed earlier this year as most corporations are expected to owe roughly 40% less than 2017’s tax liability. A large portion of this windfall has been directed to financial engineering through such tactics as share repurchases. However, a meaningful amount of after-tax profits has been invested in capital equipment and Research and Development. According to a CNBC story dated 9-17-2018, Goldman Sachs reported that capital spending on buildings and equipment was 19% higher in the first half of 2018 compared to the same period in 2017. Similarly, spending on Research and Development increased 14% over the first half of the year. Companies are also increasing salaries and benefits to compete in the market place. Average hourly earnings are up 2.9% over last year according to the Department of Labor’s latest Jobs Report.
Individuals also received a significant tax break which has received less attention since a number of high-income earners lost valuable deductions for state and local taxes. Personal income grew roughly 4.5% over the first half of 2018 compared to 2017 according to statistics published by the Bureau of Economic Analysis. At the same time, tax receipts from personal income taxes fell by 0.2% according to the St. Louis Federal Reserve Bank. In summary, the corporate and individual tax cuts have been very stimulative and explain the above trend growth experienced by the economy.
The tax cuts have not been an unalloyed positive since government spending has grown causing greater deficits. The government has increased its issuance of bonds to keep financing its debt. This issuance, or increase in the supply of bonds, has increased interest rates in conjunction with tighter Federal Reserve policies. Therefore, the amount of funds that the government directs to servicing its debt has also increased substantially. Interest as an expense is projected to increase about $100 billion from 6.6% of the budget in 2017 to 8.2% in 2019. The Congressional Budget Office then predicts that this figure will balloon to 13% ten years from now. This trend is unsustainable and will cause economic dislocations unless deficits are somehow brought under control.
US Trade negotiators have reached an eleventh-hour agreement with Canada on NAFTA 2.0 which will be renamed as the United States-Mexico-Canada Agreement (USMCA). This agreement appears to resolve a couple of contentious issues surrounding the manufacture of automobiles and selling of dairy products. A greater percentage of autos will be required to be produced with higher wage rates to escape duties so more production will move from Mexico to the US and Canada. US dairy farmers also now have greater access to Canada’s market. Canada and Mexico also won the argument to maintain a separate tariff board to resolve disputes and limit the US’s ability to act unilaterally. It should be noted that this treaty needs to be ratified by Congress in 2019 before it becomes law.
On the other hand, the trade war with China seems to be escalating rather than reaching a resolution. The US has applied a 10% tariff to $250 billion worth of Chinese goods and these duties are scheduled to expand to 25% in 2019. China has responded in kind to which the US administration indicated that it is strongly considering applying similar levies to an additional $269 billion in imports. China cannot respond with tariffs to this escalation since China only imports roughly $190 billion in goods from the US. However, China has indicated that it will not be bullied, leaving economists to speculate regarding the form of retaliation.
Many dynamic US companies such as Apple, Starbucks, and Tesla look to China for a growing portion of their revenues and profits. China could retaliate by limiting the supplies of these companies or restricting their ability to sell within its country.
While China does not buy much from the US, it does buy from the rest of the world, especially the developing world. Therefore, if China’s economy is damaged by US tariffs, then it buys less from countries such as Vietnam, Malaysia and Brazil. The developing market is under stress now as Turkey’s currency has weakened dramatically and Argentina petitioned the International Monetary Fund for loans to prevent another collapse. It’s impossible to tell how much of these crises are due to the trade war with China, but the least diversified economies are always the first to get hurt.
The world’s economy is now more inter-connected than at any time in history. The World Bank tracks the size of trade relative to world GDP over time. This figure now stands at 56% compared to 24% in 1960. It is virtually impossible for the United States to remain an island of prosperity if our trading partners go into a recession. It is still too early to determine whether the current trade posture from the US is part of a negotiating strategy or an effort to reinstate mercantilist policies, but it is in the interests of China and the US to strike a deal in the near term.
It’s also impossible to determine whether trade disruptions or another factor will cause the next recession and we are not recommending getting defensive at this point in the cycle. However, trade is vital to our economic well-being. Any agreements reached need to be well thought out and based on the principal that freer and fairer trade benefits the world’s economy. Zero-sum thinking or punitive policies could impact investment and business sentiment in short order.