Equity Valuations and Financial Market Liquidity

There is overwhelming and consistent evidence, both statistical and anecdotal, that a synchronized global economic expansion is underway, which most probably is still in its early innings.  Virtually all developed and emerging economies are participating.  This is helping corporations around the world to begin to achieve meaningful revenue growth and a leveraged improvement in profits.  This is especially true for those companies which have spent the last several years cutting costs and disposing of non-core businesses.

This memo is an attempt to measure the impact on U.S. equity prices over the intermediate term and to point out the danger signals that would precede the end of this expansion, which would most likely trigger a significant correction in equity prices.  We see few signs that such a development is even on the horizon, so this is merely a road map for the future. 

So far this year, the S&P 500 Stock Index has gained 15%, excluding dividends.  Yet, the forward P/E ratio of the Index, looking four quarters ahead, has not increased very much since consensus forward profit estimates have been marked up each quarter.  At the beginning of this year, consensus estimates for this index called for earnings of about $125, leading to a forward P/E of approximately 18X.  The consensus for the year has now moved up to $135, which implies a P/E of 19X, equivalent to an earnings yield of 5.2%, which compares favorably with the current BBB bond yield of 4.3%.  Even this overstates the current valuation of equities because profits in the 4th quarter of this year are likely to achieve an annual rate of more than $140 per share, and preliminary indications suggest that if the expansion continues at its current pace, even without a corporate tax cut, earnings one year out could reach $150, which puts the forward P/E back to 17X, equivalent to a 5.8% earnings yield.

U.S. corporations, particularly our multinationals, are ideally positioned to benefit from global expansion, due to our leadership in many industries, particularly high tech, as well as our increasingly favorable cost structures and a relatively soft U.S. dollar relative to the Euro and the Yen.  The latter is a boon to our export earnings and also to the translation of foreign source earnings back into dollars as it magnifies the Dollar based earnings per share.  In addition, because there is still ample excess capacity both here and abroad, U.S. companies are generating cash flow well-above their needs for working capital and plant expansion or modernization.  Much of this surplus is being returned to shareholders in the form of stock buybacks and dividend increases.

However, it is important to note that neither extremes of high nor low equity valuations by themselves will determine the course of stock prices going forward.  That will depend on the degree and trend of financial market liquidity.  To gauge current liquidity conditions, we track a number of metrics.

First, there is the growth rate of broad money supply (M2), which we compare with the growth of nominal GDP.  So far in 2017, M2 has increased just about 5.0% year on year, but Nominal GDP in the U.S. is up only about 4.1%, year on year, which implies a surplus of money supply, which inevitably finds it way into financial asset markets, including bonds, equities and real estate.  A more sensitive measure compares the growth rate of money supply with the growth rate of bank loans.  Against the 5.0% rate of growth of M2 so far this year, bank loans are up only 3.6% year on year.  Admittedly, loan growth has accelerated over the past seven months to a 5.8% annual rate.  Ergo, this relationship will bear careful watching.  If inflation were to pick up noticeably, it would have to be financed, and if money is required to finance inventories, receivables and capital expenditures, that would tighten the system.  However, in a world of floating exchange rates, money is fungible and as long as the central banks of the U.S., Great Britain, Japan and the ECB are growing money supply faster than global GDP, financial system liquidity is unlikely to tighten enough to impact equity prices.

There are other market-based indicators which offer real-time insights into financial market conditions.  Among these is the yield spread between 10-year U.S. Treasuries, currently at 2.33%, minus the yield on the 2-year note of 1.62%.  This leaves a positive spread currently of 71 basis points, still a long way from an inverted yield curve.  If an overheated economy, coupled with rising inflation, caused the yield curve to invert, clearly that would be a danger signal.  At this point, however, given global excess capacity, technological innovation and various corporate disrupters (e.g., Amazon), as well as demographic factors, all keeping a lid on pricing power, there are no inflation warning signs yet visible.  Finally, we take note of various credit spreads, including high-yield over seven year Treasuries, or BAA spreads over Treasuries, as well as indicators of global short rates.  None of these suggests any tightening of financial conditions at this time.

The bottom line is that at some point in the future, history suggests the U.S. economy will overheat.  As growth exceeds potential (defined as labor force growth plus productivity growth), inflation will rise and the Federal Reserve Board will be forced to tighten monetary policy more aggressively than what the FOMC has indicated recently is its policy of gradually reducing monetary accommodation.  At that point, the risk of recession will rise substantially and a resulting decline in stock prices could be exacerbated by the liquidation of ETFs, which have become a multi-trillion dollar factor in the $27 trillion U.S. equity market.

A Warning to Our Valued Clients

We at Bryden-Abrams Investment Management LLC are outraged at the unethical and perhaps illegal treatment that Fidelity Investments has imposed on those of our clients whose accounts are held there in custody by blocking our access to their holdings and kicking them out as customers. 

As a result, we are removing all of our client accounts from Fidelity’s custody and transferring them over to Charles Schwab & Company, who have personally assured us that such treatment would never occur at their firm.

Fidelity refuses to explain why they are kicking our clients out, saying only that their Risk Management Department has deemed them unsuitable customers. Our best guess is that since we are long term, low turnover, value oriented investors and do not use margin borrowing that our accounts simply do not generate enough commission revenue to satisfy Fidelity's management. 
 
We caution all of our clients who may have additional accounts held at Fidelity to be aware of the shabby treatment that we have just received and to take whatever precautions they deem necessary. 

All of us at Bryden-Abrams thank you for your continued confidence and trust in our management services.

Keep Calm and Carry On

Hardly a day passes without at least one well-known Wall Street pundit or a famous investor proclaiming that a major correction, or even a crash, in the US equity market is at hand.  Their arguments range from (1) a belief that stocks are in a bubble, greatly and unsustainably overvalued to the notion (2) that an economic recession is looming, or (3) that the Fed will soon remove the vast excess liquidity that has sustained the bull market since 2009.  Before dealing with each of these fallacious notions perhaps it is worth remembering the wisdom of John Templeton.  To wit: “Bull markets are born on fear, grow on skepticism, mature on optimism, and die on euphoria.”

Judging by the massive sales of US equities in recent years by individual investors and many large institutions as well as the defensive stance adopted currently by most hedge funds, euphoria is certainly not present.  If there is any “irrational exuberance” to quote Greenspan, it is in the bond market.  There are few signs of a rise in inflation, despite the unprecedented monetary stimulus on the part of the world’s central banks.  However, there is clearly underway a synchronized global economic expansion.  Over time the “real economy” will absorb more and more liquidity and interest rates will inevitably rise even in the absence of higher inflation.  Bond investors will get burned, and equities will not be immune.  That day has not yet arrived, but it is useful to assess where we are in the business cycle, which governs the overall trend of corporate profits.

Currently, there are no signs of the typical cycle ending imbalances.  There continues to be slack in the labor markets, enabling a monthly average of about 180,000 new jobs to be created, whereas less than half that number is needed to absorb new entrants to the workforce.  Nominal wages are growing at about 2.5% annually, somewhat faster than inflation.  In any event, rising wages have never been a driver of higher inflation.  Commodity prices remain well below their prior peaks in the early 2000s.  Inventories are in generally good shape, and in the aftermath of the hurricanes, the slightly bloated automobile stocks will get drawn down.  There is ample excess capacity in the US and abroad, particularly in the emerging economies, and bank loans in the US are up only 3.3% year on year.  With an overall operating rate below 80%, there is no sign of a capital spending boom.  The Treasury yield curve has flattened somewhat, but at this writing the 10/2 spread is 84 basis points, still far from an inversion.  High yield spreads remain very tight.  Despite the recent weakness in the US dollar, which is more reflective of economic improvement abroad, the year over year increase in the Import Price Index is only 2%.  If there is one number that could become a cause for concern, it is the Household Savings Rate, which has now dropped to 3.5%, down from more than 5% a year ago.  That said, overall consumer credit is not particularly stretched, and loan defaults have not moved significantly higher.

Finally, earnings growth, the principal driver of equity prices, continues to be robust, aided in significant measure by the strength of economies abroad, as well as the weakness in the currency, which benefits both exports and the translation of foreign source earnings.  At 2500 on the S&P 500 Stock Index, the market is capitalizing our estimate of prospective 2018 earnings of $142 at less than 18 times, which implies an earnings yield of about 5.7% and compares quite favorably with the typical BBB bond yield at about 4.3%.

The key then is to monitor these leading indicators of a recession, most likely to occur only when rising inflation forces the Fed to intervene.  In the meantime investors can expect the Fed to reduce its aggressive monetary stimulus very gradually, since inflation is not an issue, and the FOMC surely does not want to precipitate an economic downturn.  Broad Money Supply (M2) is growing at 5%+, while Nominal GDP is advancing at about 4%, and because of the hurricanes, growth is clearly going to slow down in Q3 and Q4.  Ergo, surplus liquidity is not likely to begin to get absorbed even as the Fed begins to let its balance sheet contract VERY SLOWLY.  The pace at which maturing securities are allowed to run off without the proceeds being reinvested will initially be very gradual and is likely to be increased only when the economy displays sufficient strength to handle it.

Finally, we do not expect Nominal or Real GDP to accelerate significantly even if some fiscal stimulus is enacted next year.  Our best guess is that sustained growth at a 3% pace is all one should expect as a result of tax cuts, deregulation or an infrastructure rebuilding program.  There is simply not enough available skilled labor, and big gains in labor force productivity are unlikely.  None of this is a recipe for a liquidity squeeze.

The Death of the Hedge Fund Industry

Hardly a day goes by that the financial press fails to report the poor absolute performance or the actual winding down of one or more hedge funds, usually managed by some recently minted billionaire. Out of respect for some who are among our friends, we will refrain from naming names. The fact is that the heyday of high double digit returns that were enabled by leverage during the market's run-up to the financial crisis of 2008 is long since over. The broad market averages are no longer rising at a 20%+ pace. Concentration and leverage are no longer driving exceptional returns. Moreover, a great number of fund managers have been skeptical of the economic and stock market recovery since the crisis. As a result many have remained underinvested, or worse yet, have hung onto losing short side positions. Moreover, as the bull market has advanced and matured there are fewer and fewer undervalued asset classes or individual equities. As a result more and more leveraged funds have found themselves in "crowded trades," and when something goes wrong, and the crowd heads for the exits, the losses are large and come swiftly.

Many funds have been way under-diversified. Their concentrated positions often resulted from following other self-styled experts whose positions on both the long and short side were proudly and widely touted. Think Valeant Pharmaceuticals on the long side or Caterpillar Tractor among the shorts. The simple fact is that very few of these managers are able to outperform the broad market indexes consistently unless they are benefiting from very strong tailwinds and high leverage. At some point interest rates will rise and the cost of leverage will increase more than proportionally. Equity prices are likely to decline as well, and unless a fund is net short, its results are likely to suffer.

In addition, the traditional 2 and 20 fee structure, plus high transaction costs and the fees paid to feeder funds, put performance at a disadvantage unless stocks are roaring ahead. Also, since most of the gains these funds achieve are short term, the tax burden renders them poor risk adjusted investments for domestic taxpayers. Moreover, many funds have multi-year lockups, which greatly reduce the ability of dissatisfied investors to cash out quickly.

The rise of the ETFs has injected not only extreme volatility in the stock market; it also causes "innocent bystanders" to get crushed when just one constituent of an ETF sells off, because every other position goes down as traders rush to sell the ETF itself. Market volatility has also increased enormously in recent years as computer driven algorithmic traders jump on every bit of news and data, economic or even political. This makes it nearly impossible for a fundamentally based strategy to cope.

Finally, the evidence so far suggests that the current economic expansion will grind along at a 2%+/- pace for quite some time. Corporate earnings will also continue to rise at a modest pace. The odds of a near term market selloff deep enough to give these funds a fresh running start are not high, to say the least. Belatedly, to be sure, more and more large institutional investors in hedge funds are likely to cash out. Any fund that is forced to raise cash to meet redemptions is bound to underperform its benchmark and quite likely in absolute terms as well. Perhaps the saddest factor is that often those redeeming their interests in poorly performing funds end up reinvesting the proceeds into passive investment vehicles which admittedly have low fee structures but can only offer average to mediocre performance with no flexibility to adjust to changes in circumstances.

Perhaps the best summary of our position was stated by Warren Buffet in his 2016 letter to Berkshire Hathaway shareholders. We quote as follows:

“Finally, there are three connected realities that cause investing success to breed failure. First, a good record quickly attracts a torrent of money. Second, huge sums invariably act as an anchor on investment performance: What is easy with millions, struggles with billions. Third, most managers will nevertheless seek new money because of their personal equation – namely, the more funds they have under management, the more their fees.”

“The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients.”

The Danger of a Faulty Premise

I confess that I am dumbfounded by all the emphasis placed on wage growth as a driver of higher inflation.  Adherence to this wildly incorrect notion by many economists and even members of the FOMC might end up causing an unwarranted tightening of monetary policy with the attendant risks of sharply lower financial asset prices and perhaps a new recession.  I know of no instance in post-WWII history in which higher wages precipitated higher inflation.

Historically, wage inflation was a lagging indicator, as higher selling prices in an overheating economy brought forth demands on the part of labor to get its fair share.  This was more true in past decades when a stronger labor union movement forced company managements to pay up.  In today's globalized world, with sluggish aggregate demand, wherein American workers are fighting low wage labor from abroad as well as an explosion of technological breakthroughs that are displacing workers, labor's bargaining leverage is greatly reduced.  Indeed, there are many instances in which higher domestic labor costs have resulted in job cuts following greater investment in new, more efficient technologies.  Of course, there are exceptions, particularly for highly skilled positions, but these are still a relatively modest share of the total workforce, albeit rapidly growing.  Despite an unemployment rate of 4.3%, which appears to be headed gradually lower, and nearly 6 million unfilled job openings, nominal wages are growing at only a 2.5% annual rate.  Even today's sluggish productivity advances of only about 1% per year are sufficient to prevent an acceleration of inflation.

The simple truth is that accelerating inflation does not result from the cost push side.  Rather, it is demand driven: too much money chasing too few goods.  As the late Milton Friedman documented decades ago, inflation is always and everywhere a monetary phenomenon.  It occurs when excessively easy monetary policies, coupled with strong demand lead to rapid loan growth, which turbocharges both the rate of money supply growth and overall aggregate demand which in turn enables outsized increases in selling prices, leading to a large increase in the general price level.  Typically, as larger wage increases follow, sellers are able to re-raise prices, resulting in an inflationary spiral.  Even when there is excessive money supply growth there is a long lag of a year or more before the rate of inflation breaks out.  Suffice it to say, that those preconditions are nowhere near present today.  On a year over year basis, broad money supply is up 5.5%, total bank loans are up only 3.7%, and nominal GDP has gained about 4.0%.  Moreover, even if the enabling monetary conditions were present today, excess global capacity and powerful competitive forces, both domestically and from abroad, would cap the ability of producers to sharply boost prices.

As we have noted in previous memos, the U.S. economy is locked into a 2% +/- rate of growth in which the legacy components of the economy are gradually losing share to the highly efficient technology based sectors.  Even if the Administration succeeds in boosting manufacturing jobs, an aging population has a higher propensity to save rather than consume.  Put together, especially in an environment in which monetary stimulus has already peaked, the likelihood of inflation reaching the Fed's 2% target anytime soon is remote at best.

Currently, the Fed has indicated its intent to normalize interest rates and to reduce the size of its balance sheet in order to attain some flexibility in the event of an economic downturn.  While that is a perfectly sensible objective, the members of the FOMC would do well to recall that every recession in the postwar period, with the exception of the credit collapse of 2008, was precipitated by the Fed as it acted to curb rising inflation.  Since, in our judgment, excessive inflation is hardly a risk at this time, under current global circumstances, we question the rush to normalize policy.  If the Fed continues to mistakenly believe that a tightening labor market poses the threat of higher inflation, the outlook for the economy and the financial markets will darken prematurely and unnecessarily.

Goldilocks is Alive and Well

Last week the Bureau of Labor Statistics reported that payroll employment for May increased by only 138,000 jobs, 147,000 in the private sector, minus a 9,000 decline in Government employment.  This was viewed in many quarters as a major disappointment, perhaps indicating a slowdown in economic growth, or perish the thought, an impending recession.  The bond market rallied sharply, pushing the yield on the 10-year Treasury Note down to 2.15%.  The Dollar Index (DXY) fell below 97, and oil declined nearly 2%.  How come then that the stock market continued to rally to new all-time highs?  As we note below, none of this should come as a surprise.

A few points.  First, the U-3 unemployment rate already stands at 4.3%, a 16-year low.  Next, there have been in past years some anomalies with the seasonal adjustment factors for the month of May.  Accordingly, some observers believe that June will show a snapback in job growth.  We discount this factor, however, in part because both the March and April job gains were revised downward by a total of 66,000.  More significant is the fact that a broadening range of industries are reporting a shortage of skilled workers, thereby inhibiting the pace of hirings.  Construction, oilfield services, trucking, even fast-food workers are in short supply, as the monthly report on job openings (JOLTS) continues to show nearly six million unfilled positions.  The state of Maine is releasing some non-violent offenders from prisons to ease a shortage of summer workers.  In addition to this shortage of skilled and mobile workers, it is clear that many businesses are holding off hiring until there is more clarity regarding the Administration’s fiscal stimulus, deregulation, infrastructure and healthcare plans.  Business sentiment has clearly improved since last year’s election, but this has yet to be translated into more vigorous hiring and capital spending.  Besides, the economy requires only about 75,000 new jobs each month in order to absorb new entrants into the labor force.  Ergo, the pace of hirings is slowing, gradually eating into the pool of underemployed workers (U-6), as indicated by the steady decline in the underemployment rate, which now stands at 8.4%, a 10-year low.  The three-month moving average of job gains is, as to be expected, slowly declining from 201,000 per month, in February, down to 121,000 in May.  As we have noted numerous times in the past, the trendline growth rate of GDP continues at about a 2% pace, reflecting a less than 1% per annum growth in the labor force, plus productivity gains of around 1% annually.

As with employment, Average Hourly Earnings continue gradual monthly increases, but are still running only 2.5% above their year-ago level.  Among other factors, this reflects the retirement, at about 10,000 per month, of baby boomers whose wages are higher than those of new entrants and part-time workers.  In addition, this sluggish pace of wage gains reflects the increasing proportion of service workers as a percentage of the total workforce.  Manufacturing represents only 12% of GDP and is increasingly automated.  Even so, this supports a fairly steady pace of personal consumption, with household debt service at a manageable level.

Why then is the Standard & Poors 500 Stock Index in record territory, with a forward P/E ratio of nearly 19, which indicates a 5.3% earnings yield, still comfortably above the 4.5% return from BBB bonds?  Corporate profits have begun to rise much more rapidly than the economy as a whole, in part because nearly half the revenues of S&P 500 companies are derived abroad, either through exports or local foreign sales.  Recent weakness in the Dollar’s exchange rate helps both exports and the translation of foreign source income.  The economies of Europe and Asia, as well as some emerging markets, are all in solid uptrends.  As an aside, first quarter GDP growth in France, of all places, ran at 1.8%, compared with 1.2% in the U.S.  Seriously?  Investors do not buy GDP; they buy a share of corporate profits.

No doubt, we are in the minority insofar as we believe that the Administration’s attempts to increase GDP growth to more than 3% annually on a sustainable basis will fail.  First of all, there is not sufficient available skilled labor to sustain this pace, particularly in view of the Administration’s immigration policies and our inadequate education system.  Second, the tax cuts currently envisioned are skewed to the wealthiest earners, whose propensity to consume is relatively low.  Third, with ample excess capacity around the globe, there is little reason to expect a capital spending boom anytime soon.  Finally, if policies do succeed (for a few quarters) in over-stimulating economic activity, the risks of inflation exceeding the Fed’s 2% target will cause the central bank to tighten monetary policy.  This will quickly be reflected in lower stock prices.  We haven’t even noted the President’s protectionist threats because recent experience suggests he will back away from his campaign rhetoric, just as our trading partners will harden their positions during any negotiations.

The bottom line is that the U.S. workforce is aging and growing more slowly.  Today’s growth industries are asset light, not capital intensive.  Moreover, there are numerous disruptions caused by innovation, technical and otherwise, which will keep price competition intense and will employ only those workers with the skills and adaptability needed in a globally competitive world.  An aging population has a higher propensity to save.  This is a 2% growth economy with low inflation, low interest rates, and rising corporate profits.  Corporations are keeping costs down, returning free cash flow to shareholders via dividends and share buybacks, as well as making acquisitions and dispositions, all with the objective of enhancing shareholder value.  Now that’s a porridge that’s neither too hot nor too cold.

What’s so bad about that?

The Truth Comes Out

Ever since Trump's election as President, we have contended that he did not "inherit a mess."  Indeed, he inherited an economy that is growing at about 2% annually, which is all one should expect, given net workforce growth of about 0.7% per annum and productivity gains of about 1.0%  at best.  Indeed, real GDP growth for the last four quarters was 1.9%.  We have argued consistently that any attempt by fiscal means (tax cuts and infrastructure spending) to increase this rate of growth will inevitably result in higher inflation and a more hostile Federal Reserve Board monetary policy.  Never mind the deleterious impact on the Federal deficit.  The U-3 Unemployment Rate is currently down to 4.5%, and the U-6 is 8.9%.  While some observers may contend that this leaves room for faster employment growth, particularly by absorbing the under-employed, the fact is that because of a skills mismatch as well as labor force immobility, there are currently six million unfilled job openings.  There are already shortages of skilled workers in many industries, including construction, trucking, and the oil patch, among others.  Wages are gradually rising, and there is already evidence of margin compression among many companies.  As long as aggregate demand growth remains sluggish and the overall labor market tight, more margin squeeze is likely.  Indeed, the impressive growth of corporate earnings reported so far for the first quarter of this year is in significant part due to stronger business out of Europe and Asia. 

But fear not.  Yesterday, Treasury Secretary Mnuchin, a strong advocate of the President's tax reduction and reform plans, admitted that it will take at least two years for economic growth to reach a 3% annual rate.  This belated recognition, which jettisons the 4%+ promise made by the President during his campaign, also recognizes that no tax bill will be passed in time to impact growth in 2017.  The vast majority of corporate leaders hoping for tax relief are not moving ahead with capital spending plans until such legislation is passed.  Assuming some form of stimulus is enacted in time to have an impact on growth next year, the acceleration in the economy is unlikely to increase inflation enough to cause a markedly tighter monetary policy.  The core PCE deflator for March was only 1.56% above the year-ago figure, still well below the Fed's 2.0% target.  In this environment, it is highly likely that policymakers will move slowly and deliberately to normalize interest rates through increases in the Federal Funds Rate as well as shrinking the Fed's $4.5 trillion balance sheet.  Most experts suggest that the latter will take five years to complete, assuming the Fed merely allows the securities in its portfolio to mature rather than selling them outright.

In this environment, a normalized Federal Funds Rate should be no more than 3.0%, if even that high.  This level should not impede the stock prices of those companies which continue to grind out a minimum annual earnings growth in the mid-single digits.  We continue to expect that S&P 500 earnings will reach $130 this year, with further gains probable in 2018.  Accordingly, the forward P/E multiple is currently about 18, representing a 5.4% earnings yield.  This still compares favorably with a 4.5% average yield among BBB rated bonds.  Admittedly, these are not bargain basement valuations, but they are not dangerously high.  Moreover, further modest expansion of the economy is probable in 2018, which should support further gains in equity prices.  In this environment, a broad range of exceptionally high yielding vehicles such as REITs and MLPs, among others, should also prove to be rewarding investments.

Stay Focused

The cacophony of nonsense emanating from both the White House and the Congress often makes it difficult for investors to focus on the far more important economic, corporate and financial market fundamentals which drive the prices of both equities and bonds.  Most important, even without any pro-growth initiatives out of Washington, it is clear from a mountain of current high frequency data as well as critical free market indicators, including interest rates, commodity prices and the Dollar, that the U.S. economy, as well as those in the Eurozone and China, are experiencing faster rates of growth, which are contributing to a further rise in corporate profits.  Although some recent data have been mixed, it appears that wage growth, which began to pick up in 2015, is continuing to accelerate, with a resulting positive impact on domestic consumption.  Employment among Millenials is accelerating, partially offsetting the retiring Baby Boomers.  Inflation, which has been suppressed, due to global excess capacity, the steep decline in the price of oil as well as the benefits of a strong Dollar, is also creeping toward the Federal Reserve Board's long-term target of 2%.

Labor markets are gradually tightening, as business confidence has picked up in the hopes that the Trump Administration will reduce taxes, dismantle onerous regulations, reform healthcare and initiate a multi-year rebuilding of our infrastructure.  None of this has yet occurred, and in our view, the enactment of the necessary legislation will require many months and the actual implementation, particularly regarding healthcare and infrastructure rebuilding, will take years.  Notwithstanding these lags, the Federal Reserve's Open Market Committee is on the verge of a series of interest rate boosts, which at the outset will be interpreted as a vote of confidence in the economic expansion, but over time will gradually reduce the surplus financial market liquidity, which has driven stock prices higher over the last eight years in the face of lackluster corporate earnings.

At its current level of about 2,370, the S&P 500 stock index is selling at roughly 20 times trailing earnings for 2016, clearly a very full valuation.  While it is too early to have firm conviction on 2017 profits, the current consensus suggests a number around $130, which brings the forward P/E down to 18.  Even with corporate BBB yields of about 4%+, this valuation is also pretty full.  On the other hand, a reduction in the Federal tax rate on corporate profits could augment this forecast significantly.  Moreover, as long as the U.S. Dollar does not appreciate too much from its current level, and assuming no foolhardy protectionist measures are undertaken by this Administration, the economic expansion could be extended. However, with an unemployment rate already below 5%, albeit with an underemployment rate still at 9%, the labor market is clearly tightening.  There are already shortages of skilled construction and oilfield workers as well as long haul truck drivers, among others.  The monthly JOLTS survey shows more than 5.0 million unfilled job openings due to a skills mismatch or labor immobility.  As wage growth picks up further, however, some of those currently unemployed may return to the work force.  Any successful attempt to limit immigration will clearly inhibit GDP growth, even if productivity picks up from its abysmal pace of recent years.  A Border Adjustment Tax (BAT) also has the potential to impede economic growth by disrupting the global supply chains upon which much of American manufacturing relies, and, in addition, consumer prices for many essential goods will increase.  Moreover, if a BAT results in a stronger dollar, American exporters will be at a further disadvantage, even if they receive a tax break.

In short, the probability of gradually rising inflation and a less accommodative monetary policy will inhibit the advance of equity prices, even if the Fed stops short of precipitating the next economic recession.  The current Administration did not "inherit a mess."  Indeed, it inherited an economy that was already gathering momentum and beginning to run short of labor market slack.  Over the near term, as the pace of economic growth and corporate profit gains picks up, investors will be in the "feel-good" stage of the rally, but irrespective of whatever pro-growth policies are eventually enacted and implemented, the business cycle will not be repealed, and investors will do well to keep an historical perspective in mind.  Without a higher rate of labor force growth and a higher rate of productivity, real growth cannot accelerate.  Any attempt to stimulate output will serve only to boost inflation, and bring forth a tighter Fed policy. We remain bullish for now, but as bond yields continue to increase to reflect rising inflation and a less accommodative monetary policy, stock market volatility will increase, and many equities will top out long before the economy crests. The simple truth is that the stronger the economy gets, the less liquid the financial system will be; the lower the returns from financial assets.  The only unknown is the timing.

Year End Nonsense

The only things we forget faster than year-end prognostications by Wall Street pundits are people's New Year's resolutions to lose weight and exercise more.  Yesterday, a former member of the Federal Reserve Board's Open Market Committee should have been ashamed of himself for cautioning on national television that today's optimistic market is analogous to the bullish sentiment greeting Reagan's election and might be just as short-lived.  Although the stock market rallied from the election of Ronald Reagan in 1980 until his inauguration on January 20th, 1981, this former central banker warned viewers of this well-known financial news network that it declined 20% during the rest of 1981.  What he forgot to mention was the fact that beginning in late 1979, Fed Chairman Paul Volcker had embarked on a policy of extreme monetary tightening in order to break the back of double-digit inflation, a legacy of the Carter Presidency and the Burns/Miller Fed.  A steeply inverted yield curve precipitated the market decline and the brief recession which followed.  Of course, this paved the way for a long period of declining inflation and a thirty-five year bull market in fixed income securities, which is now just about over.

To equate the circumstances surrounding the election of Trump to those of 1980-81 is shortsighted at best.  First of all, low inflation caused by excess capacity and lack of demand is the major economic issue of the day.  The yield curve from 2-year Treasury Notes out to 10 years has become progressively steeper since Trump's election, as in all likelihood, numerous pro-growth economic policies will be implemented over the course of the next year.  Also, part of the reason for the rise in the yield of the 10-year Note since the election reflects the liquidation of bonds by yield hungry investors who have held on too long and are now running for the exits.  Fear of inflation as a result of new growth initiatives is misplaced for several reasons.  First of all, there is still ample slack in the labor force, as well as a steady flow of new entrants, and secondly, there is still vast excess capacity on a global basis.  Moreover, it will be many months before tax reform, deregulation, increased infrastructure spending and higher defense spending are both authorized and implemented.  At this point, no one knows the extent of the legislative compromises which will be required, because even amongst the Republican Party there are many strongly-held, differing viewpoints.  As we assess Trump’s choice of advisors and Cabinet members we have become less concerned about a reversion to protectionism leading to trade wars and massive job losses.  We do expect, however, some favorable renegotiation of NAFTA and our trade relations with China.  In short, the Trump agenda should be viewed as a four-year plan, not a 100-day wonder.

The growth rate of GDP equals the growth rate of the workforce (adjusted for hours worked) plus the increase in productivity.  The Bureau of Labor Statistics projects that between 2012 and 2022, the workforce will grow by only 0.7% annually, in large part due to the ongoing retirement of the baby boomers.  Forecasting productivity growth is more problematic, but given the current operating rate in manufacturing, at 75% of capacity, it is unlikely that more than a modest pickup in productivity enhancing capital expenditures can be expected in the near to intermediate term.  Moreover, there are headwinds with which the economy must contend next year including a strong Dollar, rising mortgage rates, increased corporate borrowing costs, and a higher oil price.  Although wages are increasing at a modest pace, consumers are still deleveraging and spending at a pace within their incomes.  Simply put, GDP growth in 2017 is likely to remain in the 2%-3% range, and inflation is not likely to reach the Federal Reserve Board's 2.0% target during the year.

Corporate profits, on the other hand, have begun a renewed upturn after six calendar quarters of decline.  In recent years, the consensus earnings estimates for individual companies produced by Wall Street securities analysts have essentially mirrored the guidance disseminated by corporate managements at their quarterly conference calls or investor days.  Few analysts are willing to venture forth with out of consensus forecasts.  Accordingly, corporate managements have been understandably very cautious when giving out forward guidance in recent years, always hoping for an upside earnings surprise that will boost their stock prices.  Not enough time has passed, nor have there been enough changes in Washington for managements to venture bolder forecasts for next year.  Therefore, analyst estimates of 2017 profits are actually behind the curve at this time, which suggests that at nearly 2300 on the S&P 500 stocks are really cheaper than the 18 P/E ratio that current forward estimates imply.  Moreover, if there is a large scale repatriation of profits trapped abroad, much of this will fund share buybacks and higher dividends.

Continued modest GDP growth accompanied by high single-digit profit growth and restrained inflation is likely to keep the Federal Reserve from tightening monetary policy next year, although a couple of boosts in the Federal Funds rate, bringing it up to 1%-1.25% should be expected.  This will not significantly impede further gains in stock prices over the months ahead, although January is likely to witness some profit taking by individual investors, hoping lower tax rates will be enacted next year.  By late 2017, and into 2018, if there is a meaningful surge in growth accompanied by rising inflation, that will clearly be troubling for the financial markets.  However, those forecasters fearing an imminent, serious correction in equity values should relax and begin to reallocate their exposure to companies, particularly those domestically oriented, which will benefit from new economic initiatives.

Implications of a Republican Sweep

We are well aware that following any massive surprise event the initial responses of the “experts” are more often than not incomplete, if not outright wrong. Accordingly, we approach our analysis of the Trump victory and the sweep of both houses of Congress with a heavy dose of humility and caution. One factor is clear, however. As the late Herb Stein used to say, “If something is not sustainable, it won’t be.” Ergo, beginning in the early Nineties, following the downfall of Communism and the beginning of economic globalization, there began, slowly at first, a wedge in the composition of GDP in America. That is, the share of the pie going to labor began a decline, which has persisted up to now, while corporate profits as a share of GDP have increased by roughly the same amount. Yesterday’s election reflected the inevitable tipping point, when labor coalesced in sufficiently large numbers to overturn the failed policies of income redistribution. It should be noted that both outsourcing and offshoring were not the only causes of this divergence. Huge technological advances in recent decades have enabled the economy to produce more output with fewer workers. Moreover, those jobs which remain, even in manufacturing, now pay lower wages, e.g. auto workers in the Southern right-to-work states.

The economic program put forth by Trump is clearly pro-growth. The likelihood is that, with some modifications, Congress will implement the bulk of it. This will accelerate economic growth for at least a few years. However, since we are close to full employment, wage growth will speed up faster than the 2%+ pace of recent years. Some companies will be able to pass this on with higher prices. Others may not. Some will offset wage pressure with capital spending to increase in-house productivity, which in turn will accelerate growth. Less burdensome regulation, higher defense spending, increased energy investment and a major infrastructure rebuilding program will all contribute to faster growth as will, of course, lower corporate and personal income taxes and repatriation of more than $2 trillion of profits trapped overseas. There is no doubt in our mind that faster growth will be accompanied by somewhat higher inflation, which will cause the FOMC to boost interest rates more aggressively than would otherwise be the case. If corporate profit growth speeds up, however, the stock market should be able to cope with modestly higher rates provided the trade-weighted value of the US dollar does not spike. The biggest unknown, and a risk that cannot be overstated, is Trump’s stand on trade deals. It is critical that he softens his protectionist policies. These were a useful tool to energize an angry electorate, but if he were to persist in tearing up trade deals or imposing punitive tariffs on Chinese or Mexican imports, the impact on our economic growth and security as a nation would be devastating.

We recognize that this initial reaction will be subject to revision and amplification. Accordingly, we welcome any comments you may have.