Nobody likes volatility. It can scare the heck out of the best of us, and certainly can prompt any of us to second-guess ourselves. That’s when we have to engage the intellect, look at the situation rationally, and realize that sometimes volatility isn’t a bad thing – it’s not a harbinger of a crash or downturn.
That is the situation today. So far this year, the Dow has been 7.6% higher than the 2017 year-end close, 4.8% lower than year-end, and now, as we write, is up 350 points from the morning opening. We can’t tell you where it will end the day or this quarter, but we can say with absolute assurance that market volatility is a warning sign only if there are fundamental economic problems – something that could actually cause a recession. We do not see that today. In fact, we believe equities are still undervalued, but we’ll get to that later.
Let’s consider four essential elements of economic health. They are: tax & spending policy, monetary policy, regulatory policy and trade policy. All four remain sound.
Taxes & Spending Policy: The tax cut passed last year is the most pro-growth tax cut since the Reagan years. Some have argued that the tax savings will only be used for share buybacks or that it will only “benefit the rich”. Both run counter to sound economic analysis.
First, lower taxes have always been an incentive for companies to invest more in some combination of plant, equipment, and labor.
Second, even if this time around the tax savings only went to shareholders, those shareholders would have more money to spend in the economy – or to save in banks, which in turn would lend to other businesses which want to grow. It would still help the economy.
Third, even if the savings were somehow passed along only to the wealthy, they also would either spend more in the economy or invest it in businesses which want to grow.
On the spending side, we are cautiously optimistic. Spending is ultimately the same as taxation. Whatever the government spends, it must take in taxes, or in borrowings, which ultimately must be paid with future taxes. The critical question is how much government spending is as a percentage of the total economy. The higher it is, the less growth there is. In the last round of budget negotiations, the administration and Congress increased spending, pushing its share of the overall GDP up a bit from 20.8% last year to a projected 20.9% this year. Not a concern now, but if this represents an opening of the floodgates and profligacy, it will become a drag on the economy.
Monetary Policy: There will always be pessimists. We sometimes are amazed how people find negatives in a sea of positives, but that seems to be exactly what has happened in response to the Fed’s last announcement.
The Fed’s economic projections improved allowing more room for interest rate hikes in 2018 and beyond. Some people see any interest hike as a bad thing. That couldn’t be further from the truth. Interest rates can be too high, but they can also be too low, ushering in an inflationary shock to the system. Even if the Fed hikes rates 4 times in 2018, they will be miles away from “restrictive”. If they don’t raise them, we will see damaging levels of inflation. So, we see reasonable rate hikes as good news – even 4 of them.
Regulatory Policy: Not a lot to say here other than it is all good. Similar to the points we made in discussing taxation, cutting red tape stimulates economic activity, in the same way, reducing taxes does. One can always argue that a given regulation is needed for this protection or that, but there is a point when the burden is excessive, or the implementation is so capricious as to dampen investment. We had reached that point of burden and capriciousness, and the current administration has moved aggressively to reduce the red tape. That will expand the economy.
Trade Policy: The bottom line here has always been the same: trade wars are terrible for growth and the economy. The administration’s recent tweets and tariff announcements have created the perception of a potential trade war, but they have also walked back many of those statements by granting exemptions somewhat generously. We are cautiously optimistic that this president’s negotiating style is bombastic but that his actual policies are realistic. We are not ignoring the threat of a trade war, but we believe the probability of one is still very low.
Putting these all together, we believe strongly that the market’s current volatility is just background noise, not a warning of recession. We also see the government’s final report on 4th quarter GDP reinforcing our conclusions. Real GDP growth came in stronger than anticipated and was revised up from a 2.5% to a 2.9% annual growth rate. Corporate profits also remained strong – up 2.7% from a year ago. With all this, our economic analysis still indicates that US stocks remain relatively cheap both in today’s interest rate environment and even with a higher 3.5% 10-year Treasury rate.