The Lay of the Land

Consumer spending picked up meaningfully in recent weeks as evidenced by the most recent Retail Sales report for July (+6.4% compared to July, 2017) as well as positive quarterly sales reports from many of the retailers.  The strength reflects the tax cuts, job growth, wage gains, a rising stock market and improved confidence.  While we are pleased to see the improvements, we are somewhat skeptical as to whether this bounce will last.  Middle-class incomes are still not growing much.  In fact, growth in real average hourly earnings was negative in July (-0.4% compared to July, 2017), meaning that the consumer lost purchasing power after accounting for inflation.  And the wage picture may not improve much in the immediate future.  The unfortunate reality is that the Fed is likely to offset an otherwise improving wage-growth picture with interest rate hikes that it believes are necessary to prevent the economy from overheating.  The net effect is likely to be continued stagnation in the financial well-being for a large portion of the population.

The Fed released the minutes from its Aug 1 meeting yesterday.  The language suggested that although a September hike is all but assured, a pause in the interest-rate increases may be in store in the not-too-distant future.  It’s clear that some on the Board are worried about an inversion in the yield curve, which historically has been a very good indicator of looming recessions.  We suspect that the recent strength in the dollar is also a factor for the Fed as a rising dollar weighs on exports (and therefore GDP growth) and multinational corporate profits, and it can be very destabilizing for emerging-market economies.  Businesses and governments in the emerging markets have issued a ton of debt denominated in dollars in recent years.  As the dollar has risen due largely to interest-rate increases in the US, these emerging market entities will find it much harder to service and refinance that debt.
President Trump has begun to jawbone the Fed, saying he is not happy about the interest-rate hikes.  There are two schools of thought about this interference in the Fed’s independence.  Will the president’s comments increase the likelihood of a pause in deference to the Commander in Chief, or will the comments increase the likelihood of additional hikes so as to clearly establish or emphasize the Fed’s independence?  It’s not clear.  As noted, the recent dollar strength will tighten financial conditions and act as an inhibitor of economic growth.  The dollar strength will also create deflationary pressures in the US.  The Fed’s failure to appreciate a rising dollar’s effect on inflation and growth could increase the likelihood of a Fed policy mistake (ie, they keep hiking when they should be pausing).  My view is that the economy cannot withstand too many more rate hikes.  The currency markets are a stabilizing mechanism that keep the US economy from “decoupling” too much from the rest of the world.  Therefore, I think the odds of a policy mistake are fairly high at this point, with or without the president’s interference in the Fed’s affairs.
With regard to Tuesday’s legal developments, the take-away is that it remains unlikely that a sitting president will be indicted (even though he will probably be named a co-conspirator).  This controversy will play out in the court of public opinion.  Nothing happens to President Trump unless his base abandons him.  This is true even if the Democrats win control of the House.  Trump could get impeached by the House but a two-thirds vote in the Senate would be required to remove him.  It is unlikely that there will be enough support for impeachment in the Senate necessary to remove the president from office.  Furthermore, the market reaction to all these developments has been almost nil.  This could reflect what I just wrote, or it could reflect the fact that the administration has already enacted its market-friendly policies (tax cuts, spending, de-regulation, etc), and therefore it would matter much less if the president got removed out of office.
There are reports of progress with the Mexican trade negotiations.  We are hearing there could be an announcement of a hand-shake agreement very soon.  Following an agreement to terms with Mexico, the administration is likely to pivot to Canada using the leverage it has created.  China still appears a ways off as there are only low-level meetings scheduled.  While David Malpass is a capable diplomat, it’s unlikely he has authority to sign a deal.   And North Korea concerns are starting to emerge again – probably not a coincidence as China likely believes the North Korean situation provides leverage in negotiations.  There are also a ton of other levers that the Chinese can use, like selling its massive Treasury holdings.  Will China be emboldened by the controversies surrounding the Trump administration?  The market doesn’t seem to think so.  I think it’s likely we will see progress on these trade deals by election day, regardless of the concessions Trump has to make, so the administration can claim some successes on the trade front.
Corporate profits look great, but they are fueled, in part, by tax cuts and stock buybacks.  And though we are encouraged by the recent improvement in the economic data, it remains unclear whether the momentum can carry into next year.   At this point, expectations for next year appear high to us, especially given the slowdown in the global economy (outside the US), the strength in the dollar, rising interest rates, the slowdown in housing, and the trade-related uncertainty.  Furthermore, sustainably higher rates of economic (and therefore earnings) growth will likely require more participation from the middle class.

Stay tuned . . .