The Second Quarter of 2018

The economy continues to plow ahead, despite the threat of trade wars and uncertainty of US trade status on this continent, Europe and Asia. For the year so far, stocks as measured by the S&P 500 and the Vanguard Total US Market index are up 4.7% and 6.3%, respectively. All of that return has come in the second quarter, which is the topic of today’s Brief.

Possibility of an all-out global trade war and the threat of regulatory risks of technology companies, like Facebook and Google, drove the market down during the first quarter. But a meeting between President Trump and Kim Jong Un with the hope of a denuclearized Korean Peninsula and the lack of discernible impact of tariff threats on the broad economy (so far anyway) reversed early-year declines.

Besides sweeping domestic and global political issues, investors have wrestled with at least two significant economic issues: one is ages old with lots of historical data, and the other is relatively new offering relatively little  experience in  the traditional sense of economics.

Tariffs have been a part of this country’s history since the very beginning, with decidedly mixed results. The impact for the country imposing the ‘taxes’ on imported goods is immediately beneficial, as money from tariff rolls into the government coffers and domestic industries benefit from improved sales when their pricing falls below those of formerly lower-priced imports now made higher by the tariffs.

In complex economies, however, there are always unintended consequences. One is that ancillary companies, usually in far greater numbers than the tariff-protected industry, which have built business models and grown to depend on the lower prices of the imports suffer badly as prices rise on the commodities bearing the tariffs.

In order to survive, businesses must adapt or go out of business. When domestic suppliers are unable to compete with lower prices from their offshore competitors, they change their business model or they go out of business.

Following WWII, the US economy was split fairly evenly in terms of services and manufacturing, government excluded. The mix today is closer to 70% services and 18% manufacturing. It is a long-term trend and has as much or more to do with what is going on outside the US than inside. Workers in developing countries, can for a time, afford to work for far less than those of developed countries, like the US. Mexico, Pacific Rim countries, even Ireland workers have offered to produce goods for American manufacturers far cheaper than their American counterparts.

The US has also seen its manufacturing suffer declines at the hands of more efficient and higher quality global producers, like Japan and Germany. The most significant industry impacted by superior global competition was the automobile industry.

The long term decline of manufacturing jobs in the US, characterized above, has more to do with better manufacturing environments abroad than with unfair price manipulation. But more recently, the US and other developed countries have faced a global competitor like no other in the nation of China. It is a country unified in policy and efficient execution of that policy by a smart totalitarian government, bent on global economic, and quite likely military, dominance. Only time will tell whether the latest raft of tariffs by the Administration will have any impact on blunting what is undeniably the most rapid and injurious transfer of intellectual and economic capital from one country to another, not at war, in global history.

According to Econoday, the nation’s trade gap narrowed sharply in May, to $43.1 billion from a revised $46.1 billion in April. Exports jumped 1.9% to $215.3 billion to well exceed a 0.4 % rise in imports which totaled $258.4 billion. Exports of goods were up a strong 2.6% to $144.9 billion with imports up 0.5% to $210.7 billion. Exports of capital goods, including aircraft showed special strength as did exports of food.

China’s trade surplus with the United States was $33.2 billion in May and $152.2 billion year-to-date, up 13.5% over the same period last year. But a trade war with China will eventually hurt them far worse than it does the US. Our exports to China represent just 1% of our economy, while China depends heavily on its exports to the US for its economic growth. Only 15% of US imports come from China.

The US economy is growing well above the 2% of the past decade. Estimates for the second quarter range from 5.3% at Macroeconomic Advisers, to 4.5% at the Atlanta Fed. Whether or not this pace is sustainable is the question. Business investment has not accelerated this year in the wake of the corporate tax cuts and tariffs may blunt growth.

Another potential threat comes from inflation and how the Federal Reserve responds to it with interest rates. The Fed has three mandates from Congress that essentially compete with one another: The firs is to maximize employment, the second, to control inflation, and the third, to moderate long-term interest rates. The closer the economy gets to full employment, the greater the chances of wages rising from the shortage of workers to spark inflation.

Inflation just hit its highest rate in more than six years, rising to 2.9% in June. That’s the fastest pace since February 2012 according to the Wall Street Journal. It’s also the second month that annual inflation fully offset average hourly wage growth over the previous year. Blue collar workers saw their wages fall 0.2% in June in the rising economy, according to the Journal.

In response to rising inflation worries, interest rates have increased this year. The 7-10 year Treasury index investment (IEF) we use to offset stock market volatility is down 1.9% year-to-date. Just as with stocks, all the declines in Treasury prices occurred in the first quarter of this year. The investment was flat during the second quarter.

Market volatility may also increase as technology companies increasingly dominate the US economy and markets. The growth almost certainly brings with it the need for some regulatory restraint. Earlier in the year Facebook disclosed a series of problems with the security of their users. It was the latest reminder for Congress and investors of just how pervasive, influential, and powerful tech companies have become on our lives and on our markets.

The NYSE FANG+ Index, which tracks 10 global tech heavyweights, fell 2.4%, its worst one-day drop on Tuesday March, 29, a particularly bad day of disclosures for Facebook’s security lapses. The declines had an out sized impact on broader indexes as the growth of tech companies has rapidly increased their weightings. Technology companies represent 14% of the S&P 500 Index and a full 20.1% of our VTI, or Vanguard Total US Market Index. That proportion exactly matches that of the Financial Sector.

International stocks are down 3.9% for the year with most of their declines coming in the second quarter (down 3.5%). The drivers were Trump’s backing out of the Iran deal in early May, which would have significant impact on European countries doing business there, uncertainty around existing trade agreements like NAFTA, European trade, and the TPP in the Pacific Rim, Russian sanctions, Brexit falling on hard times in Britain, clouding the way forward for trade agreements between them and the US, and a host of other disruptions to the status quo of global trade.

While we do not make any projections as to the direction of the US economy, corporate earnings, or the stock market, we believe it is helpful to review the economic issues that impact your businesses, your jobs, and your budgets to varying degrees, if not your long term life plans. We hope you find it interesting.

For our clients, we expect to post your quarterly reports in your portal this afternoon. The reports have been designed to quickly answer any and all the questions you might have about how your invested wealth is performing, how it is allocated for appropriate risk, gains and losses for the year, and how much money has been added or withdrawn. Please give us call if you have any questions.