JOHN DESSAUER INVESTMENTS, INC. 
8679 Blue Flag Way  Naples, Florida  34109   Phone: 239-597-0880   Fax: 239-254-5096

Weekly Hotline
 

 25

 

John Dessauer’s market review and update as of Wednesday April 18, 2018.

  President Trump’s tariffs have resulted in a sharp rise in steel and aluminum prices, increased stock market volatility, and have given pessimists fuel for their doom and gloom forecasts. One forecasts a 40% decline in stock prices over the coming eighteen months. The common theme in the dire predictions is that the tariffs will weaken the economy while the Federal Reserve raises interest rates. That combination, the pessimists argue, will be devastating for both stocks and bonds.

Contrary to expectations, Sukup Manufacturing in Sheffield Iowa has seen steel prices soar 40% since November. American farm machinery makers are suffering order cancellations for grain elevators and a wide range of farm equipment. Steel makers did not wait for the tariffs to be implemented. They raised prices to get ahead of the tariffs’ effects. The President expected the price hikes to develop after the tariffs took effect and that the rise would be modest. Now it looks as if the economic impact of the tariffs will hit the economy sooner and harder than expected. This feeds the Pessimists’ scary prognostications.

Two years ago, in the summer of 2016 the ten-year Treasury bond yield fell below 1.5%. Pessimists then argued that we would have never-ending slow growth and low interest rates. They were wrong. This year the ten-year Treasury bond yield briefly rose above 2.9%. In spite of stock market volatility and trade war fear, the yield is holding around 2.8%. Pessimists have brushed aside their earlier wrong forecasts of slow growth and low interest rates. Now they predict that interest rates will keep rising, resulting in a bond market plunge. They make three points that seem realistic and scary. They argue first that tighter monetary policy will mean an overreaction as investors dump bonds in an effort to get ahead of an aggressive Federal Reserve.  Second, they add that the federal government has to sell a lot more debt to finance its deficit and cover the roll-over of the enormous existing U.S. national debt. Third, they say we are in grave danger of offending China, a major holder of U.S. government debt.

Soaring interest rates would be very bad news for the economy, bonds and stocks. However, all three of the pessimists’ points are overblown. They were wrong about interest rates staying low and they will be wrong about interest rates soaring.

China buys and holds U.S. government debt because it is in China’s economic interests to do so. It is a myth to think that China buys and holds U.S. government debt as a favor to us. If China started dumping U.S. government debt that would push the dollar down sharply making imports from China more expensive for American consumers and giving U.S. exports a boost. That would be a really dumb move with a possible trade war looming between China and the United States. The Chinese are not given to dumb moves.

For the past three decades China has been nurturing relations with neighbors. For example, China came to the rescue of neighbors who suffered from severe capital outflows during the late 1990s currency crisis. During our recent trip across the Indian Ocean, we saw the Chinese influence everywhere. South Africa is exporting more and more agricultural products to China. Fishermen in the Maldives use Chinese made desalinization machines to get fresh water for ice. Malaysia is a prosperous country thanks to trade with China. The last thing the Chinese would do is jeopardize decades of efforts by disrupting bond and currency markets. The pessimists are wrong about China and its holdings of U.S. government debt.

They are also wrong about the bond market and the Federal Reserve. Jerome Powell, the new chair of the Federal Reserve has signaled the Fed’s tightening plans well in advance. The bond market has already included the tightening in current bond prices. In addition, economists generally agree that the QE asset purchases brought the ten-year government bond yield down by only about 1%. The yield has already risen from its 2016 low by more than that, more evidence that bond investors have taken the tightening into account.

Interest rates are now already high enough that they could be cut if the tariff impact threatens growth.

When it comes to fiscal policy and the $1 trillion of net new government borrowing, the pessimists forget that in the twelve months from February 2017 to February 2018 the U.S. government sold over $9 trillion of debt. The fact that interest rates remained low during those twelve months says that there is enormous public and private demand for U.S. government debt.  Finally, countries usually have fiscal wiggle room as long as they grow, in nominal terms, at a rate higher than the interest on their debt. The United States is well within that comfort zone.

Interest rates may move a little higher, but they are not likely to become a threat to the economy, the bond market or the stock market. In fact, slightly higher interest rates would become an additional positive, giving the Federal Reserve more maneuvering room if the tariffs result in slower economic growth. The Fed would have that much more room to cut rates and keep growth alive.

When it comes to stocks the pessimists have a lot going against them. CFRA is the largest independent research firm. They expect first quarter profits for the S&P 500 companies to be up 16.3% over the first quarter of 2017. Blackrock and Delta opened the first quarter earnings season with better than expected earnings. Several major banks followed with similar news. If CFRA is right, this will be the best quarter for earnings growth since 2011 when the S&P 500 were crawling out of the depths of the last recession. In the first quarter of 2011 S&P 500 earnings rose 19.5%.

This will be the first quarter where the new lower corporate tax rates are in effect. Prior to tax reform analysts expected first quarter earnings growth at 10.4%.

There is some concern among analysts about the trade situation and the increased stock market volatility. They worry that corporate managers will temper their second quarter outlook to take these conditions into account. However, with stock prices already down and earnings growth likely to beat expectations, odds are the pessimists will be wrong about stocks as well as bonds.

I will have the next market review and update for you one week from today on Wednesday April 25, 2018. 

 All the best,   

John Dessauer                                                                                                            

©April 2018