Manufacturing Is Contracting: Another Economic Indicator Flashes Red
Yet another important economic indicator rolled over this week which has triggered a sell-off in the U.S. equity markets. Each month the Institute of Supply Management (“ISM”) issues two reports: Manufacturing ISM ReportNon-
Yet another important economic indicator rolled over this week which has triggered a sell-off in the U.S. equity markets. Each month the Institute of Supply Management (“ISM”) issues two reports:
Manufacturing ISM Report
Non-Manufacturing ISM Report
A reading above 50 indicates an expansion and a reading below 50 indicates a contraction. The Manufacturing ISM Report was released on Tuesday and it showed a reading of 47.8 for September indicating that manufacturing in the U.S. is beginning to contract. Not only was it the first contraction of the index within the last few years but the index reached a level not seen since 2009. In this article we will cover:
Why the ISM Index is important
Historically what happens to the stock market after the reading goes below 50?
What caused the unexpected drop in the ISM index?
Manufacturing trends around the globe and how they could impact the U.S. stock market
Why The ISM Index Is Important
The ISM Manufacturing Index tells us how healthy the manufacturing sector of the U.S. economy is. This index is also referred to as the Purchasing Managers Index (PMI) and I will explain why. The ISM issues a monthly survey to more than 300 manufacturing companies. The purchasing managers at these big manufactures are on the front line when it comes to getting a read on the pulse of business conditions. The survey includes questions on the trends in new orders, production, inventories, employment, supply chain, and backlog orders. The ISM assigns weightings to each metric, aggregates all of the responses together, and it results in the data point that signals either an expansion or a contraction.
If most of the manufactures in the U.S. have a ton of new orders, inventories are low, and they are looking to hire more people, that would most likely produce a reading above 50, implying that the outlook is positive for the U.S. economy as these big manufactures ramp up production to meet the increase in demand for their products.
On the other hand, if these surveys show a drop off in new orders, inventories are rising, or hiring has dropped off, that would most likely produce a reading below 50, implying that manufacturing and in turn the U.S. economy is slowing down. Analysts will use the ISM index to get a read on what corporate earnings might look like at the end of the quarter. If the index is dropping during the quarter, this could be foreshadowing a shortfall in corporate earnings for the quarter which the stock market will not find out about until after the quarter end.
Here is a historic snapshot of the ISM’s Manufactures Index:
As you will see in the chart, manufacturing has been slowing over the course of the past year but up until September, it was still expanding at a moderate pace. For September, economists had broadly expected a reading of 50.4 but the ISM report produced a result of 47.8 signaling a contraction for the first time since 2016.
What Does This Mean For The Stock Market?
So in the past, when the ISM Index has gone below 50, what happened to the stock market? To answer that question, let’s start by looking at a chart that shows the correlation between the ISM Index and the S&P 500 Index:
The dark blue line is the ISM index and the light blue line is the S&P 500 Index. Looking at this data, I would highlight the following points:
The ISM Index and the S&P 500 Index seem to move in lockstep. While the ISM might give you a preview of what quarterly earnings might look like, it does not give you a big forward looking preview of bad things to come. By the time the ISM index starts dropping, the stock market is already dropping with it.
We need more data. There have been a few times that the index has gone below 50 within the last 20 years and it has not been followed by a recession. Look at 2016 for example. The ISM index dropped below 50, but if you trimmed your equity positions at that point, you missed the big rally from January 2017 through September 2019. We need more data because historically multiple back to back months of readings below have signaled a recession.
If the index hits 45 or lower within the next few months, watch out below!!
What Caused The Most Recent Drop In The ISM Manufactures Index?
When it comes to unexpected market events, there is usually a wide mote of differing opinions. But it seems like the most recent drop could be attributed to a continued weakening of spending by U.S. businesses. While the U.S. consumer seems to still be strong and spending money, spending by businesses on big ticket items has tapered off over the past few months.
As you will see in the chart above, durable goods orders have dropped over the past two months which is the main barometer for business spending. When businesses are uncertain about the future, they tend to not spend money and business owners have no lack of things to be worried about going into 2020. The growth rate of the U.S. economy has been slowing, uncertainty surrounding global trade continues, and 2020 is an election year. One or more of these uncertainties may need to resolve themselves before businesses are willing to resume spending.
Global Manufacturing Trends
While manufacturing in the U.S. just started contracting in September, the picture is a little darker when we look at the manufacturing trends in other parts of the world. Below is a heat map that shows the PMI Index for countries all around the world. Here is how you read it:
Green is good. Manufacturing is expanding
Yellow is neutral: Manufacturing is flat
Red is bad: Manufacturing is contracting
If you look at 2017 and 2018, there was a lot of green all around the world indicating that manufacturing was expanding around the globe. As we have progressed further into 2019, you are beginning to see more yellow and in some areas of the world there is red indicating contraction. Look at Germany in particular. There has been big change in the economic conditions in Europe and the global economy is very interconnected. The weakness that started in Europe seems to be spreading to other places throughout the globe.
ISM Non-Manufacturing Index
Now, you could make the argument that the U.S. is a services economy and it does not rely heavily on manufacturing, so how much does this contraction in manufacturing really matter? Well, if we switch gears to the ISM Non-Manufacturing Index which surveys the services sector of the US economy, the September report just came out with a reading of 52.6 compared to the 55.3 that the market was expecting. This is also down sharply from the 56.4 reported for August.
While the services sector of the U.S. economy is not contracting yet, it seems like the numbers may be headed in that direction.
What Investors Should Expect
There are pluses and minuses to this new ISM data. The contraction of the ISM Manufactures Index and the deceleration of the growth rate of the ISM Non-Manufactures Index in September is just another set of key economic indicators that are now flashing red. Implying that we may be yet another step closer to the arrival of the next recession in the U.S. economy.
The only small positive that can be taken away from this data is that the Fed now has the weak economic data that it needs to begin aggressively reducing interest rates in the U.S. which could boost stock prices in the short term. But investors have to be ready for the rollercoaster ride that the stock market may be headed towards as these two forces collide in the upcoming months.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
We Are Sleep Walking Into The Next Crisis
The U.S. economy is headed down a dangerous path. In our opinion it has nothing to do with the length of the current economic cycle, valuations, interest rates, or trade wars. Instead, it has everything to do with our mounting government deficits. We have been talking about the federal budget deficits for the past ten years but when does that
The U.S. economy is headed down a dangerous path. In our opinion it has nothing to do with the length of the current economic cycle, valuations, interest rates, or trade wars. Instead, it has everything to do with our mounting government deficits. We have been talking about the federal budget deficits for the past ten years but when does that problem really come home to roost?
A Crisis In Plain Sight
An economic crisis is often easier to spot than you think if you are looking in the right places. Most of the time it involves identifying a wide spread trend that has evolved in the financial markets and the economy, shutting out all of the noise, and then applying some common sense. Looking at the tech bubble, people were taking home equity loans to buy tech stocks that they themselves did not understand. During the housing bubble people that were making $40,000 per year were buying homes for $500,000 and banks were giving loans with no verification of income. Both of the last two recessions you could have spotted by paying attention to the trends and applying some common sense.
Government Debt
Looking at the data, we think there is a good chance that the next economic crisis may stem from reaching unsustainable levels of government debt. Up until now we have just been talking about it but my goal with this article is to put where we are now in perspective and why this "talking point" may soon become a reality.
Debt vs GDP
The primary measuring stick that we use to measure the sustainability of the U.S. debt level is the Debt vs GDP ratio. This ratio compares the total debt of the U.S. versus how much the U.S. economy produces in one year. Think of it as an individual. If I told you that someone has $100,000 in credit card debt, your initial reaction may be “wow, that’s a lot of debt”. But then what if I told you that an individual makes $1,000,000 per year in income? That level of debt is probably sustainable for that person since it’s only 10% of their gross earnings, whereas that amount of credit card debt would render someone who makes $50,000 per year bankrupt.
Our total gross federal deficit just eclipsed $21 trillion dollars. That’s Trillion with a “T”. From January through March 2018, GDP in the U.S. was running at an annual rate of $19.965 trillion dollars (Source: The Balance). Based on the 2018 Q1 data our debt vs GDP ratio is approximately 105%. That’s big number.
The Safe Zone
Before I start throwing more percentages at you let's first establish a baseline for what's sustainable and not sustainable from a debt standpoint. Two Harvard professors, Reinhart and Rogoff, conducted a massive study on this exact topic and wrote a whitepaper titled "Growth in a Time of Debt". Their study aimed to answer the question "how much debt is too much for a government to sustain?" They looked at historic data, not just for the U.S. but also for other countries around the world, to determine the correlation between various levels of Debt vs GDP and the corresponding growth or contraction rate of that economy. What they found was that in many cases, once a government's Debt vs GDP ratio exceeded 90%, it was frequently followed by a period of either muted growth or economic contraction. It makes sense. Even though the economy may still be growing, if you are paying more in interest on your debt then you are making, it puts you in a bad place.
Only One Time In History
There has only been one other time in U.S. history that the Debt vs GDP ratio has been as high as it is now and that was during World War II. Back in 1946, the Debt vs GDP ratio hit 119%. The difference between now and then is we are not currently funding a world war. I make that point because wars end and when they end the spending drops off dramatically. Between 1946 and 1952, the Debt vs GDP ratio dropped from 119% to 72%. Our Debt vs GDP ratio bottomed in 1981 at 31%. Since then it has been a straight march up to the levels that were are at now. We are not currently financing a world war and there is not a single expenditure that we can point to that will all of a sudden drop off to help us reduce our debt level.
Spending Too Much
So what is the United States spending the money on? Below is a snapshot of the 2018 federal budget which answers that question. As illustrated by the spending bar on the left, we are estimated to spend $4.1 trillion dollars in 2018. The largest pieces coming from Social Security, Medicare, and Medicaid.
federal deficit
The bar on the right illustrates how the U.S. intends to pay for that $4.1 trillion in spending. At the top of that bar you will see “Borrowing $804 Bn”. That means the Congressional Budget Office estimates that the U.S. will have to borrow an additional $804 billion dollars just to meet the planned spending for 2018. With the introduction of tax reform and the infrastructure spending, the annual spending amount is expected to increase over the next ten years.
Whether you are for or against tax reform, it’s difficult to make the argument that it’s going to “pay for itself in the form of more tax as a result of greater economic growth.” Just run the numbers. If our annual GDP is $19.9 Trillion per year, our 3% GDP growth rate I already factored into the budget numbers, to bridge the $804B shortfall, our GDP growth rate would have to be around 7% per year to prevent further additions to the total government debt. Good luck with that. A 7% GDP growth rate is a generous rate at the beginning of an economic expansion. Given that we are currently in the second longest economic expansion of all time, it’s difficult to make the argument that we are going to see GDP growth rates that are typically associated with the beginning of an expansion period.
Apply Common Sense
Here’s where we apply common sense to the debt situation. Excluding the financing of a world war, the United State is currently at a level of debt that has never been obtained in history. Like running a business, there are only two ways to dig yourself out of debt. Cut spending or increase revenue. While tax reform may increase revenue in the form of economic growth, it does not seem likely that the U.S. economy is at this stage in the economic cycle and be able to obtain the GDP growth rate needed to prevent a further increase in the government deficits.
A cut in spending, in its simplest form, means that something has to be taken away. No one wants to hear that. The Republican and Democratic parties seem so deeply entrenched in their own camps that it will make it difficult, if not impossible, for any type of spending reform to take place before we are on the eve of what would seem to be a collision course with the debt wall. Over the past two decades, the easy solution has been to “just borrow more” which makes the landing even harder when we get there.
Answering the “when” question is probably the most difficult. We are clearly beyond what history has revered as the “comfort zone” when to comes to our Debt vs GDP ratio. However, the combination of the economic boost from tax reform and infrastructure spending in the U.S., the accelerating economic expansion that is happening outside of the U.S., and the low global interest rate environment, could continue to support growth rates even at these elevated levels of government debt.
Debt is tricky. There are times when it can be smart accept the debt, and times where it isn’t helpful. As we know from the not too distant past, it has the ability to sustain growth for an unnaturally long period of time but when the music stops it gets ugly very quickly. I’m not yelling that the sky is falling and everyone needs to go to cash tomorrow. But now is a good time to evaluate where you are risk wise within your portfolio and begin having the discussion with your investment advisor as to what an exit plan may look like if the U.S. debt levels become unsustainable and it triggers a recession within the next five years.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Are The New Trade Tariffs Good Or Bad For The Stock Market?
US businesses often imports their manufactured goods from China. This is because the cost of manufacturing products is much lower than in other places so they want to take advantage of this. The government makes money off this relationship by imposing tariffs on certain products coming into the US. President Trump announced on March 8, 2018
US businesses often imports their manufactured goods from China. This is because the cost of manufacturing products is much lower than in other places so they want to take advantage of this. The government makes money off this relationship by imposing tariffs on certain products coming into the US. President Trump announced on March 8, 2018 that the United States will begin imposing a tariff on steel and aluminum imported into the U.S. from countries other than Mexico and Canada. The tariff on steel will be 25% and 10% on aluminum. There are two main questions that we will seek to answer in this article:
What happened the last time the U.S. implemented trade tariffs?
How will the stock market react to the new trade barriers?
What Is A Tariff?
First, let's do a quick recap on what a tariff is. A tariff is a special tax on goods that come into the United States. Tariffs are imposed to make select foreign goods more expensive in an effort to encourage the U.S. consumer to buy more American made goods. For example, if the government puts a 25% tariff on cars that are imported into the U.S., that BMW that was manufactured in Germany and shipped over to the U.S. and sold to you for $70,000 will now cost $87,500 for that same exact car due to the 25% tariff. As a consumer this may cause you not to buy that BMW and instead buy a Corvette that was manufactured in the U.S. and carries a lower price tag.
What Does History Tell Us?
history of tariffs in the US
It’s very clear from this chart that the U.S. has not imposed meaningful tariffs since the early 1900’s. Conclusion, it’s going to be very difficult to predict how these tariffs are going to impact the U.S. economy and global trade. Even though we have some historical references, the world is very different today compared to 1930. The “global economy” did not even really exist back then.
As you can see in the chart, the average import trade tariff in 1930 was about 20%. Since 1975, the average trade tariff on imports has been below 5%. More recently, between 2000 and 2016 the average tariff on imports was below 2%.
History Will Not Be A Useful Guide
As an investment manager, when a big financial event takes place, we start to scour through historical data to determine what happened in the past when a similar event took place. While we have had tariffs implemented in the past, many of those tariffs were implemented for reasons other than the ones that are driving the U.S. trade policy today.
Prior to 1914, tariffs were used primarily to generate revenue for the U.S. government. In 1850, tariffs represented 91% of the government’s total revenue mainly because there was no income tax back then. By 1900 that percentage had dropped to 41%. As many of us are well aware, over time, the main source of revenue for the government has shifted to the receipt of income and payroll taxes with tariff revenue only representing about 2% of the government’s total receipts.
During the Industrial Revolution (1760 – 1840), tariffs were used to protect the new U.S. industries that were in their infancy. Without tariffs it would have been very difficult for these new industries that were just starting in the U.S. colonies to compete with the price of goods coming from Europe. Tariffs were used to boost the domestic demand for steel, wool, and other goods that were being produced in the U.S. colonies. These trade policies helped the new industries get off the ground, expand the workforce, and led to a prosperous century of economic growth.
Today, tariffs are being used for a different reason. To protect our mature industries from the risk of extinction as a result of foreign competition. Since the 1950’s, the global economy has evolved and the trade policies of the U.S. have been largely in support of free trade. While this sounds like a positive approach, free trade policies have taken their toll on a number of industries here in the U.S. such as steel, automobiles, and electronics. Foreign countries like China have access to cheap labor and they are able to produce select goods and services at a much lower cost than here in the United States.
While this a good thing for the U.S. consumer because you can purchase a big screen TV made in China for a lot less than that same TV made in the U.S., there are negative side effects. First and foremost are the U.S. jobs that are lost when a company decides that it can produce the same product for a lot less over in China. We have seen this trend play out over the past 20 or 30 years. Tariffs can help protect some of those U.S. jobs because it makes products purchased from foreign manufactures more expensive and it increases the demand for U.S. goods. The downside to that is the consumer may be asked to pay more for those same products since at the end of the day it costs more to produce those products in the U.S.
In the announcement of the steel and aluminum tariffs yesterday, the White House also acknowledged the national security risk of certain industries facing extinction in the United States. Below is a chart of production of steel in the U.S. from 1970 – 2016.
As you can see in the chart, our economy has grown dramatically over this time period but we are producing half the amount of steel in the U.S. that we were 47 years ago. If everything stayed the same, this reduction in the U.S. production of steel would probably continue. It begs the question, what happens 50 years from now if there is a global conflict and we are unable to build tanks, jets, and ships because we import 100% of our steel from China and they decide to shut off the supply? There are definitely certain industries that we will always need to protect here in the U.S. even though they may be “cheaper” to buy somewhere else.
There is also monopoly risk. Once we have to import 100% of a particular good or service, those producers have 100% pricing power over us. While I would be less concerned over TV’s and electronics, I would be more concerned over items like cars, foods, building materials, and other items that many of us consider a necessity to our everyday lives.
Free or Fair?
While we have had “free” trade policies over the past few decades, have they been “fair”? Elon Musk, the CEO of Tesla, recently highlighted that “China isn’t playing fair in the car trade with the U.S.” He goes on to point out that China puts a 25% import tariff on American cars sold to China but the U.S. only has a 2.5% import tariff on cars that are manufactured in China and sold in the U.S.
In response to this, Trump mentioned in his speech that the U.S. will be pursuing “reciprocal” or “mirror” trade policies. Meaning, if a country puts a 25% tariff on U.S. goods imported into their country, the U.S. would put a 25% tariff on those same goods that are imported from their country into the U.S.
Trade Wars
While the reciprocal trade policies seem fair on the surface and it also makes sense to protect industries that are vital to our national security, the greatest risk of transitioning from a “free trade” policy to “protectionism” policy is trade wars. We just put a 25% tariff on all of the steel that is imported from China, how is China going to respond to that? Remember, the U.S. is part of a global economy and trade is important. How important? When you look at the gross revenue of all of the companies that make up the S&P 500 Index, over 50% of their revenue now comes from outside the U.S. If all of a sudden, foreign countries start putting tariffs on U.S. goods sold aboard, that could have a big negative impact on the corporate earnings of our big multinational corporations in the United States. In addition, when you listen to the quarterly earnings calls from companies like Apple, Nike, Pepsi, and Ford, the future growth of those companies are relying heavily on their ability to sell their products to the growing consumer base in the emerging market. Countries like China, India, Russia, and Brazil.
I go back to my initial point, that history will not be a great guide for us here. We have not used tariffs in a very long period of time and the reason why we are using tariffs now is different than it was in the past. Plus the world has changed. There is no clear way to know at this point if these new tariffs are going to help or hurt the U.S. economy over the next year because a lot depends on how these foreign countries respond to the United States moving away from the long standing era of free trade.
Canada & Mexico Exempt
The White House announced yesterday that Canada and Mexico would be exempt from the new tariffs. Why? This is my guess and it's only guess, the U.S. is currently in the process of negotiating the NAFTA terms with Canada and Mexico. NAFTA stands for the North American Free Trade Agreement. Trump has made it clear that if we cannot obtain favorable trade terms, the U.S. will exit the NAFTA agreement. The U.S. may use the recent tariff announcement as a negotiation tool in the talks with Canada and Mexico on NAFTA. "Listen, we gave you an exemption but if you don't give us favorable trade terms, all deals are off."
Coin Flip
While tax reform seems like a clear win for U.S. corporations, only history will tell us whether or not these new trade policies will help or harm the U.S. economy. If we are able to protect more U.S. jobs, protect industries vital to the growth and protection of the U.S., and negotiate better trade deals with our trading partners, we may look back and realize this was the right move at the right time.On the flip side of the coin, if trade wars break out that could lead to a decrease in the demand for U.S. goods around the globe that may cause the U.S. to lose more jobs than it is trying to protect. As a result, that could put downward pressure on corporate earnings and in turn send stock prices lower in the U.S. Only time will tell.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
What Does Tax Reform Mean For The Markets In 2018?
2017 ended up being a huge year for the U.S. stock market. The rally in the stock market was unmistakably driven by the anticipated passing of tax reform and Congress delivered. However, the sheer magnitude of the stock market rally has presented investors with a moment of pause and a lot of unanswered questions as we enter into the first quarter
2017 ended up being a huge year for the U.S. stock market. The rally in the stock market was unmistakably driven by the anticipated passing of tax reform and Congress delivered. However, the sheer magnitude of the stock market rally has presented investors with a moment of pause and a lot of unanswered questions as we enter into the first quarter of 2018. The two main questions being:
What does tax reform mean for the markets in 2018?
We are now in the second longest economic expansion of ALL TIME!!! I know what goes up, eventually comes down. Are we overdue for a major correction in the stock market?
Without a crystal ball, no one knows for sure. However, the purpose of this article is to identify indicators in the economy and the financial markets that may help us gauge the direction of the U.S. economy and equity markets as we progress through 2018.
Tax Reform: Uncharted Waters
While tax reform is a welcome friend for corporate America, we have to acknowledge that this also puts us in uncharted waters. Looking back, there has never been a time in history where the U.S. has injected fiscal stimulus (tax reform) into an economy that is already healthy. The last major tax reform was in the early 1980’s when the U.S. economy was trying to dig itself out of the long 1970’s recession.
When the economy is in a recession, the U.S. can either inject fiscal stimulus or monetary stimulus to get the economy growing again. The U.S. used monetary stimulus to dig us out of the Great Recession of 2008 – 2009. They lowered interest rates to basically 0%, pumped cash into the economy in the form of bond buying, and provided a financial back stop for the U.S. banking system.
These economic stimulus tools are similar to the concept of giving a patient in a hospital a shot of adrenaline. If a patient is flat lining, it provides that patient with a huge surge of energy. The patient’s body goes from 0% to 60%+ in under a minute. So what happens when you give someone who is completely healthy a shot of adrenaline? Do they go from 100% to 110%? My point is a healthy patient does not go from 100% to 160%. Both patients get a boost but the boost to the healthy patient is much lower as a percentage of where they started.
While we have never given the U.S. economy an adrenaline shot after a long economic expansion, I think it’s reasonable to apply the same general concept as our two hospital patients. Tax reform may very well lead to another year of positive returns for the stock market in 2018 but I think it’s very important for investors to set a reasonable expectation of return for the U.S. equity markets given the fact that we are injecting growth into an economy that is already at “full employment”.
Not Enough Workers
One of the greatest challenges that the U.S. economy may face in 2018 is a shortage of qualified workers. Prior to tax reform being passed, companies both large and small, have had plenty of job openings but have not been able to find the employees with the skills necessary to fill those positions.
For example, if Apple had 1000 job openings in November 2017 just to meet the current demand for their goods and services but in 2018, due to tax reform, consumers have more money to spend, and the demand for Apple products increases further, Apple may need to find another 2000 employee to meet the increase in demand. They are having trouble now finding the 1000 employees to meet their current demand, how are they going to find another 2000 quick enough in 2018 to meet the increase in demand? If they can’t make the phones, they can’t sell the phones. Fewer sales equals less revenue, which equals less net profit, which may lead to a lower appreciation rate of the stock price. For disclosure purposes, I’m not picking on Apple. I’m just highlighting an issue that may be common among the companies that make up the S&P 500 Index if tax reform leads to a spike in demand in 2018. If Wall Street is expecting accelerated earnings, how are the companies expected to deliver those enhanced earnings without the employees that they need to increase supply?
The unemployment rate in the U.S. is currently 4.1%. You have to go all the way back to the late 1960’s to find an employment rate below 4%. So we are essentially at “full employment”.
Rising Wages
The blue line in the chart above is also very important. The blue line represents wage growth. This answers the question: "Are people making more for doing the same amount of work?" If you look back historically on the chart, when the unemployment rate was falling, typically wage growth was increasing. It makes sense. When the economy is good and the job market is healthy, companies have to pay their employees more to keep them. Otherwise they will go work for a competitor, who has 10 job openings, and they get paid more. Wage growth is good for employees but it's bad for companies. For companies, employee wages are usually their largest expense. If you increase wages, you are increasing expenses, which decreases profits. Lower profits typically results in lower stock prices. Companies in 2017 had the luxury of strong demand but limited wage growth. My guess is you will begin to see meaningful wage growth in 2018 as companies see an increase in demand as a result of tax reform and end up having to raise wages to retain and attract employees. This is just another reason why 2018 may be a good year for the stock market but not a great one.
What Fuels GDP Growth?
Gross Domestic Product ("GDP") is the economic indicator that is used to measure how much the U.S. economy produces in a year. It's how we gauge whether our economy is growing or contracting. Since March 2009, the GDP growth rate has averaged about 2.2% per year. This is subpar by historic standards. In most economic expansions, GDP is growing at an annual rate of 4%+.
Before we get into what pieces of tax reform may help to increase the GDP growth rate, let us first look at what GDP is made of. Our GDP is comprised of 5 categories (for my fellow econ nerds that assign 4 categories to GDP, we split capital spending into two separate categories):
Consumption or "Consumer Spending" 69.1%
Government Spending (includes defense) 17.3%
Investment (ex-housing) – "Business Spending 12.7%
Housing 3.8%
Net Exports -2.9%
Consumer Spending (+)
Consumer spending which makes up 69.1% of our GDP should increase as a result of tax reform in 2018. In general, if people have more discretionary income, they will spend all or a portion of it. Tax reform will lower the tax bill, for not all, but many U.S. households, increasing their disposable income. Also, if we see an increase in wage growth in 2018, people will be taking home more in their paychecks, allowing them to spend more.
Dr James Kelly, the chief economist of JP Morgan, made a very interesting observation about the evolution of the tax bill. When the tax bills were in their proposed state, one for the Senate and a separate bill for the House, each bill to stay under the $1.5 Trillion 10 year debt cap reduced taxes by about $150 Billion dollars per year. 50% of the annual tax reduction was going to businesses with the other 50% going to individual tax payers.
In order to get the bill passed before the end of the year, Congress was forced to shift a larger proportion of the $150 billion in tax brakes per year to individual taxpayers. In the tax bill’s final form, Dr Kelly estimated that approximately 75% of the tax reductions were now being retained by individual taxpayers with only 25% going to businesses. With a larger proportion of the tax breaks going to individual taxpayers that could increase the amount of discretionary income available to the U.S. consumer.
Government Spending (Push)
The anticipated increase in government spending really stems from the Trump agenda that has been communicated. One of the items that he campaigned on was increasing government spending on infrastructure. At this point we do not have many details as to when the infrastructure spending will begin or how much will be spent. Whatever ends up happening, we are not forecasting a dramatic increase or decrease in government spending in 2018.
Investment - Business Spending (+)
Even though business spending only represents 12.7% of our GDP, we could see a sizable increase in spending by businesses in 2018 for the following reasons:
Corporate tax rate is reduced from 35% to 21%
The repatriation tax will allow companies to bring cash back from overseas at a low tax rate
Prior to tax reform, companies already had historically high levels of cash on their balance sheet. What are they going to do with more cash? (See the chart below)
If having more cash was not a large enough incentive by itself for companies to spend money, the new tax rules allowing immediate expensing of the full cost of most assets purchased for the next five years should be. Under the current tax rules, when a business purchases a new piece of equipment, a fleet of trucks, office furniture, whatever it is, the IRS does not allow them to deduct 100% of purchase price in the year that they buy it. They have to follow a "depreciation schedule" and they can only realize a piece of that expense each year. The current tax rules put companies at a tax disadvantage because companies are always trying to shelter as much income as possible from taxation. If Company XYZ buys a piece of equipment that cost $1,000,000, the IRS may require Company XYZ to depreciate that expense over a 10 year period. Meaning they can only realize $100,000 in expenses each year over that 10 year period, even though they already paid the full $1,000,000 for that new piece of equipment.Under the new tax reform, if Company XYZ buys that same new piece of equipment for $1,000,000, they can deduct the full $1,000,000 expense against their income in 2018. Whoa!!! That's huge!! Yes it is and it's a big incentive for companies to spend money over the next five years.
Housing & Net Exports (Push)
We do not expect any significant change from either of these two categories and they represent the smallest portion of our total GDP.
Watch GDP In 2018
The GDP growth rate in 2018 may give us the first indication as to how many "extra innings" we have left in this already long bull market rally. If we do not see a meaningful acceleration in the annual growth rate of GDP above its 2.2% average rate, the rally could be very short lived. On the flip side, if due to tax reform consumer spending and business spending leaps forward in 2018 and 2019, we may be witnessing the longest economic expansion of all time. Time will tell.
Share Buybacks
You will undoubtedly hear a lot about “Share Buybacks” in 2018. Remember, U.S. corporations will most likely have piles of cash on their balance sheets. Instead of spending that money on hiring new employees, buying new equipment, or building a new plant, what else might they do with the cash? The answer, share buybacks.
If a public company like Nike has extra cash, they can go into the market, purchase their own stock, and then get rid of those outstanding shares. Basically it increases the earnings per share for the remaining shareholders.
Example: Let’s assume there are only 4 shares of Nike owned by 4 different people and Nike is worth $100,000. That means that each shareholder is entitled to 25% of that $100,000 or $25,000 each. Now because of tax reform, Nike has $50,000 of extra cash just sitting in its coffers that it otherwise would have paid to the government in taxes. Nike can go into the market with $50,000, purchase 2 shares back from 2 of the shareholders (assuming they would be willing to sell), and then “retire” those two outstanding shares. After that is done, there are 2 outstanding shares remaining but the value of Nike did not change. So the two remaining shareholders, without paying anything extra, now own 50% of Nike, and their shares are worth $50,000 each.
Share buyback may push stock prices higher from a simple math standpoint. If the formula is the value of the company divided by the number of shares outstanding, the fewer shares there are, assuming the value of the company stays the same, the price per share will go up. The incentive for these share buybacks will most likely be there in 2018. Not only will companies have the cash but share buybacks are a way that public companies can reward their current shareholders..
Is The Stock Market Too Expensive?
The P/E ratio of the S&P 500 Index is another barometer that investors will need to keep a close eye on in 2018. P/E ratios help us to answer the questions: “Is the stock market cheap, fairly valued, or expensive at this point?” The “Forward P/E Ratio” divides the price of a stock by the estimated future 12 months of earnings. The average Forward P/E ratio for the S&P 500 Index between December 1989 – September 30, 2017 was 16.0. As of December 22, 2017, the Forward P/E ratio of the S&P 500 Index is 19.99. In other words, it’s running at 25% above its 25 year historic average. See the chart below:
Conclusion, the U.S. stock market is not “cheap” and it’s a stretch to even classify it as “fairly valued”. I think we are well into what I would consider “expensive territory”. What does that mean for investors? You have to stay on your toes!!
Now, we have an anomaly in the mix with tax reform and history does not speak to how this could play out. If tax reform leads to an acceleration in corporate earnings, that in turn could slow the steady climb in the P/E ratio of the S&P 500 because earnings are the denominator in the formula. If stock prices and earnings are accelerating at the same pace, the stock market can go up without a further acceleration of the P/E ratio. Thus, keeping the stock market from becoming more overpriced and further increasing the risk of owning stocks in the S&P 500.
Summary
In 2018, investors should keep a close eye on the U.S. GDP growth rate, the level of spending by corporations and consumers, the volume of share buybacks by U.S. companies, and the P/E ratio of the S&P 500 Index.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
Attention Middle Class: The End Is Near
I'm not a fan of conspiracy theories and I'm not a fan of "doom and gloom" articles. However, I feel compelled to write this article because I want people to be aware of a trend that is unfolding right now in our economy. This trend will strengthen over time, we will cheer for it as it's happening, but like many great things in history, it may have an
I'm not a fan of conspiracy theories and I'm not a fan of "doom and gloom" articles. However, I feel compelled to write this article because I want people to be aware of a trend that is unfolding right now in our economy. This trend will strengthen over time, we will cheer for it as it's happening, but like many great things in history, it may have an unintended consequence. I fear that the unintended consequence of this new trend will be the elimination of the U.S. middle class.
More Profits
I’m an investment advisor so I naturally love a strong bull market that results in large investment gains for our clients. The stock market generally goes up when companies are more profitable than the consensus expects. Higher profits equal higher stock prices which equal more wealth for investors. Corporations have become laser-focused on findings new ways to increase profits. This is important because businesses that struggle to make profits and have constant losses are not so successful and will probably end up shutting down in the near future, according to websites like https://www.laraedo.com/signs-that-my-business-is-ripe-for-a-shutdown/. The equation for net profit is easy:
Revenue – Expenses = Net Profit
Let me ask you this question: What is typically a company’s largest expense?
Answer: Payroll. Said another way, the employees. Salaries, benefits, the building to house the employees, training, workers comp, payroll taxes, and the list goes on and on. If you are the owner of a company that makes cell phones and I told you that I have a way that you can make TWICE as many cell phones with HALF the number of employees, what do you think is going to happen to profits? Up!!! In a big way.
The scenario that I just described is not something that might happen in the future, it’s something that is happening right now. Here is the data to support it.
The chart below compares the 10 largest companies in the S&P 500 Index in 1990 to the 10 largest companies in the S&P 500 in 2016. First, you may notice that none of the companies that were the largest in 1990 remained on the list in 2016. But here is the trend that I want to point out. When you look at the 10 largest companies in 1990, they produced $368 Billion dollars of revenue and employed 1.4 Million workers. Fast forward to 2016, the top 10 largest companies produced $1.2 Trillion dollars in revenue and employed about 1.6 Million workers. Now let’s do some quick math, between 1990 and 2016 the gross revenue of the largest 10 companies in the S&P 500 increased by 239% but the number of workers employed by those companies only increased by 14%. Companies are already doing more with less people.
Just when you thought things were going good for the company, I now come to you, the owner of the company, and tell you I have a way to make profits double within the next 3 years. Are you interested? Of course you are. All we have to do is buy these three machines that will replace another 50% of the employees. These machines work 24 hours a day, don’t need health insurance, don’t get sick, and we can move to a smaller building which will reduce rent by 60%. How is that possible? Welcome to the party…..artificial intelligence.
Not A Terminator Movie
What do we think of when we hear the words “artificial intelligence”? Terminators!! Fortunately for us that’s not the artificial intelligence that I’m referring too. But a machine that thinks and learns from its mistakes? The human mind is not as unique as we would like to think it is. Just take a Myers Briggs personality test. You answer 100 questions and then it tells you how you react to things, what annoys you, what your strengths are, how you communicate, and what you have difficulties with. It’s kind of scary as you read the results and realize “Yup. That’s me”
Think about it. Google may know more about you than your spouse. What do you want for Christmas? Your spouse may not know but Google knows all of the items that you looked at over the past 3 months, what items you spent the most time looking at, did you click on the description to read more, and what other items did you look at after you click on the initial item. It tells Google how you search for information. Also Google acknowledges that we all search for things differently and what we are searching for tells Google more about us. Essentially Google learns at little bit more about you every time you search for something via their website.
What about a machine that can respond to questions and it sounds just like a person when it speaks? Oh and it speaks perfect English. No more overseas call centers with people you can’t understand. With most call centers, there are probably 20 questions that represent 80% of all the questions asked. If the machine is unable to answer the question, it automatically routes that call to a living, breathing person. The programmers of the machines are notified when a question triggers a transfer to a live person, they listen to the call, and then update the software to be able to answer the question the next time it is asked. The easy math, this could reduce the number of customer service representatives that the company needs to employ by 80%. Oh and the number of employees will continue to decrease as the machines learn to answer more questions and the software gets more sophisticated.
While a company may go this direction to reduce expenses, we as the consumer will also champion this change. Think about how painful it is to call the cable company. What if I told you that when you call you won’t have to wait on hold, the “person” that you are speaking to will know how to resolve your problem, and you will be off the phone in less than 2 minutes. Time is a valuable commodity to us. Fix my problem and fix it quickly. If a machine can do that better than a real person, be my guest. If companies want it and we as the consumer want it, how fast do you think it’s going to happen?
I Can't Be Replaced By A Machine.....Wrong
While we will cheer how the new A.I. technology saves us time and makes life easier, many of us will have the hubris that “a machine can’t do what I do?”. While a machine may not be able to replace 100% of what you do, could it replace 50%? It’s going to be presented like this, “you know all of those daily tasks that you don’t like to do: paperwork, scanning forms, payroll, and preparing financial reports for the weekly managers meeting. Well you don’t have to do those anymore.” Yes!!!! Oh and more good news you don’t have to train a new employee to complete those tasks and wonder if they are going to leave a year from now and have to train someone else.
Programming a machine to complete a task is not too different from training a new employee. When you hire a new employee many of them may know very little about your industry, they have no idea how your company operates, how to answer tough questions from prospects, etc. You have to train them or “program” them. Then they learn on the job from there. The value of having 20 years of experience is you have seen many difficult situations throughout your career and you learned from your past experiences. The next time the same or similar problem surfaces you know how to react. Normally what you do is you teach those lessons to each new manager and employee over and over again. That takes time. What if you only had to teach that lesson one more time and every new employee already knew how to react in the same tough situation? That’s artificial intelligence.
My point, this trend will not be limited to just manufacturing or customer services. This new technology will eventually impact each of our careers in some way, shape, or form.
3 Stages
I expect this to happen in three stages.
Stage 1: Companies do MORE with only a FEW MORE employees
Stage 2: Companies do MORE with the SAME number of employees
Stage 3: Companies do MORE with LESS employees
We are already through Stage 1 and we are entering Stage 2. How long will it be before we reach stage 3? That’s anyone’s guess. But with most evolution, Stage 1 takes the longest and the following stages evolve more rapidly. If Stage 1 took 16 years, my guess would be that stage 3 will be here a lot sooner than we think.
So What Happens To All Of The Employees?
The million dollar question and I don't know the answer. If I had to guess, the current middle class is going to be divided into two. Half of the middle class is going move up into the "upper class" and the other half will be "unemployed". The level of education will be the dividing line. Companies will continue to do more with less people. The only way to stop it is to tell companies that need to stop trying to be more profitable. Good luck. Our entire economy is built on the premise that you should accumulate as much as you can as fast as you can.
War and Conflict
When I look back in history, major conflicts arise when there is a large deviation between the “Have’s” and the “Have Not’s”. The fancy name that is used today is “income inequality”. When you have a robust middle class, everyone has something to lose if a conflict arises because that conflict generally disrupts the current system, uncertainty prevails, the economy goes into a recession, people lose their job, and they in turn cannot make their mortgage payment.
If instead, a majority of the population is unemployed and they can’t find a job because the jobs don’t exist anymore, that group of individuals has nothing to lose by burning the current system to the ground and rebuilding a new one from the ashes. I know that sounds dark but there is no arguing the gap between the Have’s and the Have Not’s is getting larger. Just look at the labor participation rate:
The Labor Participation Rate answers the question, how many people in the U.S. that could be working either are working or are looking for work? If there are individuals who could work, don’t have a job, and stop looking for work, they drop out of the labor force which decrease the labor participation rate because there are less citizens participating on the work force. As you can see in the chart above, in 2006 the labor participation rate was around 66%, and while we continue to experience one of the longest economic expansions of all time, the labor participation rate is still lower now than it was prior to the beginning of the economic recovery. Remember we are in an expansion and it has dropped by about 3%. What do you think will happen when we hit the next recession? While the baby boomer generation has had an impact on these numbers as you can see based on the large percentage of that decrease attributed to an “aging population”. Traditionally when someone retires, the company will promote the person below them and then hire another person to fill there spot. As many of us know, that’s not how it works anymore. Now that key employee retires, the company promotes one person into their role, but instead of hiring a new employee they just redistribute the work to the current staff. If anything, the baby boomer generation moving into retirement has made this transition to “do more with less people” easier on companies because they don’t have to fire anyone.
Tax Reform Will Accelerate The Trend
If you combine tax reform with the current 4.1% employment rate, I would expect this to accelerate the development of artificial intelligence. Companies are going to have cash from the tax savings to reinvest into new technologies which includes artificial intelligence. If the economy continues to grow at its current 2% pace or accelerates, one would expect consumption to increase which increases the demand for products and services. With the unemployment rate at 4.1%, we are already at "full employment". There are not enough qualified workers for companies to hire to meet the increase in demand for their product or service. The answer, let's accelerate the development of artificial intelligence that will allow the company to enter Phase 2 which is "Do MORE with the SAME number of workers".
People Will Cheer
These advances in technology are potentially setting the stage for levels of profitability that companies have only dreamed of. Higher profits traditionally equal higher stock prices. Investors will cheer this!! It may even lead us to the longest economic expansion of all time. In the short term, investors may have a lot to be excited about but we may look back years from now and realize that we were unintentionally cheering for the end of the middle class as we know it.
Again, this article is not meant to be a “dark cloud” or a new conspiracy theory but rather to keep our readers aware of the world that is changing rapidly around us. Like many of the economic challenges that the U.S. economy has experienced in the past, the hazard was in plain view, but investors failed to see it because they got caught up in the moment. When investing, it’s ok to take advantage of short term gains but never lose sight of the big picture.
About Michael.........
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
