There is an eerie sense in the market these days as five mega-technology companies power higher while the rest of the stock universe is treading water or floundering. The big five are Netflix, Facebook, Amazon, Apple and Alphabet (formally Google). The technology index to which these companies belong advanced 6.3% during the second quarter and is up 8.8% since the start of the year. Conversely, the largest U.S. industrial companies eked out a meager 0.7% rise during the second quarter and are down 1.8% year to date. Over half of the 30 blue chip companies in the Dow Jones Industrial Average sell more than half of their goods and services outside the U.S. so they are highly dependent upon the free movement of materials and global supply chain, conditions now at risk if there is a trade war. The total U.S. stock market index was up 2% through June 30th due to price advances in the five companies named above.
The implication of the divergence of the stock performance of this handful of companies from the rest of the pack is important. With the current U.S. stock bull market almost 10 years old, the government’s gamble on stimulating growth through tax cuts, regulatory changes, and now trade negotiations are worth examining. Much of this commentary will be devoted to trying to understand the reality behind the posturing of politicians around the world in response to the President’s desire to “make America great again.”
One worrisome trend is that much of the investing public is piling into index funds, many of which would have zero returns if it were not for the 5 mega-technology companies. The broad based Standard & Poor’s 500 performance has also been skewed towards the big five’s dominance since the technology sector has grown so much relative to traditional companies such as utilities, consumer staples and healthcare. Should technology companies falter, many index investors will be surprised by a rapid decline in what they now perceive to be “safe” holdings.
The international stock markets are now mired in negative territory with global indexes, those that exclude the United States, down 4.6% year to date. Even the economic power house of Germany’s stock market is down 4.7% so it appears that Trumpean economic saber rattling is unsettling our allies and competitors more than U.S. investors and for good reason. The U.S. remains the economic powerhouse of the world and even though interest rates are higher here than overseas, most investors have a high degree of confidence in the U.S. economy.
In the bond area, U.S. bonds have declined 3.26% so far in 2018 due to rising interest rates. The benchmark 10-year U.S. treasury ended the second quarter at 2.85%. International bonds, in particular the emerging markets, had a much rougher go of it. Due to their high degree of reliance on the U.S. dollar, emerging market bonds declined 9.98% while the composite performance of all international government bond markets was flat – neither gaining nor declining.
In the commodity markets, natural gas continued to plummet, losing 21% of its value so far this year. Oil staged an impressive recovery, at least temporarily, rising almost 20% during the first six months of 2018. Gold and silver continue to underperform stocks, declining between 3% and 5%. Precious metals seem to have lost their luster over the last decade.
The Federal Reserve Bank has pledged to continue raising U.S. interest rates slowly, one quarter of 1% at a time, in order to give U.S. policy makers increased flexibility when the next recession arrives. So far, stock markets have barely reacted to this upward movement in rates, so investors have not yet been adversely affected by the new interest rate climate. It is crucial to the Trump administration that the U.S. economy grow more than 4% per year so that the potentially negative effects of the 2017 Tax Act and stimulus program don’t result in a huge bump up in our national deficit. The Federal Reserve Bank of Atlanta reported second-quarter GDP growth at 4.8% which is a good sign though no one knowledgeable about economics really thinks of this short-term effect as sustainable. Real estate markets in many parts of the country continue to boom as the result of an increased sense of wealth among financial asset holders.
The good news on the employment front is that the U.S. work force participation rate ticked up for the first time in a decade and is projected to continue to do so. This means that people who formally had given up looking for jobs are reentering the workforce. There are now 6.7 million unfilled job positions in the United States so if every person who is unemployed and looking for work actually had the requisite skills, there would be work for everyone. Unfortunately, the technical skills and math/science background required by many of the jobs that are available are not widespread amongst people graduating from American high schools. We hope the community college system around the country can help train workers for these kinds of positions but many lack the funding to accomplish this all important goal.
Global Trade War
The biggest headline in the economic news is the likely beginning of a trade war as retaliatory actions on the part of major foreign governments against the United States in response to the Trump administration’s strident position on China and Europe continue uncompromisingly. People have assumed for the last 50 years that world trade is a good thing for most consumers. The World Trade Organization (WTO), the successor to the post-World War II era’s General Agreement on Tariffs and Trade, is under fire by the Trump administration. It’s not unusual for politics to find its way into the trade court system which is supposed to deliver justice to aggrieved nations. The Trump administrative policy is to starve the WTO of personnel and funding because of its perceived anti-U.S. bias.
The current world trade disputes seem to be the product of the U.S. threatening a barrage of tariffs on most imports and this has slowed down both Chinese and European exporting activity. The President’s antagonistic tone has taken its toll on the NAFTA negotiations, thereby producing a backlash from Canada and Mexico. Business people understand that adversarial negotiating tactics can be effective in achieving one’s underlying goals, so it could be that Trump is talking up a trade war in order to extract concessions from our “friends” and “enemies” alike.
The mathematics of trade are fairly straight forward – if a country consumes more than it produces, it will have a deficit, and this is certainly the case in respect to the United States. A reduction in our deficit with the Chinese would mean that our deficit with some other nation would increase. The only way to change this is for U.S. consumers to buy less foreign goods and services, save more or become more productive through education or innovation.
One main goal of the U.S. trade negotiators’ efforts is to deal with the long-standing and ongoing problem of Chinese theft of intellectual property. Thus far, nothing has dissuaded Communist China from stealing other nation’s industrial secrets which they use to buttress the fortunes of their state-owned enterprises. The Chinese require all companies that do business on mainland China to surrender their intellectual property to obligatory local partners. This means that China doesn’t compete through its own research and development. No one knows if China has the ability to achieve their goal of world domination in the biotechnology, artificial intelligence, robotics, quantum computing, advanced weapons technology, ocean mining, militarizing space, and nonpetroleum energy production based industries based on their own steam. Economic supremacy in the mid-to-late 21st century will depend on this battle and the way things are happening now, they can cheat their way to victory.
This conflict will produce casualties and one hears many justifiable complaints from businesses that stand to be adversely affected by a trade war. From Maine lobstermen to car manufacturers in the deep South, escalating tariffs and retrenchment on free trade agreements will have an adverse effect on certain companies and industries. Consumers in the U.S. will feel the impact of a trade war. U.S. importers of goods will be more affected than companies who export to China from the U.S. Domestic industries such as film studios and real estate developers, who have come to rely on Chinese funding, stand to see a slowdown in their ability to get funding to expand or sustain their current level of business activities. Will Americans buy fewer imported cars as they become more expensive? Probably, but certain European models such as SUVs are already built in the United States. Our ability to export passenger cars made in the United States to other places around the world will diminish, thereby endangering jobs in the U.S. auto industry.
We depend on foreign nations for some of our government’s financing. It is difficult to predict the potential impact of trade wars on the flow of funds between investors and cash hungry nations around the globe. Americans are not savers, and since there is no way the U.S. government is going to run smaller budget deficits under the Trump administration, our ability to borrow funds from overseas may be constrained by political backlash. Continuing to run huge trade deficits with the Chinese means that China has already amassed ownership of trillions of dollars of U.S. government debt. The Chinese are attempting to acquire as many U.S. technology companies as they can with their large stash of U.S. cash.
Since 2012, China has purchased over 600 American technology companies worth over $20 billion through a nationalistic venture capital fund based in Silicon Valley. The Chinese have also funded 300 U.S. startup companies including 25 firms specializing in artificial intelligence inside the United States. At the same time, they are actively soliciting recent graduates of U.S. technology and science programs to leave the United States and come to China to start companies there. The U.S. has good reason to try and stop many of these efforts so that 20 years down the road, we don’t find ourselves without domestic capacity in key industries. Constraints on capital flows may follow tariffs in a second round of trade conflict.
For many years, Europe has unfairly levied higher tariffs (10%) on U.S. car imports than the U.S. has charged on European imports (2 ½%). Therefore, the goal of equalizing tariff rates may be seen as reasonable and fair. Harley Davidson recently announced that it would shift some production outside the U.S. to avoid the cost of new European tariffs to be levied on U.S. goods in retaliation for Trump’s actions. We import six times as much value in cars than we do in steel so it’s not hard to understand how unfair tariffs have helped Germany and other Northern European countries in the past.
The Big Picture
Stepping back, let’s try to make some sense of what achievable goals and long-term benefits might possibly accrue to the U.S. in a trade war. Everyone knows that manufacturing jobs are not coming back to America as a result of trade negotiations. We also know that changes in technology have already created opportunities for highly paid knowledgeable workers as well as many lower paying jobs in the service, construction, and healthcare industries in certain regions of the country. Ultra-low interest rate policies over the last decade have created an ongoing real estate boom in the 25 U.S. markets identified in the following chart. These growing areas have, as their common basis, increasing employment opportunities in industries that would only be marginally impacted by tariffs or a trade war.
The President is a real estate developer with cutthroat instincts and “keep them guessing” tactics. His goal is to be seen as creating a strong economic growth environment. If his tax cut and looser regulatory experiment fails, he will not be reelected so everything he does is based on his drive to negotiate a great deal. He is not constrained by rules of good behavior, statesmanship or other behavioral patterns that most presidents have tried to embody. Because this president is by nature a maverick, the rest of the world, the media and even his own people are purposefully kept off balance. It remains to be seen if this unorthodox behavior helps America advance in the world economy. Trump’s haranguing European leaders to shoulder their fair share of the cost of mutual defense burden is not politically motivated or thought about in terms of strategic alliances. Everything is part of his struggle to achieve economic advantage.
Most educated people know that the trade wars are bad and that immigration policies that bring talent, money, and entrepreneurial spirit into a country are good. The administration’s efforts to stem illegal immigration is pandering to his political base and is more useful in keeping his adversaries off guard as to achieve any particular outcome. Trump’s frequent switch of his position and ever-present position at the center of media attention is an attempt to be in control of the topic and message. His admiration for Putin is based on their shared use of tactics that threaten, cajole, and entice.
To understand current events, watch for actions and results as opposed to the rhetoric. The 2017 Tax act has been beneficial for corporations and some of that is trickling down into the general economy. Talking with North Korea directly, withdrawing from the Iranian nuclear pact, and asking Europe and China to deal with America on fair terms are consistent economic actions. The jury is out as to whether any of these strategies will be successful but none of the goals are unreasonable.
There will continue to be casualties of Trump’s combative style: immigrant families, environmental standards, and the U.S. deficit. Mapping out the reality of the country’s condition is difficult due to misinformation and rampant divisiveness, but here is a summary of a few issues:
China as an economic and military competitor is gaining on the U.S. and our importing their products feeds China’s wealth and allows them to disregard international rules of trade and borders. Tariffs may work to lessen China’s advantages, but little middle ground exists for compromise. Europe has relied on the U.S. military for 70 years. The EU’s current unfair trade practices have withstood previous U.S. efforts to negotiate and to do so, America’s appetite for European luxury items needs to moderate.
The migration of jobs to Mexico under NAFTA is real and likely irreversible. Unskilled Americans will likely not get to return to their living standards of the 1960-1970 era. Scapegoating Mexico and Canada is ineffective and will likely backfire if the agricultural, food service, and construction industries run out of low cost labor. The cost of effectively implementing effective border control will never get passed on to Mexico. After the mid-term elections in November, no budget approval for a “wall” from Congress will be forthcoming.
Rob: Most of my business travel involves checking in with various people and business projects across the country. Wherever I go, it’s important to get outside and have some kind of fun with my hosts. This past quarter, I began what may become a regular back-country adventure on The Pacific Crest Trail. A friend and I started at the U.S.-Mexico border and we hiked 110 miles in 5 days up to Warner Springs, CA, where I hope to return for the next leg of the 2500-mile journey.
Anthony: Our daughter Amaya recently turned three. This year was especially fun for her because she got to choose the theme of her party which was Unicorns. She had lots of fun playing with her cousins and singing Happy Birthday to herself. We continue to take advantage of the new home and backyard by hosting parties and family get togethers. We are also played host to some out of town family members for the 4th of July holiday. Since the City of Santa Fe has moved the annual fireworks show to the Santa Fe Place Mall, we enjoyed a great view from the comfort of our own home.
Patrick: As the summer rolled in with longer days and hotter temperatures, I continued my volunteer efforts at ARTsmart (www.artsmartnm.org), shifting into high gear as Board President. Our annual Edible Art Tour was a success as everyone seemed to enjoy walking downtown and on Canyon Road to see art and taste the scrumptious food provided by local restaurants. We appreciate the generous folks who show up to support the event and it definitely gives one hope for the future of our community. In July, I will be taking a vacation and heading up to Montana to take pictures, float rivers, mountain-bike, and relax with my friends.
Kyle: In May, I graduated from Leadership Santa Fe, an eight-month program with workshops focused on building leadership skills along with sessions dedicated to various civic awareness topics. I was honored to be selected as one of the graduation speakers where I was able to speak on the impact of the program. The school year ended for my kids and they started right into the summer program at the Genoveva Chavez Community Center. This year, the boys will be participating in a full slate of sports including volleyball, soccer, golf and baseball.
Contessa: The spring season started off with a promise of outdoor adventures as a failed attempt at a long-planned backpacking trip to bottom the Grand Canyon led to the exploration of the Kaibab National Forest and an aerial excursion above the canyon. This led to a renewed desire to climb down the Bright Angel Trail in the future. The hot weather in Santa Fe has prompted the U.S. Forest Service to close trails which limits access to some favorite summer activities, but this has given my family an opportunity to focus our attention on projects around our house. It has also helped me reflect upon the things in life I’ve always for granted such as the blessings that moisture provides for all living things around us. With that said, I hope to report on the dramatic change in moisture patterns affecting the state when I update you this Fall.
Keren: The first part of summer has seen an extension of my duties as Treasurer of the Acequia Madre PTC Board. I served on the hiring committee for a new Principal for Acequia Madre Elementary School and a new After Care program to the school. Kyle and I attended Opening Night at the Santa Fe Opera as part of the Opera Business Council and Contessa, and I will be presenting a personal financial management seminar to the opera apprentices at the end of August. My son and I spent a week in NY eating dim sum, visiting museums of Natural History and attending a Broadway show. We even got to go backstage to visit with Renee Fleming. I am excited about the 2018 Santa Fe Opera season and looking forward to attending a Schwab conference in San Francisco in August.
Jeff: We continue with the renovations and projects at our new house which is located a few miles south of the City limits. There are endless makeover projects inside and it needs new decks and portals outside. We have remodeled several houses in the past and are reluctantly acknowledging that we just might be a bit “older” this time. Oh well, we will get there even if it takes longer!
Gayle Johnson: I am grateful for the team at Rikoon, and for my loyal clients, in helping with this exciting transition! We are normalizing and back to our daily routines and client reviews, and appreciative of your patience as we moved through growing pains. In June, I had the pleasure of attending my granddaughter Claire’s princess/unicorn 4th birthday party in Denver, accompanied by her (sleeping) 7 month old sister Violet. I have enjoyed a couple trips to the lake with friends on my boat; New Mexico lakes continue to provide adventure and stories to tell. I am thankful we have been blessed with rain, both here in Santa Fe, and at my family farm and ranch in North Dakota. The Midwest will always be in my heart; in October I will celebrate my 33rd year in New Mexico!
Please join us for our quarterly gathering at 2218 Old Arroyo Chamiso in Santa Fe to discuss economic and market related events on Wednesday, September 19th from 3:30 to 5 p.m. (MT). The call-in ”tea” will occur on Thursday, September 20th from 3:30 to 4:30 p.m. (MT). The call-in number is 719.234.7872, code: 470070#.