Before settling into the main topic of this writing, let’s spend some time reviewing the economic and markets state of the world. The Federal Reserve (aka – the Fed) recently met for the first time under the leadership of Jay Powell. Succinctly, the Fed updated its economic projections – forecasting stronger growth, lower unemployment and modestly higher inflation, resulting in a .25% higher Fed Funds rate. GDP growth for 2018 is now expected to be +2.7% vs. +2.5%. Unemployment is forecasted to drop to the mid-3% range and core inflation is anticipated to be +1.9%. This is all “pretty strong stuff”, but not so strong as to warrant a faster or higher increase in interest rates than is expected by the markets. This is important. Further, below the reader will find a “Recession Dashboard” recently published by Credit Suisse which clearly demonstrates their positive economic outlook for the US.
Elsewhere in the world, India expects GDP growth exceeding 7% this year, while China looks forward to approximately +6.5%. Germany will grow close to 2.5% and the Eurozone around 2%. Inflation around the world has a bit more “pop” to it, but is still below a level where central banks will get concerned that they are “behind the curve”. The US is leading the move amongst central bankers to become “less accommodative” monetary policy-wise. But no one is close to having a “tight” monetary policy. Money is still cheap and will remain so for some time.
US company earnings are anticipated to increase some 25% in 2018. This includes the beneficial effects of the recently passed corporate tax reduction act. Overseas earnings are expected to be similarly robust. However, with market P/E ratios lower abroad than in America, numerous international exchanges are thought to be of better value than the US. We would concur. We are not saying that the US market is wildly overvalued. We do not believe that, especially after going nowhere in Q1. First quarter earnings “season” is about to start. We think it should be a good one, which will further demonstrate value in the markets. If good earnings do not spark a move up in stock prices, then at least the earnings will provide further support for equity prices, both here and abroad.
Interest rates in the US are up and will continue to increase. The Fed is leading that “charge”. Bond prices concomitantly are down and will continue to be so. It is “the way of the world”. We would only have shorter duration bonds in a portfolio in this environment.
THE MIDDLE KINGDOM……..
China is a force with which to be reckoned – politically, economically, militarily and scientifically. It is the scientific and economic challenges that we wish to discuss briefly here. As an example, let us examine Chinese scholarship in AI (artificial intelligence). According to Michael Wooldridge, Professor of Computer Science at University of Oxford, AI used to be solely within the purview of US academia and business. Remember IBM’s Deep Blue which defeated Russian chess Grandmaster Garry Kasperov. Think today of Watson, also an IBM system. Stanford University, Silicon Valley and DARPA (an agency for US government research expenditures) all have played vital roles in exploring, funding and experimenting with AI. In scientific papers, US academics were for years the predominant authors. In 1980, the first Association for the Advancement of AI conference was held and dominated by US researchers. There was not a paper presented by the Chinese and only some European presence. In 1998, America still dominated the proceedings – but the Europeans made themselves felt and one paper was delivered by the Hong Kong Chinese, a year after Hong Kong reverted to mainland Chinese control. Then in 2018, China’s researchers submitted 1,242 papers as compared to 934 submitted by US scientists. Of the papers accepted, China was only three behind the US. Some readers might consider this a crude “yardstick”. Nevertheless, as a measure, the US is no longer dominant in AI – it is now competitive and competitive with China. Why did we select AI as an example of a changing landscape in scientific competition? Because a growing number think that AI will be as important to the world’s future as was the harnessing of electricity for civilization. AI is an important intellectual pursuit with worldwide consequences and the Chinese are “in the race”.
So now let us look beyond China’s competitive “bona fides” to the current distant drum beat of a trade war with the US. America is China’s largest customer and China is America’s third largest customer. US companies have spent decades establishing supply chains which integrate Chinese manufacturers from low tech shoe soles to high tech computer chips into manufacturing processes. To say that we are embedded with one another would be an understatement. Just announced are two tariff positions – first from the US and a response from China. America, after a 60 day consultation period, if no satisfactory progress has been made in negotiations, will impose a 25% tariff on approximately $50 billion of selected goods. The additional $12.5B charge would equal a price increase of 2.9% on all of China’s US exports. The additional tariff equates to only 0.1% of China’s GDP and affected exports account for only 2.2% of total Chinese exports. So the direct impact of these taxes would seem to be limited. China, in reaction to just the aluminum and steel tariffs, will institute a tax of 15% on approximately $1B of various US products and then could place a 25% tariff on a further $2 billion of American goods. Again, the direct impact of the new Chinese charges on American goods will be very limited. Even the indirect costs of these policies (if enacted) should be quite manageable. In any case, markets around the world did not react well. International trade is the “lifeblood” of the world’s economic system. Messing with it is always a scary idea and we think that it is “the scary idea” that has unnerved investors. Extrapolating a bad idea, which is of no particular consequence today (and we would argue is our present condition) to a future with escalating formidable “trade” battlements is a “step too far” at this juncture. That could be our future – but we don’t think so right now.
The US and China are important to one another. This is obvious. Terms of trade will be renegotiated. This has started. A deal will get done – because this is necessary.
PREDICTIONS FOR 2018
1) Inflation will rise above 2%, using the Fed’s favorite measure. – Still believe, not quite there yet
2) US GDP >+3% & international GDP growth will accelerate. – Still believe – tax cuts of late 2017 not reflected yet in numbers
3) US unemployment will decline to 3.6% & ex-US unemployment will decline. – Employers are hiring, but new workers coming off underemployment rolls
4) US corporate profits +12% with higher profit growth ex-US. – Q1 earnings reports are about to flow, so we’ll find out
5) The dollar will drift lower. – Yes
6) The US bond curve will get “flatter” but not “invert.” – Yes
7) Investment spending will rise again. – Still believe
8) Republicans will take a “political beating” in the midterms. – With several upsets (Alabama, Pennsylvania) in “Red” states, looking more the case
9) Consumer confidence in the US & abroad will stay strong. – Yes – very strong
10) Equity markets will do well, while bond markets will stagnate. – Bonds have stagnated, while stocks “rocketed” early in New Year & have given up gains
A FINAL THOUGHT
The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.
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