From the Desk of Joe Rollins
It seems like every time I turn on the TV the financial news reporters are hyperventilating over tariffs. I, on the other hand, have never quite grasped the urgency of the matter. From a philosophical standpoint, there is absolutely no question that a properly trained economist would not want any type of tariffs on any type of goods being transferred between countries. However, in order for trade to be on a fair and equal basis, it must be in a totally free economy, where governments do not control companies and competition. Unfortunately, that is not the case for China.
There is no question that trading with China has needed reformed for decades. Their capital structure, which owns or controls many industries in China, attempts to compete with U.S. based companies that are not controlled by the government. The end result of that competition is that while the consumer benefits from lower prices, it is detrimental to the U.S. economy in that it transfers goods formerly manufactured in the United States over to China, with the corresponding loss of U.S. jobs. If they were competing on a fair basis, there is no question that the consumer would benefit from the economic windfall; however, for the consumer to win, but the country to lose, is a complete misnomer and not good for the United States.
The media’s overreaction to this tariff matter is almost mindboggling. I often fear that investors get all of their financial information from just reading the headlines or on social media. Too many investors do not bother to do their own research to determine whether the severity of this situation warrants the incredible volatility that the stock market has suffered through this year. But before I go into more significant details regarding the incredibly negative headlines, I just want to give you one fact.
According to Deutsche Bank, there has been roughly $5 trillion in losses within the equity markets due to the perceived issue regarding tariffs. Just as a basis for comparison, Deutsche Bank points out that this $5 trillion loss equals 12 full years of the bilateral merchandise trade deficit with China. Therefore, in a period of less than 6 months, we have suffered losses in our own equity markets greater than the import export deficit over the last 12 years. If you really want to talk about an overshoot or a lack of understanding of economics, there it is in black and white.
Ava feeding geese in Ohio
Ava on her 8th birthday
Before I launch into more interesting topics, I do have to cover the financial markets for the month of May. Clearly it was a down month in every respect, but the year-to-date numbers are still quite impressive.
There is no other explanation for the economic performance during the month of May other than it was pretty crappy. The Standard and Poor’s Index of 500 stocks was down a cool -6.4% for the month, but continues to be up 10.7% for the year 2019. For the one-year period it is up 3.8%, the 3-year period it is up 11.7 % and the 5-year period 9.7% annualized. The Dow Jones Industrial Average was down -6.3% for the month of May, but it is still up 7.5% for 2019. The one-year returns are 4.1%, three-year 14.4% and five-year 10.9% annualized. The NASDAQ Composite was the big loser of the month as it was down -7.8%, but yet it is up 12.8% for the year 2019. The one-year returns are 1.2%, three-year 15.9% and five-year 13.2%.
As you would suspect, when the equities are down the bonds will be up. The Barclays Aggregate Bond Index was up 1.8% for the month of May 2019, 4.8% for the year 2019, 6.7% for the one-year return, with the three-year up 2.5% and the five-year 2.7% annualized. Even though the one-month numbers were pretty ugly, the year-to-date numbers for 2019 are still quite respectable. As I will explain later, I expect better returns as the year 2019 progresses.
Often times, I feel like the hysteria that you see in the media must be political rather than informative. How could respected journalists actually misinterpret the information and inform the public so poorly that it could be anything other than intentional. It has gotten to the point where the facts are completely drowned out by the noise. Let us take the recent proposed increase in tariffs between the United States and Mexico, for example. You would have thought that an economic disaster was imminent given the reaction in the media. But wait a minute, did you even bother to look at the facts or did you actually sell before you understood?
I am reminded of the recent quote by Warrant Buffet’s 95 year old right-hand man, Charlie Munger, who has demonstrated economic prowess for the majority of his life. While Charlie has openly supported Democrats over the years, he recently expressed that “Donald Trump is right on (immigration).” At the shareholders meeting at the Berkshire Hathaway company, he exclaimed “Democrats are committing suicide…they hate him (Donald Trump) so much that they’re against him even when he’s right. We should have way more control over our borders than we do.”
So, the proposed tariff increase in Mexico was basically a call for help in the immigration disaster that is occurring along the southern borders. This weekend it was announced that over 900 immigrants were crammed into a border control center that was designed for 125 people in El Paso, Texas. There is a bona fide disaster occurring along the borders of the southern United States, but you rarely read about it in the press.
I sit at home sometimes and contemplate what exactly Congress is talking about when it comes to immigration. Surely no one in their right mind wants unlimited immigration into this country, or do they? Does anyone understand the economic effects of trying to take care of all these immigrants during the short-term and then supporting them over the long-term? Do we not have laws on immigration?
These immigrants come to this country with virtually nothing. The U.S. government supports them in every form and fashion after their detention. The cost of supporting them is astronomical and we, the taxpayers, pay every dollar of it. And yet, the elected officials in Congress cannot have a reasonable discussion on the subject since it has become so politicized. Surely, they want to protect our borders.
Notwithstanding the political ramifications of such a move, did you even bother to consider the economic aspects of this transaction? Even though the 5% proposed tariff has not occurred, our financial markets sold off with immediate haste. Did you even realize that the peso declined by 2.7% on Friday? So in just one day, the cost of the 5% proposed tariffs was already reduced by half.
It is also true that there is a high likelihood that these tariffs will never be put in place. It would not be a huge commitment for the Mexican government to make an attempt to regulate the borders, which would postpone such tariffs. They do almost nothing now. But assuming the absolute worst situation, the full tariffs imposed in the automobile industry, according to Deutsche Bank, would be $93 billion. If the auto industry was responsible for the full absorption of this cost and passed this along to the consumer, this would increase the cost of a vehicle by $1,300 per unit sold. Ponder the economic reality of those numbers.
First off, most people do not buy a new car every year. In fact, now the average age of a car in the United States is roughly 9 years old. So the effect of the purchase of new cars would only affect relatively few Americans. I believe that if it costs $1,300 per car to attempt to bring the border matter under control, then that seems like a cost that each and every American should be willing and happy to absorb. I am not sure exactly what it costs to house, feed and provide medical care to the flood of immigrants that are coming across the southern United States border, but I would bet that the $93 billion referenced above would be close.
Let us move on to the Chinese tariffs, where the information is so misleading that I rather suspect that most people do not grasp the economic effect of these proposed tariffs. Let us look at the real numbers as compared to those quoted in the financial press. The only numbers you should evaluate when comparing the U.S. against the China’s economy is nominal GDP. For 2019 the U.S. nominal GDP is projected to be $21.3 trillion, with China’s projected to be $14.2 trillion. So in true economic terms, the U.S. nominal GDP is approximately 50% higher than the Chinese nominal GDP as of 2018.
Josh skydiving for his birthday
What are the true numbers regarding imports and exports from China? During 2018 the United States imported from China roughly $539 million. Correspondingly, the U.S. exported to China $120.3 billion in 2018. The financial media argues there would be an enormous financial effect on the U.S. taxpayer if China no longer imported goods from the United States. Article after article has been about the farmers’ financial disaster because of the lack of exports to China if tariffs are imposed. Farm crops exported to China in 2018 were $5.9 billion. You may have read most recently where the President provided a subsidy of $15 billion to U.S. farmers affected by the lack of exports to China – this amount is 3 times the actual dollars exported to China. More fake news.
What real effect do China tariffs have on the U.S. consumer? Do you realize that if we were to exclude 100% of the exports of China, the effect on the U.S. GDP would be less than ½ of 1%? Why are we so paralyzed by the potential of losing such a small amount of goods?
Let us also evaluate the other side of the transaction. What would happen if 100% of the proposed 25% tariffs were also imposed on all of the goods coming from China to the United States? According to Oxford Economics, the full cost of that tariff would be $62 billion per year on the goods already proposed for the 25% increase. Now listen to the economic effect of this carefully. Based on Oxford Economics, the total out of pocket cost for this increase in tariffs of 25% would only be $490 per household. Based on the media, you would think that this number would be crippling to the U.S. economy. While $490 is a lot of money to some people, to most Americans it is insignificant. I think if the public totally understood the financial implications of getting our arrangements straight with China, they would gladly support this cost (which barely equals double their Netflix monthly subscription fee on an annualized basis).
So, here we are evaluating both sides of the tariff arrangement with China. We recognize that our exports to China are relatively immaterial to the U.S. economy, and that the cost of the tariffs on imports from China is totally immaterial to the average U.S. household. But what else are we not evaluating that should be considered?
During the month of May, the stock of Apple went down 20% because of the perceived problems with the Chinese tariff matter. I recognize the fact that journalists might not be the smartest business people in the world, but surely you must realize that the most profitable company in the world has long since contemplated this issue. Do you really think that Apple has not looked for other means of handling their goods coming out of China? Do you not think that they have adjusted their supply lines from China to Vietnam, India and other Southeast Asia countries? Do you think that the most profitable company in the world is not smarter than the financial analysts that write the headlines?
You may rest assured that Apple, along with most all U.S. companies manufacturing in China, have already evaluated moving their production out of China to a part of the world much more efficient. The longer China holds out to making a deal with the U.S., the more manufacturing that will escape that country and move to more U.S. friendly countries. Yes, it is possible that China could prevent all U.S. imports from occurring and they could also punish U.S. companies that function in China, but it would be to their own detriment.
China is in a situation where they need us a lot more than we need them. Certainly, they could punish U.S. companies operating in China, but that means that Chinese citizens would lose their jobs. If manufacturing and supply lines moved out of China, then who would replace those jobs, and at what cost? The Communist party has been able to control the government in China over the last 30 years for one simple reason. As long as the people are working and they are able to move from the fields to the cities in China, they are happy with the nondemocratic government. But China realizes that they cannot risk putting citizens out of work. That risk would be overwhelmingly negative for their non-representative government. It is my opinion that China will do everything to prevent that from occurring and certainly they will not punish U.S. manufacturers in China if it means higher unemployment for the average Chinese citizen.
I was reading an article the other day in USA Today that made me wonder whether the journalist writing the article did any research whatsoever to base the story upon. Basically, his assumption was that China will get really irritated with the U.S. over this trade matter and “invoke its nuclear option”. No, not nuclear in the way of a military bomb but economically, by selling 100% of the U.S. treasury’s bonds held by the Chinese government. While this article may have been written to scare the average investor, it is certainly not based on any type of economic reality.
First off, it is believed that the Chinese government directly holds over $1 trillion in U.S. Treasury bonds. As a point of fact, there are not enough bonds issued by all of the governments in the world that would be a substitution for these Treasury bonds. For example, if the Chinese government attempted to sell all of these bonds immediately, who would be the buyer? Clearly, a wholesale rush to sell these bonds would lead to much higher returns and losses on these bonds leaving the Chinese with absolutely nowhere to invest the money since there are not enough bonds issued by any government in the world to replace the U.S. $1 trillion.
The principal reason why the Chinese government could never sell the bonds is more basic. If they sold the bonds that would mean that they would be selling their U.S. dollars and converting that money back to their local currency. The effect of that transaction would be to absolutely destroy the valuation of their currency in the world market. When you convert from U.S. dollars to local currency, you dramatically decrease the value of the dollar against your local currency. This would be devastating to the exports from their country, therefore lowering the value of their currency in all worldwide transactions. Certainly not a smart move by the Chinese government even if they just want to inflict pain on the U.S. government. I do not think the Chinese are so dumb that they would make any moves that would be detrimental to their own currency.
This week they once again rolled out the assumption that the yield curve inversion between the 3-month Treasury bills and the10-year notes would certainly mean a recession in the United States. The same people who wrote the article in 2018 were writing it again - that it was a 100% indicator that the economy will fall into a recession when short-term yields are higher than long-term. If you want an example of how silly interest rates have become, consider the facts. At the current time the 5-year Treasury is earning less than a money market account in America. What sane person on Earth would take a 5-year risk on a bond when you could make exactly the same rate of return or even higher on a money market account? Secondly, the dividend rate for the S & P 500 is now greater than the interest rate on the 10-year Treasury. Would you prefer to invest in something that has growth potential or would you rather take a 10-year risk that interest rates will not go up over the next decade? Once again, not a reasonable comparison to the informed investor.
Yet, here we are again. The same people who have forecasted a financial disaster in the fall of 2018 are back again making the same prediction. Do you want to know when the last time that the inversion of interest rates created a market sell-off, followed by forecasts that the U.S. economy would soon be in a recession? That was in September 2018. The so-called experts projected recession would clearly follow and the markets would fall. While it was true that the market fell in the last quarter of 2018, the economy today is as strong as then and clearly shows no signs of decline. No recession in sight. Fake news.
The reason why the 10-year Treasury rate is so low has everything to do with competing interest rates around the world. As of the date of this writing, a 10-year Treasury has a current rate of 2.133%. While that rate is extraordinarily low, by worldwide comparisons it is an extraordinarily high rate. The 10-year bond in Germany has a current yield of -0.207%, in Japan their 10-year Treasury has a current rate of -0.102% and no, that is not a mistake. Those rates are actually negative in both Germany and Japan. Basically, if you buy a 10-year Treasury in either Germany or Japan, at the end of the 10-year period they will give you back less money than you actually invested. Now that is a good deal?
Ava fishing in Florida. After this
picture was taken, I showed her how
to cast and the rod slipped, fell into
the water and sank. I prefer to buy my
fish at the market anyway.
What reasonable investor would make the decision to buy these bonds when they can buy a similar bond in the United States with better credit, yielding 2.133% or higher. The belief now is that there are roughly $10 trillion in government bonds around the world that are yielding negative rates of return. Germany is fighting a potential recession and they are encouraging people not to save money, but rather invest it in the economy. The same has been true for Japan for roughly 20 years as their economy basically sits at breakeven. Therefore, there is a flood of money from the rest of the world investing in U.S. Treasury rates that, while incredibly low, are still the highest in the world at the current time with the very best credit list.
So, to use the words of my nemesis, Dr. Alan Greenspan, when asked why long-term interest rates would not go up, “it’s a conundrum.” You would think by reading the financial headlines that the U.S. economy is a conundrum and therefore susceptible to huge risks. In fact, nothing could be further from the truth.
Low interest rates are extraordinarily favorable to stocks, which we have at the current time. At the beginning of this year, it was estimated that the U.S. S&P 500 companies would earn $171.10 per share during 2018. Since that time, it is now estimated that the S&P 500 earnings for 2019 will now be $175 per share. More importantly, it is projected that S&P 500 earnings in 2020 will be $187, going up 7.5% year over year. Do you recall reading that there would be a huge reduction in corporate earnings this year due to the tariffs and the potential recession? Completely false – fake news.
It is amazing to me that people write headlines, but that they do not check the facts. Let us assume that we only use $175 estimated earnings for 2019 and put a 17 multiple on those earnings; we would expect that the year-end numbers for the S&P 500 would be 2,975. As I write this posting the current valuation of the S&P 500 is 2,752, which would imply an 8.1% gain in that index before the end of the year.
So back to my original thesis as to what is going on in the equity markets. I think, for reasons that are unclear, the media is trying to scare the average investor from their position so that the professionals can take advantage of the upswing in the market that is surely to come. I have no idea what their motivation is to write such negative articles other than maybe they do not have anything else to write about since things are so good. If you evaluate the U.S. economy based on its full employment, extraordinarily low interest rates, and great earnings that are increasing as the year progresses, a higher stock market is almost surely at hand. Notwithstanding there will be high volatility based on headlines, this too will soon pass. While the economy is slower than it was earlier this year, it is still extraordinarily strong.
You should never invest your money based upon current headlines or an analyst’s interpretation of the facts. You should independently evaluate facts and make a determination as to their validity. As of today, nothing has changed. While the volatility is upsetting and it clearly affects your portfolio, the only thing that would create a permanent long-term reduction of the value of your investments would be an oncoming recession. As of today, clearly there is no evidence of such a downturn coming this year.
As always, we encourage you to come in and visit with us and discuss your goals and financial plans. If you are interested in discussing your specific financial situation, please feel free to call or email.
As always, the foregoing includes my opinions, assumptions and forecasts. It is perfectly possible that I am wrong.
Best Regards,
Joe Rollins
