Us Versus Them

Economic progress continues in the United States, making the current expansion likely to be the longest since World War II. While investors might be expecting signs that the economy’s momentum is losing its mojo because of its duration, the data coming in is some of the strongest we have seen in this cycle. Recent reports on employment show a continuing expansion of the workforce, a strong increase in average hourly earnings and real Gross National Product well in excess of 3%. In spite of this evidence of economic growth, interest rates and inflation, while increasing, remain relatively low. As a result of reduced taxes and increased spending on defense and infrastructure, the Federal deficit is rising. So far, however, the impact on interest rates has been small. Critics worry that the increase in Federal debt will eventually cause interest rates to rise sharply and stifle housing and capital spending, but that has not happened yet.

Meanwhile, the economic news across the rest of the world is not so favorable. In Europe, where the economy was growing at close to 2% last year, business activity has tapered off. The United Kingdom faces growth of 1%, compared to a level of twice that before the Brexit referendum. In the final Brexit outcome, I expect that the European Union will avoid placing punitive trade measures on the U.K. because both sides would be hurt and they are already vulnerable. Nonetheless, whatever deal is finally negotiated will restrict travel and have a negative effect on the U.K. economy on a continuing basis. Higher tariffs imposed by the United States, plus a natural softening of demand both internally and from China, have caused Europe to slow. In addition, financial problems in Italy have weakened the banks in France and Spain. While the European financial system and the European Union are likely to survive this over the intermediate term, the problem is more serious than the Greek crisis of several years ago. At the beginning of the year, Chinese leaders wanted to slow their economy down somewhat to deal with the non-performing loans on the books of their banks and shadow banks, but demand slackened more than they expected. The renminbi weakened and capital outflows increased. The government has cut taxes and increased monetary expansion to shore up the economy. In Japan, monetary policy continues to be accommodative to maintain growth at 1%.

In addition to all of these economic challenges, the geopolitical environment remains problematic. Extreme political parties are gaining influence in Europe and leaders like Angela Merkel in Germany do not have the power they once enjoyed. The refugee crisis has been a huge source of humiliation for countries in North Africa and the Middle East. War continues and casualties mount in Syria, and an escalation of hostilities against a rebel enclave is being threatened. The Taliban is gaining strength in Iraq and Afghanistan and our relations with Iran and Russia are increasingly strained. The increase in tariffs imposed by the United States on our trading partners has made diplomatic relations across the globe more tenuous. The major question confronting investors is whether the U.S. equity market can continue to move higher when the rest of the world is experiencing an economic slowdown, political turmoil and trade disputes.

To put all of this into context, let’s start with valuation. Currently the Standard & Poor’s 500 is selling at 17 times earnings, substantially below the peak multiples reached at the end of the last century or in 2007. Using my dividend discount model (which is based on the concept that stocks compete with bonds and that as the yield on fixed income rises equities become less attractive), the index is now slightly above equilibrium, or fair value. In terms of sentiment, investors are optimistic, but not as euphoric as they were in January. These factors would argue that the market could move somewhat higher, but that a major surge is unlikely.