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Budget Disgrace. Markets Don't Mind.

The Days Ahead:
Big jobs number. If it’s good, June is a go.

We had the usual flurry of Trump headlines but U.S. stocks hit record highs and U.S. Treasuries rallied. Some of that was the run up to a long weekend. No trader wants an open position over three days when other major markets remain open. We've not had a 5% draw down in stocks since last June. It’s not the longest stretch of unbroken gains ever…but it’s close. Why so good? Well, we’d repeat that it’s about global growth, a cracking earnings season (up 14%) low policy expectations and ability so shrug off politics.

1. The sun hasn't set on this Fed yet: It seems the Fed is itching to raise rates as a sort of “mission accomplished” victory lap. But the pesky data keeps getting in the way. So, yet again, lower inflation, possible slack in the labor market, no wage inflation, all came up as reasons to hold back. We would entirely agree. It’s tough to see where the economy is running hot. Again last week, we saw lower existing home sales, a wider trade deficit and not-so-great durable goods orders. Here's just one of those:

That top line is capital good orders running flat for several months. The aircraft orders, the blue columns, are basically Boeing, were down, although we’re the first to admit that aircraft have a fiendishly difficult seasonal adjustment so will be revised.

We expect Q2 GDP growth to come in higher than the Q1, which was 1.2%, but on track for not much more than 2% for the year. The economy could grow at 3% but we have to see cracking productivity growth, increased labor force participation, lower unemployment or a big increase in output. But those won't happen and tax cuts won't make an ounce of difference.

The bond market seems to think so. Despite the increase in Fed Funds, an overnight rate, three-month Treasuries haven’t risen above 1% since 2008. That means a flatter yield curve, shown here.

Now, we’re way off getting to levels that indicate a recession (see highlighted areas). It tells us that the market simply does not believe it when the Fed says the weakness is “transitory.” 

If this week’s job numbers are good, the Fed will raise rates in June. But that’s all in the price and we would not expect bonds to move much.

2. Europe. Not a loser: Regular readers and clients will know we’ve liked European stocks for a while now. The Euro has climbed 8% since the election and major markets like Germany are up 13% in local terms and 21% for dollar investors. We can put this down to solid fundamentals: high, real dividend yields, double-digit earnings growth, global trade and a pick up in inflation. We also like the technicals.

Without diving into too much jargon, it shows that momentum that has worked well for the last 20 years. As we’ve said before, we don't trade on technicals, but others do and we think many investors are putting money into Europe based on a chart like this one. For us, it’s reassuring that the fundamentals and earnings, that we look at, align with the technicals and quant types.

3. That Budget: The White House Budget came out mid-week. You would have thought a budget that planned to cut spending as a percent of GDP by 2% (so around $350bn a year), increased GDP growth to 3% and eliminated the deficit in 10 years would be welcome news to the markets. But no, the Treasury market barely moved and ended up on the week. At the heart of the budget is the “2-Penny” plan that decreases non-defense spending by 2% a year. That's equivalent to taking 1.2% out of the economy. But no worries because GDP grows at 3% for 10 years, which pays for:

  • Cuts in tax cuts for corporations and…
  • High-earners and…
  • The estate tax and…
  • Capital gains and…
  • Unearned income

There are many areas left untouched. Notably defense, Social Security, Medicare, net interest, veterans, border control/walls and law enforcement. So, the cuts fall on areas that make up less than 23% of the budget. They add up. So if you're a retailer who accepts food stamps, you’ll now have to pay a fee to the government, farmers will receive $38bn less, food stamps will be reduced by $160bn, subsidized student loans gone, COLA adjustments on Federal pensions eliminated, rural airports subsidies gone. The wall is still going to cost $3bn. The Peterson Institute , a pretty sober group, reckons the probability of the economy growing at 3% at 1:25, which to us means, “yeah, could happen, wing and a prayer and all”. Financial markets really didn't take the plan seriously, so we're not sure we should either.

 Anyway, it’s all here if you want to browse 300 pages of huge savings.

Bottom Line: We ran a quick screen on S&P 500 stocks to see if there was much difference in the YTD performance of stocks with high and low tax rates. Well, there is a big difference. The top 50 highest taxpayers in the S&P 500, with an average rate of 30%, returned 3.2% so far this year, compared to the index return of 8%. The 50 companies with the lowest tax rate, with an average rate of 6%, returned 12% in the same period. Now we know there’s a ton of exogenous factors at play but on this measure at least, the market does not give much hope for major corporate tax cuts.

Please check out our 118 Years of the Dow chart.  



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Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

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