By David Nelson, CFA
August was a struggle for markets as political and geopolitical events weighed on sentiment for risk assets. Departures from the White House along with miss steps from the President helped fuel concerns here while tensions over North Korea’s nuclear threat continue to mount. Every President since Reagan bears some responsibility as each test brings them closer to being able to hit the U.S. mainland.
As of this writing, there are several reports of a potential thermonuclear detonation Sunday at a test center in North Korea. Expect the usual rhetoric as leaders around the world condemn the action but with effectively no real game plan in sight. Nothing short of China cutting off ALL economic aid to North Korea will prevent this from escalating to the point of no return.
In a response on Twitter the President threatened to “stop all trade with any country doing business with North Korea.” China is of course the largest player and is responsible for an 85% share of North Korean trade. When asked by a White House pool reporter if he’d launch an immediate strike against North Korea, the President responded; “We’ll see.”
Perhaps the most telling rhetoric came from Secretary of Defense James Mattis referring to a national security meeting with the president and vice-president. In a statement to reporters he said; “Any threat to the United States or its territories including Guam, or our allies, will be met with a massive military response, a response both effective and overwhelming.”
S&P 500 1 Year Chart
In the face of the negative backdrop stocks put in a strong finish erasing a -2.5% slide earlier in the month. Investors certainly aren’t getting any help from Washington and to date the administration has a legislative goose egg hoping to put up a win with a tax reform package. As I pointed out in several interviews last week the window is tight for the administration as there is little time post the break to get meaningful legislation passed before January and the unofficial start of the 2018 election cycle. Before even mounting the effort congress has to deal with the budget and of course the debt ceiling.
Harvey’s Silver Lining
Early estimates for Hurricane Harvey weren’t even close. On Monday, best estimates for the storm were for potential damages of approximately $30 Billion. By the end of the week those numbers had climbed to north of $100 Billion. The other side of the equation is the economic boost from the rebuilding effort but of course not worth the tragedy and human cost from this devastating storm.
To fund that effort the administration working with congress has to provide aid packages. The press has repeatedly pointed to plans to tie aid to a vote to raise the debt ceiling. This could actually be the one silver lining to a storm that has caused so much damage.
You don’t screw around with the good faith and credit of the United States!
Every couple of years we are taken to the edge of the Abyss as someone in congress looks to block the debt ceiling raise, waving the flag of fiscal responsibility. You DON’T screw around with the good faith and credit of the United States. The market reaction would be violent. Economists at S&P are right when they say “it would be as catastrophic as the collapse of Lehman Brothers.” Attaching a spending package to help the victims of Hurricane Harvey might be the best way to help insure passage. What congressman or senator is going to risk political suicide by blocking needed aid?
The Good News
Despite little help from Washington company health is strong with many reporting record earnings and for the first time in a while needed revenue growth. Its true valuations aren’t compelling but it’s important to remember stocks don’t live in a vacuum. With few alternatives, stocks offering growth and often income seem a more attractive asset class than sovereign debt with a less than 2.2% 10 year and outside of this country often zero or close to it.
The Unknown
The biggest challenge and the unknown territory investors will be forced to navigate is the Fed’s unwind of a massive $4.5 Trillion balance sheet. The fed is committed but the time table seems unclear. Also unclear is the pace of future hikes and just what will the terminal rate be.
The Phillips Curve which relies on the inverse relationship between unemployment and inflation is all but broken. The fed’s has been targeting 2% inflation since the end of the financial crisis and it’s safe to say that $4.5 Trillion later the effort has failed. There are any number of explanations including technology and a very competitive landscape for jobs at the global level. However, I believe the changing dynamics of energy complex brought about by new technologies may offer the best answer.
For over 40 years the world lived under the threat of OPEC as a cartel like structure able to dictate oil prices. By carefully limiting supply to keep prices elevated Saudi Arabia and its partners maintained a stranglehold on the world and often acted as a governor to economic activity.
Energy touches everything. Manufacturing, transportation, the military and almost every endeavor in life in one way or another is influenced by the cost of energy. Of course today with the United States moving toward energy independence OPEC is effectively dead. Add the fact that we are over the tipping point for alternative energy its unlikely OPEC as a threat will ever return.
Sector Breakdown
Alpha Select still maintains overweight’s in Financials, Technology, Healthcare and Consumer Cyclicals. Earnings estimates 12 months out are still rising and as pointed out last week, geosynchronous global growth is helping U.S. multinationals.
With the exception of defensives like healthcare the portfolio is tilted toward economic growth. When the numbers change so will we.
