Much attention has been paid over the years to the low correlation that exists between economic growth and stock market performance, particularly in the nations of emerging markets. The oft-cited analogy of Mexico’s pitiful GDP growth and stellar stock market from 1993-2013 vs. China’s transformative GDP growth and pitiful stock market over the same period is a valid one, if not excessively illustrative. The United States demonstrates more muted figures to make the same point – stock markets can often confound pedestrian analysis of macroeconomics, largely because stock prices are only focused on one dynamic in an economy – corporate profits – and corporate profits do, contrary to certain opinions, have the ability to buck the macro trends via innovation, competitive strengths, cost synergies, and human action.
The 2009-2017 period of sub-2% real GDP growth in the U.S. economy was itself abnormal, especially atypical of a post-recession period. The robust stock market performance during such a tepid GDP period owes itself to a combination of events – most notably the basement-level valuations from which stocks were rebounding, the most unprecedented period of monetary accommodation in U.S. history, and of course, death-defying talent in U.S. companies to optimize profit margins, create new markets, and attract foreign capital in a time where the rest of the world looked significantly less attractive than we did. So that disconnection between our stock market and our sad GDP growth was not historically counter-intuitive, but it certainly can be said that it was stretched.
The thesis for this economic cycle and the stock market’s relationship to it coming into 2018 was that the cycle was given additional innings by the tax and regulatory reform of the Trump administration. This had the obvious mathematical support in stock prices – they are valued off of earnings, and after-tax earnings went up by default with a lower tax burden. But to see a sustainable addition to the real economy, and then provide a further rationale for corporate profits growth (once the impact of tax relief was priced in), capital expenditures (capex) would be needed in the corporate economy. Durable goods orders, capital spending, R&D investment, and all mediums for enhancing productivity had been on pause for too long, and the unpausing of those catalytic growth engines was the case for three more innings of this positive business cycle. The unpausing of those catalytic growth engines is the case for three more innings of this positive business cycle!
Something happened on the way to extra innings, the outcome of which remains unclear. Business confidence, skyrocketing since the new administration took office, collapsed 4.9% in recent months.
* Organization for Economic Cooperation & Development, Nov. 2018, Business Confidence Index
If the causation of this sudden pause in business investment proves transitory (significant uncertainty around the economics of global trade), capex will resume and with it productivity, thereby offsetting the impact of rising wages (unit labor costs). Ergo, profits can accelerate even when wage costs rise, as productivity-adjustments offset and even benefit the ratio. The generation of that productivity cannot be aspired to or miraculously wished into existence; it is an economic function of business investment.
A GDP growth of ~2% in 2019 means something very different for stock markets than a GDP growth of ~3% does. And if any singular variable will answer the 2% vs. 3% tension, it will be business investment (capex). Therefore, the trade war is the first variable since the financial crisis to intensify the correlation between economic growth and stock market performance. Investors are watching, but so are all economic stakeholders.
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