A (0:00)

This podcast has been prepared exclusively for institutional, wholesale, professional clients and qualified investors only as defined by local laws and regulations. Please read other important information which can be found on the link at the end of the podcast episode.

B (0:24)

Good morning everybody. This is Michael Sembalist with the September Eye in the Market podcast. Plenty to talk about this time. So I'm going to try to do a big assessment of the U.S. earnings and economic trends during one of the broadest policy shifts since Roosevelt. And then at the end I do want to cover this whole issue about partisan mid decade Congressional redistricting, a case for the Supreme Court, and then the issue with the census. All of which could change the math for the House of Representatives a little bit against the Democrats and in favor of the gop. So let's get started. First, we've released a lot of on the market special issues this year and there's a table in the piece that goes through the different ones, the healthcare piece, the stablecoins piece, the AI piece and the energy piece. And then of course the 20th anniversary piece came out in early July and there's links to those in case you missed any of them. In in some kind of irony, the same week that I published our healthcare piece, my internist required me to go and see a nutritionist and was pretty horrified and she has lowered the boom and have banned all of these items from my diet. You'll see quite a few things here. Pizza, onion rings, hot dogs, Pop Tarts, those chocolate covered lime coconut patties from Florida, Apple Jacks, Slim Jims, Yodels, double stuffed Oreos, meatball subs, those cookies with half black and half white frosting on them. Anyway, you get the point. So all of this is now verboten and I've gone cold turkey on this stuff for three weeks and we'll see if it helps. So now let's start with the earnings season. Q2 earnings were pretty good actually and with with the recently passed reconciliation bill is going to provide a little bit of an additional boost. For reasons I'll explain. In the beginning of the year expectations for Q2 earnings were pretty were around 11%. They sank to 4% and they came in at around 11%. So right where the year started, the MAG7 stocks are continuing to grow. Earnings at around twice the pace of the rest of the market. There was no profitability in Europe. So you know, wake me when European profitability wakes up. And earnings guidance was pretty good. Almost 60% of companies raised guidance a little above average. More companies had positive earnings revisions. Looking out over the Next couple of years, then negative revisions for the first time since early 22. Large cap profit margins are pretty resilient, of course, led by tech, but also some recent improvements in industrials and consumer discretionary. And then as I mentioned, there's some corporate tax provisions in the reconciliation bill. They're pretty meaningful, but they're meaningful from a time shifting incentive perspective. They're not tax cuts, they're just providing you the present value incentive to invest today rather than in the future. So you can defer some taxes, but they might boost cash flow by 3 or 4%. So anyway, the Q2 earnings were pretty good news and no smoking guns here for people that thought they would start to see already some of the tariff stuff showing up in either Q2 earnings or more importantly guidance and earnings revisions. So we're not seeing that yet. Part of it could be, I think you have to remember while the economy is 70% GDP, while the economy is 70% driven by the consumer, the S&P 500 particularly is really a production index make 60% or so, maybe even a little more of market cap. And earnings in the S and P are the production side of the economy rather than consumption. So we have a few charts on here showing earnings growth. Now the MAG7 earnings growth is slowing. It's picking up a little for the rest of the market, you know, in a few years maybe that converges. We have charts in here on profit margins. Of course the tech profit margins are sky high relative to all the other sectors. But you as shown here, starting to see some improvements in industrials and also in consumer discretionary. So again, you know, pretty good story. And then par for the course, large cap, profit margins look great, mid cap, small cap going nowhere. So something a few, a lot of things happened interesting over the summer, one of which was at one point the White House and Trump in particular took exception to a Goldman report because one of Goldman's economists wrote a very routine report projecting that the tariff burdens would eventually shift from businesses to consumers. And Trump didn't like that. And of course Goldman should be able to write whatever it is they want to write. Something else the President said was interesting to me, which is that he complained that he never gets a fair shake for any of his economic accomplishments and in the national media in particular. And he has a point on a couple of fronts, I will say. There's a lot of academic research that's been done on this question of polarization and financial and economic news and it is very partisan. And, and I'd list a couple of the academic papers here that have been done over the last few years that have examined that. So I have no doubt that the reporting that's been done on any administration by media that's not aligned with it is way more negative than it should be. And if some of you may remember this, I did an experiment of my own in 2019. I came home every night and Rachel would either be watching MSNBC or cnn. And I just remember this, this incessant drumbeat of negative news every single night. And of course, some of the things they were reporting on were important to report on. Different kinds of investigations into the President's policies and behaviors and things like that, national disasters and some of the governor's races and things. But we went through every, my team and I went through every nightly Transcript for Cuomo, Primetime, Anderson Cooper 360, the Rachel Maddow show, and the Lawrence O' Donnell Show. And out of hundreds and hundreds and hundreds of stories, we found three that had any reference at all to the positive news that was prevailing at the time. You might not remember this, but at this point in time in 2019, the economic news was really good. I mean, wages were rising across all levels of income. You had the highest rate of job vacancies in 20 years, particularly in construction. You had the first sustained pickup in the manufacturing sector in almost 15 years. You had the lowest misery rate, which is inflation plus unemployment, since the 1960s for all citizens and also by, by race and by gender. So, you know, I remember thinking at the time, this is really skewed reporting because isn't there news for at least isn't there room for these some news reports on the positive economy? Now, the fact that the President has since fired the head of the BLS doesn't make things any better on this front because now everything is being politicized. So anyway, with that kind of background, I wanted to see what are the growth, inflation and employment impacts of some of the President's policies. And it's only a few months, but we might as well get started trying to track these things now before we dive into it. You have to ask yourself the question, how much is the current economic landscape in the US how much are Trump policy is being masked by the fact that you've also got this AI spending boom going on? If the question is how much is AI kind of obscuring everything else that's going on? The answer is quite a bit. Technology Capex has been anywhere from a quarter to a third of the entire real GDP growth contribution over the last few quarters. So the, the magnitude of this technology capital spending boom can't really be understated in terms of its impact on the economy. So we have to remember a lot of the things that you might think you would see and that you would otherwise have seen, you won't see because of the AI spending boom that's going on now. We actually had in the last quarter for the first time I can remember the GDP growth contribution from, from tech equipment and software was higher than from personal consumption expenditures. That's kind of amazing for, for the U.S. economy. And so yeah, obviously the big question is can the big hyperscalers continue to spend increasing shares of their revenues on capital spending and R and D. And we have a chart in here showing that, that most of the hyperscalers are kind of reaching new heights. You've got Meta in the stratosphere at 65% and then a cluster of Microsoft, Alphabet and Amazon at about 35% of revenues, significantly higher than the long term average for all those companies. That's a lot of your revenues to devote to CAPEX and R& D. Anyway, we're all aware of them. But let's just review some of the policy changes that are taking place. The biggest policy changes that have taken place in decades, arguably since FDR 90 years or so ago. But none of these things happen in a vacuum. When you look at the chart on tariff rates, it looks jolting to be going back to the early 1900s in terms of tariffs. But that took place after a period in 2016 when every single country in the world had higher tariffs on the US than the US did in reverse and where other countries typically had very high non tariff barriers as well. The complete shutdown of the border, when you look at the chart of border encounters and ICE bookings to detention looks very jolting. But again that's not happening in a vacuum. Happened after the most disorganized and poorly overseen migrant surgeon undocumented migrants that took place, you know, in the post war era. Roughly a million people a year went to almost four during the Biden administration. And then the Trump's deregulatory agenda is taking place after a regulatory bonanza that took place under Biden. I like to there's a lot the the only academic source or at least the only one I've been able to find that consistently looks at this issue of regulation, how the effects the economy is done by the George Washington University Regulatory Studies center. And we, and we like to look at their cumulative number of economically significant rules and you can see Just how, as, as, as rapid as they were under Obama. You know, Biden said, hold my beer, I can beat that. And he did. And so the deregulatory agenda under the Trump administration is in part a reaction to that. And then, of course, under Trump, you have this attempt to completely redefine the breadth of the power and responsibilities into the executive branch, which has resulted in explosions of lawsuits against the president. And so far, my informal tab is that they're, they're kind of losing as many as they're winning. And then you've got the shifting priorities of the budget, of the, of the reconciliation bill that was just passed. This is a pretty big deal. This bill redistributes $5 trillion of government spending and taxation over the next 10 years. And it's a strange mix of things. It's got some Thatcherite pro business incentives in it. It's got nationalism, things against companies that operate outside the U.S. you know, it's got some Jacksonian nationalism. It's got some of Clinton's welfare reform from the 90s in it. It's got a very heavy dose of Reagan in it. Right. More on national defense and much less on the safety net for the poor. Some of the border and immigration control policies have parallels to things that were done under both Coolidge and Eisenhower. And then, of course, you've got Trump's own thing, which is his flagship aversion to the green economy. And so we have a chart in here that looks at all the uses and the sources. And this is very much an expression of the political priorities and pillars of the administration. So working people, people that are working bigger standard deductions, no taxes on tips, overtime, or car loan interest, if they're having children, they get more benefits for that. But if you're not working and you follow through the safety net, you know, it's a, there's a little bit of a giant Steinbeck outcome here. So anyway, with all of these things going on, what's going. How are they affecting growth and inflation and employment? Because we're starting to see kernels of this showing up. So first thing is, let's talk about coincident and leading indicators of growth. They all look more stable than you might otherwise think. The Dallas Fed has a weekly economic index that's supposed to be a real time proxy for growth. It looks at unemployment and retail sales, fuel sales, electricity output and things, and that's pretty stable. The Atlanta Fed has a model that projects growth for the following quarter. All of that stuff looks pretty stable. The coincident indicators for the conference board look pretty stable. What's starting to look weaker, a little bit weaker are some of the leading indicators such as business optimism and a capital spending tracker. The ISM as a survey of new orders for new stuff, less existing inventories, it's a little bit below the expansion level. So some of the leading indicators are beginning to pick up weakness that the coincident indicators are not. So that's number one. So keep that in the back of your head because that weakness is part of what the Fed is allegedly responding to in its debate about cutting rates. Now, what would prevent the Fed from, from being aggressive by cutting rates despite lower falling growth signals is if inflation was picking up. And you know, there's lots of different measures of inflation. We pick a few of them here that we focus in on. If you look at core pce, which is, you know, the, the, the, the, the measure the Fed allegedly is most focused on as an alternative to the cpi, the core, the core PCE numbers, personal consumption, expenditure, inflation, it doesn't look that bad. It's kind of hovering around 3% where it had been for quite some time, down from 6% to three years ago. And now it's not a 2% but it's kind of stable. What's going up is the core goods pce. So you're starting to see some of the tariff stuff picked up in faster inflation for goods and for services. And when you look at producer price inflation similarly, you can start to see that creeping up. To me, the bigger concerns for people that want to cut rates would be these charts that we've got in here on, on prices paid in the manufacturing and service sector. These are surveys of prices paid and input and output prices. Those are going up. And in the history of the Fed, I wouldn't say they never ease when these are rising, but they usually don't ease when these are rising. And we went back, we have a chart in here that goes back to the 60s that's actually in the eye of the market that goes with this piece. And going back to the 60s, with the exception of the SNL crisis, it's really hard to find times when the Fed was easing when these prices paid series are going up. And yet that's kind of what the Fed is on the cusp of doing. I think what's probably driving the Fed to ease or think about easing more than anything else is the deterioration in the labor markets. And again, the administration got upset at the person that's that the head of the bls. If you read most of the Articles, the, the, the good solid research articles on the bls, they would say that data wasn't rigged, it was just wrong. And in other words, they, they've had some trouble with estimations, but it's not for lack of trying. And sometimes those models don't work because the sample sizes are too small relative to the economy. And they, they've gotten numbers wrong under all administrations anyway, regardless of what the BLS had to say about that one specific number, there is a panoply of signals that you could look at that tell us that the labor markets are weakening. The change in non farm payrolls. There's an ISM survey employment indicator. You could look at the percentage of small businesses that are planning to raise worker compensation. There's the number of people or percentage of people that are quitting voluntarily which is a signal of what people do when they feel good about the job market. There has been a spike in people that have been unemployed for more than 27 weeks or more. There was a spike in unemployed new labor force entrants. And then one of my favorite ones looks at a decline in the premium that people typically get paid to switch jobs. And that job switcher to job stay or wage premium which was rocking a couple of years ago has dropped substantially. So labor markets are weakening. There's kind of no doubt about that. I don't think they're plummeting, but they're weakening at a pace that would normally signal to the Fed that it's time to cut rates. And then on tariffs, look, I know clients and investors are generally sick of hearing about them. Unfortunately, the administration is not sick of imposing them. And the latest tariffs are really head spinning. One of them is a super complicated rule that was put into place already with very little warning that says if you import something that's got steel and aluminum in it, it's a derivative composition tariff that's inside intermediate or final goods imports. You have to estimate and strip out the steel and aluminum components, put the steel and aluminum tariffs on that, on, on that compositional amount and then put the other tariff on the rest of the amount. This would make my head hurt if I was responsible for applying them in practice, but that's what they've done. And so this is kind of like the full employment act for trade accounting professionals of 2025. And, and then also new furniture and wind tariffs. President really just hates wind. Have been added to the list of pending items. So what do we know and not know about tariffs? The irony about the, about the exception the White House took to the Goldman report was everybody trying to figure out how the tariff burdens are being shared. It's just, it's unfortunately it's too early to even try to do that in my opinion. In the first and second quarters US businesses hoarded goods in advance of the tariffs coming into play. And so since they're still running those balances down, it's too early for us to know whether or not they're going to eat those in terms of margins or pass them along to consumers. It's just too early to make that assessment. One thing we do know is that exporting entities to the United States are not eating it. Right. Because there was the White House was saying over the last few months, well, exporters to the US are going to cut their prices to maintain market share. There's no evidence I can find that that's happening. So overall US goods import prices are down a grand total of 0.2% from January to July of this year. So basically import prices at the border pre tariff are flat. So then to the extent that the tariffs have to be absorbed somewhere, it's some split between US businesses and US consumers and it's just too soon for us to know how much is tariff revenue helping the long term run rate of all the tariffs if they're not, you know, if Trump doesn't lose in the appellate courts where there's two separate tariff cases pending is 230, let's call it 250 to 270 billion a year. That's not chump change, that's real money. And you know it's about 0.8% of GDP. So if you figure the United States is running large deficits of 4 to 6% of GDP, it's not a rounding error, but it doesn't completely change the complexion of the, of the size and the deficits. But those are the numbers. Something around 0.8% of GDP from tariff revenue assuming no severe knock on effect and retaliation. Okay, so just to wrap up, where does this put everything? Even though it's a little early to be making some of these assessments, I still think the US economy is going to narrowly avoid recession this year and next. Fed's probably going to ease once or twice. Should help some interest rate sensitive sectors like housing growth slows to maybe 1% or so in the second half because eventually you'll get that tariff burden flowing through whether it's on consumers or businesses. You'll get the eventual impact of slowing labor supply growth due to immigration policy. And then I think we're also getting closer. We're not there yet, but we're getting closer to a collision between all this AI spending that's going on and finite power supplies, which we talk about in the energy paper. So that's what the economic outlook looks like to me. And then next year I think we're dealing with kind of 1 1/2 to 2%, almost trend growth. And then we see where we go from there. Just to make clear in a report like this, this is an economic analysis. This is not meant to. And I'm not qualified to be giving political, judicial or other interpretations of tariff policy or deportation policies. You can look elsewhere for that. I can cite one statistic to you that I did think was interesting. Syracuse runs this track database and right now 70% of the people that are held in ICE detention centers had no criminal convictions as of August of this year. And of the 30% that do have criminal convictions, a lot of them only committed minor offenses like traffic violations. So I, I thought that was an interesting statistic because it doesn't necessarily rhyme with the messaging that I remember hearing a few months ago about what the, the purpose for some of these deportations in the first place. Okay, let's finish up. I, I do want to talk about what's going on with three things that may impact the balance in the House over the next by the midterms and then certainly by 2030. So it, so official state officials in Texas and Florida have said, well, we're doing some mid decade redistricting because there were errors in the 2020 census and there were errors in the 2020 census and they've been documented by the census itself, the General Accounting Office, the National Academies, you know, that said, the political, the political reality appears to be that some of the redistricting that you're reading about is being done for political reasons. Not a shocker. Okay. Now there's a few things that are important to understand. One, the Constitution does not prevent mid decade congressional redistricting. There's, there's nothing in the Constitution that says you can't do that. The Supreme Court also has held that the Constitution doesn't have anything in it that says that you can't gerrymander a region for partisan purposes if you want to do it. Pardon me, there's nothing in the Constitution that prevents that at the federal, at the US Constitution. The challenge is the state rules are all very different. And you might have read that California said, well, Texas, if you do this, then we're going to do this and offset the impact. Not so fast, not so simple. So we have, we put this table together because I thought it was important to understand what are we really talking about here? Well, we're talking about, first of all, we're talking about trifecta states only. What's a trifecta state when the same party controls the governor seat and both chambers and the state legislature? Right. So number one is we're talking about trifecta states. Number two, we're talking about trifectA states that have more than two states that they can try to redistrict. So I'm not going to spend too much time on a state where they might be only able to kind of redistrict one seat. So if we do that, we're looking at nine states in total, five Democratic states and four Republican states that are trifecta states that where there's control in the same party and they've got more than two opposing party seats that they can redraw. So using Texas as an example, Texas has 38 House seats. The GOP currently controls 2012, 25 of them. Democrats control 12 of them. And the redistricting plan might end up with a change of five seats. In Tech, there are several questions that you have to ask yourself if you're trying to think, can other states do this and can Texas do this? And here are the four questions. Does the state constitution explicitly prohibit this kind of political gerrymandering? Yes or no. Who gets to redraw the lines? Is it the legislature or is it some kind of by non political state commission? Three, do changes to the state constitution, are they only allowed right after the federal census every 10 years? And then the last question is, do they have to be approved in two separate consecutive legislative sessions in order for them to be effective? And in the case of Texas, the answer to all those questions is no. So in other words, there are no constraints on Texas's ability to do this. As, as we read it, the legislature can do it and they don't require consecutive sessions. There's no rule in the state constitution saying it only can be done after the census. And there's no rule in the state constitution against political gerrymandering. Unfortunately for Gavin Newsom, the answer to two of those four questions is yes. So they can't just do what Texas is doing. And, and that's why they've drafted this resolution that voters will have to vote on in the fall. And even if voters approve it, they can still be subject to certain kinds of legal challenges. So anyway, the bottom line is Illinois and Georgia are the only other states in addition to Texas that have as much legislative freedom to operate here as Texas does. If you want to learn more about this, you can read the Appetics and the Eye in the market. It goes into all the gory details. The second thing is there's something interesting happening at the Supreme Court as it relates to the Voting Rights Act. And the Supreme Court recently ordered something called a re argument, where they actually ask the both parties in the case to file briefs to answer some questions the Court has. This very rarely happens. Just to be clear, the last time this happened was Citizens United, right? It's one of the only examples from this century of when the Court ordered re argument other than when a new justice gets appointed. And if you remember from Citizens United, after the reargument, the court issued a sweeping opinion overturning a lot of the precedents and invalidating the provisions in the Federal Election Campaign Act. So what's at stake here is, sorry, is Section two of the Voting Rights act requires that these things called majority minority districts be established under certain circumstances. And you know, they're designed to give minority groups to guarantee them representation in Congress. If, if the Supreme Court invalidates part of this, that could change the balance in the House. There's the estimates of the number of these majority minority districts vary, but somewhere between 44 to 60 seats in the House may have been created to comply with Section 2 of the Voting Rights Act. And depending on the Court's ruling, states might not even be constitutionally permitted to maintain them, in which case, new legal proceedings might force states to draw new congressional maps. And so the bottom line is the Court here, in a couple of cases, is taking a close look at whether or not these majority minority districts are constitutional and should they be preserved or should they be eliminated. And then the last thing to mention is the 2030 census. So whatever the results of all this mid decade redistricting and whatever the results of the Supreme Court case on the Voting Rights act, the 2030 census might make it harder for Democrats because of what's going on in terms of interstate migration trends. And the Brennan center estimates that current interstate migration trends will result in Democratic states losing seats California, four, New Jersey, three, and then Illinois, Oregon, Minnesota and Rhode island one. And then GOP states gaining seats, Texas and Florida, four each. Arizona, Utah and Idaho, one each. And remember, when you reapportion the House, it has a direct impact on the Electoral College. And one of the examples that Brennan center has used is that if a Democrat won the state, won the same states as Kamala Harris did in 24 in the future that that could entail 12 fewer Electoral College votes. So anyway, thank you for listening and that's the story and we will we have an online Trump Tracker that we update every week that tracks a lot of the growth, inflation and employment trends going on as it really relates to Trump policies and other AI trends and things like that. That link is always at the top of the Eye in the Market. Thank you very much for listening and we will see you soon.