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Stepan Lavrouk
Stepan Lavrouk
Articles (506) 

Investors Are Overreacting to the US-Mexico Deal

Do not mistake the forest for the trees

June 11, 2019 | About:

Market watchers got some good news last week when it was reported that the U.S. and Mexico had come to an agreement regarding the latest trade dispute. This has raised some hopes that the U.S.-China issue might similarly be resolved quickly, and has led to bullishness among some investors. But, given that the stock market was selling off prior to President Trump’s threat, the non-implementation of the Mexico tariffs should not be viewed as a boost to the economy. In a recent research note, Morgan Stanley’s (NYSE:MS) chief equities strategist argued that weakness in the labor market is greater than the market is currently pricing in.

Data disappoints

As regular readers will know, Morgan Stanley’s bearish call is built on three pillars. Firstly, the Trump administration’s tax cuts were implemented at a time when the economy was nearing capacity, which caused an excessive inventory build that will now lead to a draw. Secondly, last year’s capex splurge, caused by the same will not be matched this year. Thirdly, and of most relevance to the real economy, rising labor costs are putting pressure on margins and could result in increased unemployment.

“Last week we received some concerning data points on this front: both the ADP [National Employment Report] and the Non-Farm Payroll report both showed a material slowdown in hiring trends, with the ADP report indicating that small businesses are actually reducing headcount for the first time this cycle. This jives with our analysis that shows that smaller-capitalization companies are struggling with higher labour costs, and other operating expenses. If this spreads to larger-capitalization companies over the next few quarters, we will likely experience a mild economic recession in the US later this year or next.”

Of course, companies could choose to offset these higher labor costs by tightening spending in other areas, but the data seems to suggest that we are headed for a slowdown in hiring. Crucially, all of these factors will weigh on the economy even without the U.S.-China trade dispute. In fact, Morgan Stanley’s best-case scenario (the U.S. and China put their differences aside and work towards a deal) still sees earnings stagnation for U.S. corporates in 2020. The note continued:

“Our earnings forecasts suggest greater earnings pressure on larger US companies is likely this year, so I remain of the view that the risk of an outright recession is greater today than its been since 2015. The good news is that the Fed is likely to respond quickly with interest rate cuts. In fact, the bond market is already pricing in the likelihood of such an outcome starting as soon as July. While such cuts would be welcome, it likely won’t be able to stave off a further slowdown or recession if corporate earnings deteriorate further, as I expect.”

With valuations as high as they are, and with incoming data suggesting that the market is not pricing in the increased probability of a recession, stocks seems excessively expensive. The good news is that value investors will be well positioned to strike in the event of a significant correction in the next 12 months.

Disclosure: The author owns no stocks mentioned.

Read more here: 

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About the author:

Stepan Lavrouk
Stepan Lavrouk is a financial writer with a background in equity research and macro trading. Specific investing interests include energy, fundamental geoeconomic analysis and biotechnology. He holds a bachelor of science degree from Trinity College Dublin.

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