Dear Valued Clients and Friends,
John Kenneth Galbraith, who many of you may know is not exactly my favorite economist, once famously said that “the only function of economic forecasting is to make astrology look respectable.” John Maynard Keynes is another of my non-favorite economists who had a couple of quips I love despite a lifetime of flawed ideology (“in the long run we’re all dead” and “when the facts change, I change; what do you do?”). So I will forgive Galbraith for decades of internally inconsistent love of state power and give him props for this delicious quote. Economic forecasting is a wonderful way to make oneself look very, very foolish.
In today’s Dividend Cafe, we are not going to tell you where the economy is going in the next 6, 12, 18, or 24 months. We do not know. You do not know. The others telling you they know do not know. And the astrologers do not know. If we did know, we do not believe it would automatically translate into an investment thesis. Beyond the unknowability of certain economic reality, how that economic reality would translate into markets is equally unknowable. These two premises: Economic forecasting is less reliable than astrology, and the impact of economic reality on markets is complicated, lead us to a conclusion: Have a better investment philosophy than one focused on economic forecasting.
What we are going to do in the Dividend Cafe today is not focus on where the economy is going, but actually re-ask the question, “Where is the economy now?” And hopefully, you can detect a certain point in the mere posing of this question … If there is a serious and unsolved debate over how the economy is doing in the present tense, who in their right mind believes that answering for it in the future tense is something that should drive decision-making?
Yet my agenda is very specific today. I want to make the case that there are legitimate questions about where things stand in the economy now, and that the baseline assumptions many have necessarily alter their forward projections. And if baseline assumptions and forward projections are in need of alteration, then the way we are thinking about tariff impact likely warrants scrutiny, as well. And if this case is properly made, it will call for humility in final conclusions, not over-confidence, “this time it’s different,” or any other fallacy that consumes the portfolios of investors all too often.
So if you are content to just question the current state of the economy today, and not draw undue conclusions about the future state, then jump on in to the Dividend Cafe. In the end, I promise you will find some actionable conclusions worthwhile, and it won’t require any look at a horoscope.
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In our prior episode
Last week I used the Dividend Cafe to suggest that the question around tariffs and their impact on the U.S. economy is two-fold over the next 6, 12, and 18 months: First, one has to know what they are assessing for… Is the agenda to reduce the trade deficit, to see new manufacturing jobs, to see new tax revenue, or to see the policy enhance economic growth? There are political concerns embedded in some of these, and economic concerns in others. I counter-intuitively suggested that some of the political concerns may go worse than expected (those who believe the trade deficit is going away, or that manufacturing is coming back entirely onshore, may find themselves disappointed), but that there are reasonable questions about the economic impact. My view is very similar to Dr. Lacy Hunt’s, which is that while the first-order impact of specific tariffed products may be inflationary, the second, third, and fourth-order effects are disinflationary, and not in a good way. In other words, as discussed last week, the impact of a new cost imposition either erodes demand or erodes profit margins, depending on what Lacy refers to as the “elasticity” of the price – that is, how easily it can be substituted. If demand or profits drop, and the result is a decline in international trade, there will be a decline in capital flows, and that decline in global liquidity would surely put downward pressure on economic growth.
Therefore, I suggested that where we will see real net impact from the current trade policy regime is in total trade flows, as the tension between new tariffs eroding demand and/or profits and new markets being theoretically open plays out. And out of this tension, we will see the impact on capital flows and liquidity, which will be the catalyst to either declining growth or improving growth. I stand by this theory of the case and believe in these barometers as the way to assess impact in the next 6, 12, or 18 months. They transcend the easy analysis of “what prices went up or down this month,” and understand that first-order effects are one concern, but so are the knock-on effects that come thereafter.
What is being assumed
The entire prior section, though, essentially seeks to look at the impact of tariff policies on the demand curve – that is, do tariffs cause companies to either raise prices to protect margins (what people will call inflation), or sacrifice prices to protect market share (what is the textbook definition of profit compression). It is agnostic about the state of the labor market or other economic factors going into the discussion, and isolates the economic milieu to just the impact of tariffs. And the general read of the economy that enables a sort of “neutral” if not sanguine view of the economy going into this “new tariff question” is largely, by consensus, that jobs are healthy, wages are healthy, optimism is healthy, and the consumer is healthy. Our perspective, and the perspective of most objective economists capable of de-politicized analysis, is that the story of both the GDP quarterly results this year has been noise, not signal. That is, the number was skewed down in Q1 by front-running of imports, and skewed up in Q2 by the reversal of such, and that basically both a -0.5% print (Q1) and a +3.0% print (Q2) are, well, worthless. Through that noise, there is a sort of open question about the state of the economy.
The conventional view of the economy coming into this summer was that there is some uncertainty around tariffs and what the final policies will be (there still is), and what the impact of the policies will be (there still is), but that this is on top of a pretty good economy, despite noise in quarterly GDP numbers. Most of that reasonably benign outlook has been based on a pretty benign read of the labor market. If jobs are good, the economy is good. And if the economy is good, that leaves a little margin for error in how tariffs impact their way through the economy. I would not only say that this has been the conventional view of the economy in recent months, but I think it is fair to say it has been my view.
Recent events have rendered that conventional assumption at least worthy of scrutiny.
A second look
I spent some time with the aforementioned Dr. Lacy Hunt this week. Unlike Galbraith and Keynes, Dr. Hunt is on my “favorite economists” list, and I have learned a great deal from him over the course of many years. Beyond a framework for understanding the risk to liquidity that tariff policies represent (i.e., less foreign investment because of declining trade flows), Lacy has become convinced that the base of the pyramid on which so many economic metrics are based is broken. Our assumptions about employment speak to Personal Income, to Gross Domestic Income, to Personal Savings, and ultimately to growth and productivity. The labor data is a foundational metric to so many other data points that matter a great deal. And Lacy believes a sanguine view of the jobs market does not hold up to scrutiny.
Jobs, Jobs, Jobs
We know that last week’s BLS revisions to the May and June jobs reports (down by 258,000) cast doubt on the state of the jobs market. And we know that the July number itself was very underwhelming (only 73,000 jobs created). Many spent the week questioning why the BLS data is subject to such large revisions, and of course, the President did a very good job in diversion by firing the director of the BLS, but the underlying question is still, “Is job growth a lot weaker than we have understood it to be?” And unlike most of the people asking that question, neither Dr. Hunt nor yours truly is wondering the answer to that as part of some sort of political gotcha moment. In fact, Lacy is of the opinion that not only were the most recent jobs figures off, but the entire 2024 narrative (pre-Trump) is flawed. The BLS data has consistently shown somewhere between a 4% and 4.2% unemployment rate (the percentage of people looking for a job who do not have one) – not as low as the 3.4% we saw for parts of 2023, but not a high rate by any means. But the ADP private payroll numbers have come down, with average new monthly payroll additions being cut in half twice over the last year. There has been some sort of inconsistency between the Household Survey (which includes farm and self-employed respondents) and the Establishment Survey (which only includes wage and salary jobs) for some time now. And the so-called U6 “under-employment” rate, which includes those working part-time for economic reasons, has moved up from 6.6% two years ago to 7.9% now.
What we are dealing with, whether you are a half-full or half-empty glass kind of person, is not conclusive. The BLS jobs data and establishment survey (from which we get the unemployment rate) has looked okay, not great but not bad, but now looks quite vulnerable. Anecdotally, other data have looked vulnerable, if not problematic (U6, ADP, NFIB, etc.).
But then again … the weekly jobless claims have seemed to validate the benign labor market narrative for quite some time. Weekly jobless claims have mostly stayed between 210,000 and 240,000 for several years now. The periods that dipped lower did not last, nor did the periods that went above. And this pretty right range has held for over three years, leaving me (and many others) of the opinion that the jobs market has been a strong enough pyramid base in the economy.
So, prima facie, the lack of movement higher in initial jobless claims supports a reasonably stable unemployment rate. However, and this is the mystery I cannot solve, continuing unemployment rose to the highest level since 2021. The long-term unemployed (those unemployed for over 26 weeks) have risen by 383,000 people since January. Continuing claims (still on the rolls) are over 150,000. Something is not adding up with the weekly claims. Lacy believes it may be connected (“may be”) to states having a backlog in processing claims to counter the heavy increase in fraud post-COVID (looking at you, California). I do not know the answer. What I know is that new additions to the long-term unemployed and continuing claims are over 500,000 people year-to-date, a really substantial number, and that seems very disconnected to me from just 220,000 weekly initial claims.
A nuanced view
One way to think about this is that there is limited truth in both narratives. Is the job picture for large companies mostly healthy, but the job picture for small businesses struggling (as the NFIB suggests)? Is firing pretty limited (a good thing), but hiring pretty limited, too (a bad thing)? That would explain why continuing claims and long-term unemployed are high (limited hiring), but initial claims are low (limited firing). The small vs. big business bifurcation would explain the delta between Household and Establishment surveys, as well as other adjacent supporting data. College graduates are having a tougher time finding a job, but those with length-of-service are not seeing high terminations.
Is it possible, despite the fact that this doesn’t play into a politically convenient view (for some) of a disintegrated labor market, or a politically convenient view (for others) of a rosy one, that the jobs market is weakening but not weak, selective in where it is good and where it is bad, and vulnerable to further economic weakening? Is this not the most sensible read of the current data?
Can’t skip my least favorite topic
And if we are going to talk about the economy, we better talk about trade deficits, right? Because heaven knows those must be bad, despite the fact that we have now had one for … 50 years in a row (1976-current, non-stop). The reason this topic bothers me so much is the way it is discussed – as if a trade deficit is automatically a bad thing (it quite obviously is not), or as if a trade surplus is automatically a good thing (it quite obviously is not). But what can we learn about the current state of affairs in the trade data?
The trade deficit for June was $60.2 billion, with exports down by $1.3 billion but imports down by $12.8 billion. Most of the import decline was because we brought in fewer autos, less oil, and fewer pharmaceuticals. We exported out less metal fabrications. What we are not seeing is “more domestic manufacturing because of fewer imports.” Employment in goods-producing businesses is down. We are importing more from Mexico, Canada, Vietnam, and Korea than in the past, and the total imports from China are lower than they were pre-2018, even though many assume that much of that product is just being passed through other countries.
The Budget Lab at Yale believes the new effective tariff rate will be 17.3% after consumption shifts. Strategas Research believes it is trending to 13-14%. Lacy Hunt uses CBO and NBER estimates to get near 20%. I suspect 15% is a good round number to use, but keep in mind – we are not at any of those numbers now. The real effective tariff rate last month was 8.9%. Now, more tariffs have been put on since (and others have been taken off), but all of this is projection on policy that is, at best, loosey-goosey (the academic term I would use).
More clarity (on the cost of tariffs to the economy) will come week by week as Switzerland, Taiwan, India, and others (ultimately China) find more resolution. In all cases, we will lack the knowledge of what exactly the impact on trade flows and capital flows will be for several months. What we know is the White House will announce “huge new investment in the U.S,” and often include collecting taxes on U.S. importers as “money they are raising” (instead of money the economy is forfeiting). But the important thing to say today, lacking a crystal ball about next year, is that today the % rate on tariff taxation is 9%, headed to somewhere between 15% and 20%, multiples of what it has been in recent years.
A Summary Devoid of Forecast
My hope is that the present state of affairs is enough to confuse you without adding more confusion by daring to predict the future. The jobs market is somewhere between “vulnerable” and “hanging in there,” and in no sense is “awful” and in no sense “great.” Trade, tax, and capital goods conditions are somewhere between “frozen” and “bad” but in no sense “good,” let alone “great.”
Massive AI investment is happening.
The OBBBA has some attractive supply-side offsets in the corporate income tax code that are beneficial to growth.
The U.S. federal debt overhang is dramatic, is getting worse, and has been (and will be) a drag on growth.
And in all of the above facts, you have a reasonably honest assessment of the present state of the economy, without any hubris to offer a glance at the next 6, 12, or 18 months.
What I do believe is not prophetic (about what will happen), as much as prescriptive (about what needs to happen). New markets need to be open to maintain capital flows if and when tariff impact erodes demand and corporate profits. The silliest economic narrative on earth right now is that tariffs merely eroding profits versus inflating prices would be a good thing.
If there is one thing I feel very comfortable saying, it is that profits are the mother’s milk of markets and of economic growth. And if anyone sees a CURRENT economic landscape (be it jobs or trade) that is going to BENEFIT from DOWNWARD pressure on profits, they are seeing something very different from what I am.
And that is a present tense comment, not a futuristic one.
Chart of the Week
Worse than expected, better than expected, and all in between – the total cost of tariffs as announced remains a moving target.
Quote of the Week
“In a rising market, enough of your bad ideas will pay off so that you’ll never learn that you should have fewer ideas.”
~ Daniel Kahneman
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An economic assessment without a future-predicting conclusion? How are we supposed to manage money that way? Because dividend growth, risk-based asset allocation, behavioral investing, and cashflow-driven planning do not set themselves to an economic outlook. Our philosophy is, and always has been, deep into a foundation that is neither economically pro-cyclical nor defensive. Rather, it is in pure acceptance that the economy will surprise, sometimes for the better, and sometimes not, but in order for that to mess up our investment strategy, we have to first mess up ourselves by violating our philosophy. We have no intention of doing that. To that end, we work.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
