October’s Candy-Free Mailbag

Trick or treat! While the kiddos are putting the finishing touches on their costumes and preparing to canvas the neighborhood for candy, we have a mailbag chock full of your questions. It’s educational, entertaining and sugar-free!

Does all the upheaval in French politics make you less optimistic about European stocks?

Not when we look out over the next 12-18 months, though higher uncertainty might be a short-term headwind as politicians there keep bickering about next year’s budget. But that headwind would generally be specific to France, weighing on its returns relative to the rest of Europe. Given France is only 16.9% of MSCI Europe market capitalization, we doubt it is a notable influence on regional returns.^[i]

But overall, we don’t think France’s issues make European stocks less desirable. Think through how markets work. Stocks are a share in corporate earnings over the next 3 – 30 months. Most of the headlines related to France’s political scene focus on things unrelated to corporate profits. We call that “sociology,” and there is a long history of stocks globally not minding sociology much.

Then, too, when you cut through the noise, France’s fiscal policy stalemates amount to political gridlock. It is noisy, but it also means whatever legislation squeaks through tends to be watered down through all the compromise necessary to pass it. This reduces the risk of draconian tax changes that would severely disrupt French corporations’ earnings outlook. It also reduces the risk of the government passing sweeping bills creating winners and losers. So counterintuitively, noisy stalemates reduce legislative risk, which is a positive for stocks.

Markets also move most on the gap between reality and expectations, with false fears being bullish. Entering this year, French politics was on just about every analyst and commentator’s list of risks facing European stocks. We have been writing about that for a long time and put it in the false fear column. And now here we are in October, and it is still there. We haven’t seen the gap between reality and expectations close—sentiment hasn’t caught up—despite the 27.8% rise in French stocks this year in USD (13.5% in euros).^[ii] So that brick is still a big part of France’s wall of worry.

What is the market effect of tariffs driving companies out of business?

We are going to sound really cold and mean here—sorry—but it is basically minimal. The casualties are largely small businesses, many individually owned. It makes us sad because we love small businesses and their entrepreneur founders and owners. But small businesses aren’t the stock market. The stock market is publicly traded companies, with even the “small” listed companies rather large by a Main Street big-versus-small business definition. So far, these are almost entirely weathering the storm ok. Some may have cut back in certain markets. Some may have taken an earnings hit. Some may be hard at work changing supplier relationships and adjusting their other costs and sales prices to make the earnings math work. Many are leveraging the legions of tariff exemptions at their disposal.

The market effect of all this rejiggering is simple: Global stocks are up very nicely this year, with non-US stocks leading. Markets are well aware of the challenges businesses face and have priced them in. And it seems they are telling us these headwinds are surmountable. We don’t think tariffs are beneficial, and US stocks’ underperformance is evidence of this. But stocks seem to know the lay of the land and are moving on.

When will the next recession happen?

Having just returned from a trip in our time machine (patent pending), we can report that the next recession will begin on KIDDING.

Alas, no one knows. You just can’t pinpoint these things precisely.

But in general, barring something suddenly ending the business cycle unnaturally like COVID lockdowns did in 2020, the next recession will start when the US economy gets too bloated, with too much unproductive investment, and tighter credit conditions (or something similar) force businesses to wring out all that excess and get back to fighting weight.

The problem is “too much” is clear only in hindsight—there is no predetermined tipping point. Usually, even something that may prove excessive later is rational and sensible earlier on—and it can be hard to discern which is which in the moment. And the economy can trundle along with a lot of bad investment for a while before something prompts the process of wringing everything out. Buzzy vibes, like those surrounding AI today, tell you little in isolation. You also can’t just look at a given level of interest rates, loan growth, money supply growth, or, or, or and determine credit is too tight. It takes much deeper study and analysis.

Also, note: Stocks generally move before the economy. It has been a long time since we had bear markets accompany a change in the business cycle. In 2007, stocks rolled over nearly three months before recession began. In 2000, the bear market began about a year before the recession did. So we think it is less about predicting a recession than about looking at a down market and determining the likelihood that stocks are pricing in a soon-to-be troublesome economy.

I keep seeing that wealthy folks are why consumer spending is growing. Could a pullback in their spending due to trouble in stocks or real estate lead to a recession?

Could it? In the sense that anything is possible? We guess. But this generally isn’t how spending or economies work. Let us walk you briefly through two central misperceptions in that scenario.

One is called the wealth effect. This is an old theory that posits rising stock and real estate markets drive consumer spending as folks “feel” wealthier, even if they aren’t actually using their realized capital gains to fund their next trip to the mall. There just isn’t much evidence that this is a thing. Spending relates more to disposable income than asset prices and tends to be pretty stable regardless of market volatility. If the wealth effect were real, consumer spending would plunge temporarily whenever stocks suffer a correction—a sharp, sentiment-induced drop of -10% to -20%. But it tends to be resilient. Consider the case of 2022’s sentiment-driven bear market: US stocks fell by over -25% between that January and October.^[iii] Yet consumer spending rose in every quarter that year—and every quarter since.^[iv]

Which leads us to the second fallacy: the widespread belief that because consumer spending is the largest segment of the economy, it is also the economy’s swing factor. But when we dive into the historical data, we see business investment is actually the culprit, usually falling much more than consumer spending in the downturn. That makes sense when you consider the previous question and answer, which flagged a recession’s primary purpose as wringing out corporate excess. Most consumer spending goes to essential goods and services—housing, healthcare, education, food, all the basics. So it generally doesn’t fluctuate much in recessions or expansions.

So while this scenario could play out, we think it is rather unlikely to.