April 10, 2018
As we learned after President Herbert Hoover signed the Smoot-Hawley tariff at the outset of the Great Depression, vibrant international trade is a key component to economic recovery; hindering trade is a recipe for disaster.
— Gov. Asa Hutchinson (R) AK
Following the election of Donald Trump, markets posted 15 monthly gains in a row, something that had never happened before. Stock markets continued their unrelenting climb through most of January, again posting solid returns for the month. As the calendar turned to February, something changed. The first sign of problems occurred following the January employment report released early in February. That report showed strong job growth, but it also showed a dramatic increase in unit labor costs. Higher labor costs tend to be an important contributor to higher inflation, and market participants began to worry that the Fed would be forced to increase interest rates at a faster clip in order to fight inflationary pressures.
The Fed has indicated its intent to raise interest rates three times this calendar year. True to their word, they increased rates at their mid-March meeting. But what if inflationary pressures are building? Would the Fed be compelled to raise interest rates more aggressively in order to prevent inflation from taking hold? The January employment report raised fears that the Fed would need to act more decisively. Perhaps, too, investors began to worry that the Fed was behind the curve and would need to fight harder in order to quell inflationary pressures already building.
We have previously raised concerns that a policy mistake by the Fed could be a signal that the current expansion is coming to an end. We do not have an inverted yield curve (a situation where short-term U.S. Treasury rates are higher than rates on longer issues), a clear signal of a policy error, but the January data suggested that the risks of a Fed mistake had increased.
From the intra-day highs to lows, the S&P 500 corrected nearly 12%. Markets do correct, and corrections are typically a healthy part of the cycle. What has been most surprising is not that we had a correction in February, but that we had not had a 10% correction since January of 2016. Generally, we would expect roughly one 10% correction per year, and perhaps as many as five 5% corrections per year. So while six corrections are normal, there had been none for more than 19 months.
Markets finally started to find its footing as February progressed, but markets were then hit with the second surprise. Despite the advice of key advisors, the President announced an executive order placing tariffs on imported aluminum and steel.
We are not in any way suggesting that China has been a fair trading partner. We know better. China is re-emerging as a global power, and their long-term plans are fairly well-articulated. Global domination sounds like the plot from a James Bond movie, but we underestimate the Chinese at our own peril. No matter how worthy the objective, we do not for a second believe that tariffs are good for the economy. We do not believe that trade wars are “easy to win.” Rather, we suggest that trade wars have consistently led to losers but no winners. As we suggested earlier, a policy mistake is the kind of event that could end this expansion, and a trade war could be just the kind of policy mistake we worry about.
The administration backed away from some of the most onerous aspects of their tariff policy, exempting some nations, and announcing a willingness to negotiate with others. Retaliatory tariffs were modest, and markets were hopeful that a trade war could be averted. Markets attempted to recover again.
There was another shoe to drop. Facebook, one of the most successful social media stocks, disclosed that they had not been careful enough protecting personal user information. That data was obtained, and many fear that the information was used in the campaign to sway voters during the 2016 presidential election. Mark Zuckerberg did not take a lesson from some of the best examples of corporate crisis management, and he bungled an attempt to apologize for the company’s policies.
The business model of Facebook, and to a similar extent Alphabet, the parent of Google, rely on access to user information, and the profit they can make from selling that information to willing advertisers. The backlash against Facebook seems likely to lead to greater compliance costs for these companies, and the potential that these companies will be regulated should not be underestimated.
It is ironic that an administration that has articulated a desire to purge two regulations for every new one introduced, and who has been ahead of target in the reduction of regulations, may now be considering the need to regulate some of the largest technology companies in the world. While estimates of corporate earnings have not come down, the prices of these stocks have had serious corrections, and that, once again, took the wind out of the market’s sails.
The FANG stocks (FANG is an acronym that stands for Facebook, Amazon, Netflix, and Google) have been the best performers for quite some time, and any increase in regulation that impacts these companies is likely to have negative consequences for the market. We mentioned the privacy issues that pervade Facebook and Google, and more recently Amazon has been the target of the President’s tweets. In particular, the President suggested that US taxpayers are subsidizing Amazon’s delivery contract with the US Post Office. While the USPO does lose money every year, it is legally prohibited from charging shippers less than its cost of delivery. Most of the losses stem from enormous pension obligations the Post Office is required to make to provide benefits for existing and retired workers. That has not stopped the President from attacking Amazon. Yet again, as we look at the world, we must conclude that risks have risen somewhat.
As markets try to recover from the recent set-backs, we see four risks that must be discounted into the market before we will likely see substantive gains in stock prices. First, the market must come to grips with a Fed policy that will continue to push interest rates higher. Whether there are two or three more interest rate hikes this calendar year, the fact remains that interest rates are rising. The Fed has further announced that it will let assets on its balance sheet expire. Previously the Fed was replacing assets that mature with purchases of new bonds. This was keeping the size of the Fed’s balance sheet constant. For historic perspective, the Fed’s balance sheet was less than $1 trillion prior to the Great Recession. As the Fed embarked on its “quantitative easing” policy to push the economy into a self-sustaining recovery, it acquired bonds in the open market. This kept interest rates artificially low, and it also expanded the Fed’s balance sheet to about $4.5 trillion. Late last year, the Fed announced plans to slowly stop replacing bonds that mature. Initially they allowed $10 billion per month to mature, and now they are letting their holdings shrink by $30 billion per month, with further increases expected later this year.
The Fed may also be willing to raise interest rates somewhat more quickly because of the very expansionary fiscal policy that has been put in place. Fiscal policy reflects not just the impact of the tax cuts passed in December, but also the very expansionary budget recently passed. It is very late in the cycle for such aggressive fiscal policy, and some worry that goosing the economy at this point could create more inflationary pressures. That is giving the Fed a reason to continue to tighten, even as the worries of a policy mistake are present.
The Fed is not the only central bank that is tightening policy. As monetary policy begins to tighten around the globe, the risk of a policy mistake increases. Even without an outright mistake, financial markets need to discount the fact that monetary policy is no longer getting looser around the globe.
Secondly, the market must discount the increased risk of a trade war. While initial retaliation was modest, China recently announced tariffs on meat, soybeans, and other products imported from the U.S. In a classic tit-for-tat, the President’s Trade Representative just announced an additional $50 billion of goods that would be hit with a tariff of 25%. The trade rep indicated that the list was intended to maximize harm to China while providing the least disruption to domestic industry and consumers. This is not the kind of talk that prevents a trade skirmish from becoming an outright war.
The third issue that needs to be discounted by the market is the fact that the party in power often loses seats at the mid-term election. Over the last 21 midterm elections, the President’s party has lost an average of 30 seats in the House, and an average of 4 seats in the Senate. With strong economic growth and low unemployment, it may be difficult for the Democrats to regain a majority in November. Still, history suggests that the best outcome for the Republicans will be a diminished majority and diminished power. The current Congress has been decidedly pro-business, and a weakened majority suggests a less pro-business Congress after the election. It is possible that markets may struggle to make meaningful gains until the outcome of the mid-term election comes into clearer focus.
Like the third risk mentioned above, markets seem to have tired of the chaos surrounding the President. Last year the President seemed to be a strong positive for financial markets. Lower taxes, less regulation, and a pro-business environment was a recipe for strong market gains. Now the market is dealing with disruptive tweets, threats of regulation, and the potential for a devastating trade war. We acknowledge that there are many times when we wish that government were run more like a successful business. Even his most ardent supporters must agree that no successful business is run with a revolving door on the executive suite. Until an administration is assembled that has some staying power, the market is likely to remain volatile.
We have frequently mentioned that there are three pillars that support a thriving stock market. Those include solid economic growth, strong earnings growth, and the confidence to invest. We have identified reasons why the market has lost some confidence over the past quarter. That decline in market confidence has not showed up in surveys that report on consumer or CEO confidence. Perhaps the recent market correction will reduce those confidence numbers, but so far that has not happened.
As we have previously reported, economic growth remains quite robust. Fully 19 of the G-20 nations continue to show solid economic growth. The only country recently reporting negative economic growth was Saudi Arabia. While there have been some signs that first quarter growth was a little slower than previously anticipated, economic growth in the US is likely to be well above 2% for the first quarter. This is a very respectable number, especially in the 9th year of an economic expansion. As pillars go, economic growth continues to deliver.
The third pillar we look for is earnings growth, and here too the news is quite good. Expectations are for corporate earnings to grow by about 25% this year. About half of that growth will come from lower tax rates, and the remainder comes from good old fashioned organic growth. Corporate earnings growth this strong should provide the opportunity for stocks to move higher as those earnings estimates are realized.
Like an Ali-Frazier fight, the market seems poised for a “Thrilla in Manilla.” In this corner is economic growth that will continue unabated, driving earnings estimates higher, and supported by strong consumer and CEO confidence. Markets typically follow fundamentals, and the fundamentals suggest a winner. The challenger is a market that has lost its leadership. The FANG stocks, and technology more broadly, have stumbled. Risks of regulation and negative tweets abound. An administration beset with turnover and struggling to maintain its pro-business footing is adding insult to injury. The challenger has won the first quarter as stock prices ended the quarter down very modestly. Still, it was a close first three rounds, and there are nine rounds to go. There are no signs of a recession on the horizon, so the favored fundamentals may still pull out a win, but a KO seems unlikely from either corner.
Last quarter we mentioned the fact that stock prices have increased far more than corporate earnings. That difference came from valuation metrics that have expanded dramatically. Over the past six years, more than half of the gains in the market came from stretching valuations.
It is entirely possible that the fight between fundamentals and investor sentiment may end up in a draw. Fundamentals will likely push earnings higher, but the recent lack of investor confidence suggests that valuations are likely to contract. With higher risks, we expect returns in the stock market will be more muted this year as compared with last.
As we enumerated above, we see the current environment as carrying more risk that we did at the beginning of the year. Our recession indicators are not flashing caution, and it is difficult to find systemic credit risks or cautionary data. It is the tone of the market, increases in political risk and volatility, and a loss of leadership that gives us pause for concern. Our Risk Pulse™ was previously reading Medium+ (4 on a scale from 1 to 10). We feel it is imprudent for any risk measurement tool to be below average at this juncture, so we have increased the Risk Pulse™ to Caution (5 on the scale).
This is not to say that we see an end to the current expansion. On the contrary, we see this expansion continuing and setting a record as the longest expansion in modern history. That, however, does not imply that risks are not somewhat higher.
As always, it is important that we know of any changes in your financial situation. Please feel free to call us if you have any questions or comments regarding your investment portfolio.
Bennett Gross CFA, CAIA
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