First Half Review - 2018
When the clock struck midnight on December 31st, 2017, both a new year and a new phase in this historic bull market began. With the steady and reliable rally of 2017 in the rear-view mirror, we entered a volatile consolidation stage that, despite a sound economic picture, has gone sideways in a series of grinding fits and starts.
During these first 6 months, we’ve released multiple newsletters in which we stated the case for ‘staying the course’ and ‘being willing to adjust our exposure,’ all in an effort to enjoy the fruits that the markets have traditionally borne. We intend for this update to provide a similar message. Yet instead of a comprehensive picture of the investing landscape, we will focus on a few developing stories that we think warrant your attention.
Austin Harrison will review the term structure of US interest rates and the equity market implications. Mark Gibbens will provide a timeline and qualitative discussion about the ongoing trade tensions.
First, a brief market review and then a summary of our analyst team’s findings are presented directly below.
First Half 2018 Mkt Review
It will come as no surprise to even the most casual observer of markets that the first half of the year was extraordinary. From the euphoric 7% advance in January, to the swift two-week, 12% decline that sent the market negative; 2018 has provided no shortage of both opportunity and risk.
The source of the volatility in most cases, and especially over the past couple months, has been headline-based and frequently related to global trade anxiety. The result has been tarnished sentiment in major industries and a stock market with very narrow leadership. As a rule, narrow markets tend to be more vulnerable to significant fluctuations and seemingly irrational shifts in trajectory.
As we’ve said before, the economic expansion remains healthy, and valuations are reasonable. Absent a change to the fundamental outlook, we will continue to view this price action as a consolidation within the context of an otherwise healthy bull market. As always, this broad view is tempered on a day-to-day basis based on the risk tolerance of clients. (yellow bubbles on chart below represent dates previous newsletters were distributed).
Summary of Main Topics
Trade Wars: There is plenty of politics and hype involved with this issue, neither of which are particularly interesting to us from a market perspective.
What could go wrong?
- Our businesses get ‘shut out’ of major global markets – In our view, this is the most damaging potential outcome. Our multinational corporations are relying on faster growing emerging/developing markets to provide a disproportionate amount of their growth in the years to come. A drastic change to revenue growth assumptions would challenge our positive fundamental outlook.
- Margins are compressed – The additional costs directly associated with a tariff itself, as well as potential constraints in supply would raise the cost of doing business for a broad array of businesses. The increase in expenses would compress profit margins, and companies would be less profitable. This would be a major issue for specific companies and industries. But broadly, profit margins just got a tax-reform fueled boost to near all-time highs. So it seems unlikely that current level of proposed tariffs would derail index level earnings growth. Although a scenario of continued escalation would change that expectation.
What could go right?
- Restrictions on US Exports are relaxed – A less anticipated outcome could be that instead of our tariffs or restrictions increasing, other countries could relax their trade measures. The benefits of this outcome are plainly obvious: less restricted global trade is a good thing.
Yield Curve Inversion: Yield curve inversions have reliably been an indication of a business cycle that is nearing an end. And exhausted business cycles almost always end in bear markets. While the US yield curve has not yet inverted, it is getting close. If the Federal Reserve continues its projected course, an inversion would likely take place sometime next year. The good news is that on average, equity markets tend to continue their upward trend for another 18 months after inversion does occur.
Trade Update: Bark vs Bite
On the second weekend of June this year, the United States met with its G7 partners. At that meeting the United States refused to sign on to an official communique stating that "free, fair and mutually beneficial trade and investment, while creating reciprocal benefits, are key engines for growth and job creation." While the refusal to sign the document was disconcerting, it is important to look at the hard facts of what we know to date regarding the United States and global trade.
The chart below, published by the Department of Commerce, shows the average tariffs placed on 22 major product categories by the three largest contributors to global trade: the US, China, and the EU. The European Union’s tariffs are higher than the tariffs imposed by the U.S. in 17 of the 22 major categories of goods and China’s tariffs are higher than US tariffs in 20 of the 22 categories. What does this tell us? If the trade disputes are settled amicably, it could result in reduced trade barriers for many countries critical to the global economy. Reduced trade barriers could, in turn, increase global trade in a win-win scenario. However, there remains a great deal of skepticism that this win-win scenario will come to fruition.
So where are we headed? To understand the path forward, let’s review President Trump’s proposed tariffs and the likelihood of escalation into a full-blown global trade war. The world currently engages in approximately $17 trillion worth of trade. President Trump’s maximum potential tariff base according to his public statements would be placed on $500 billion worth of products. If we use an estimated tariff rate of 10%, we arrive at a total impact of $50 billion which translates to 0.29% of global trade. As the saying goes, that is a drop in the bucket.
Top 10 countries by global trade volume
Has the trade rhetoric heated up in recent weeks? Yes, it has. Also, previously announced trade duties expected to go into effect later this week include the tariffs being placed on $12.8 billion worth of US products by Canada and on $34 billion worth of Chinese products being imposed by the US.
The real risks to the US economy posed by trade skirmishes would most likely come from either 1) an abrupt US withdrawal from NAFTA or 2) much larger tariffs placed on or by important trading partners such as China, Canada, Mexico, Japan, and the European Union. The risk surrounding a NAFTA withdrawal was somewhat reduced on June 10th as Larry Kudlow, the Chief Economic Advisor to the President, was quoted as saying, “We won’t withdraw from NAFTA. We are heavy into negotiations.” The risk remains that a tit-for-tat escalation of tariffs could take place, but the scale of the proposed actions doesn’t yet constitute an all-out trade war.
Market Aversion to Yield Curve Inversion?
In finance, it stands to reason that when you agree to loan money for a longer term, you should be paid a premium, i.e., a higher interest rate. In a normal environment, that’s exactly what happens. The yield curve, which plots a bond’s yield against maturity, is upward sloping. Sometimes, however, due to economic expectations from both financial market participants and central banks, this simple logic doesn’t hold. The result is what’s called an inverted yield curve: the interest rate on short-term bonds is higher than that on long-term bonds (see below). Why does all this matter? Since 1970, every yield curve inversion has been followed by a recession. Several Federal Reserve members, most notably St. Louis President James Bullard, have expressed concern that this phenomenon will occur again should the Fed continue along its current rate hike path. He could be right – 10-Year US Treasuries currently yield 2.8%, while the Federal Funds Rate is expected to be near 2.9% by the end of next year.
It’s not all bad news. For one, current term premiums are still positive and in ranges similar to those seen in the mid-90s and again in 2005. Moreover, if/when term premiums do go negative, the bull market doesn’t necessarily end there. Below is the S&P 500 Index spanning the previous 3 cycles. Even after the yield curve inverted, equities appreciated on average another 35% over 18 months before peaking. Of course, we can’t know whether markets will continue to advance after inversion occurs, or even if the next recession will be foreshadowed by this same indicator.
The largest hindrance to a sustained market advance is very clearly global trade concerns. Over the next few weeks we should develop a clearer understanding of where we’re headed. The spectrum of outcomes could range from a stabilization of rhetoric, to a multi-front confrontation that could last until the 2020 presidential election. We will be looking for moderation in the form of bilateral meetings, and for our congressional and agency authorities to exert more of their influence.
True to our strategy, we have reduced exposure to the equity markets at various points this year. But the byproduct of this volatility has and will be opportunities caused by inter-sector divergences and significant damage to trade-exposed equities. So as long as the healthy fundamental backdrop persists, we will be researching, monitoring, and preparing to take advantage of these opportunities as they arise.
As always, if you have any questions about the content of this message or our strategy and allocation, please do not hesitate to contact us.
Thank you and have a wonderful 4th of July,