Highlights:
· The U.S. equity markets appears to be the early beneficiary of President Trump’s policy which rejects multilateral trade agreements. International equity markets struggled to deal with the uncertainties raised by an onslaught of threatened and real tariff impositions.
· China’s leaders are eager to get ahead of any potential economic impact of the U.S. trade war so as to boost confidence in a slumping economy and stock market.
· Earnings, not sentiment, are driving the current bull market. A key question is whether U.S. economic growth will dip or the rest of the world will start to catch up.
Commentary:
The divergence in economic growth between the U.S. and the rest of the world has U.S. stocks trading at their highest premiums to international shares in years. After a tepid first half of the year, the S&P 500 gained 7.2% in the third quarter, its largest gain in nearly five years. The S&P 500 is currently in the midst of its longest bull market in history by duration and the NASDAQ index surpassed the 8,000 mark for the first time during the quarter thanks to soaring profits posted by many of the large technology companies. The surge in U.S. equity prices during the quarter was fueled by strong retail sales, rising manufacturing output and tax-fueled share buybacks. Strong consumer spending, buoyed by low unemployment, rising wages and tax cuts, continues to enable U.S. corporations to maintain earnings at current levels.
For years, rising wages were the missing ingredient in the U.S. economic recovery and forced the Fed to delay raising interest rates. With the unemployment rate currently at a 48-year low of 3.7%, employers are now competing for a shrinking pool of qualified workers by improving their compensation packages. This has resulted in wages and salaries rising at the fastest clip in a decade. Upward pressure on wages has given the Fed confidence to begin to normalize interest rates, but continued strong job growth now comes with a price tag if it results in downward pressure on corporate profit margins. Nevertheless, there is likely to be further upward pressure on interest rates with core inflation at its highest level in a decade eating into wage gains for the average American. In this regard, the Fed voted unanimously towards the end of the quarter to increase their benchmark federal-funds rate for a third time this year and signaled that one more increase is likely this year. This most recent increase marks the first-time the Fed has lifted its benchmark rate above 2% since 2008 and the first time in a decade that the fed-funds rate will rise above inflation.
Strong U.S. economic and earnings growth has provided the Trump administration with leverage in its mission to force rival countries to make concessions to the U.S. on trade. At least in the short-term, this strategy appears to be working, with Mexico and Canada recently agreeing to revise the quarter-century old North American Free Trade Agreement, and President Trump signing a revised free-trade pact during the quarter with South Korea. These deals followed an announcement earlier in the quarter by President Trump and European Commission President Jean-Claude Juncker that the two nations would hold off on further tariffs and negotiate in good faith to eliminate the tariffs and subsidies that currently fetter trade across the Atlantic.
Uncertainty about trade has been a recurring theme for businesses and investors all year and the new U.S. Mexico Canada Agreement, as it is being called, should alleviate some of those concerns. This agreement should also allow the Trump Administration to turn its focus more squarely towards even larger economic feuds with China, which to this point, have seen little progress in behind-the-scene efforts to restart formal trade talks. In fact, the U.S. escalated the trade fight with China recently with new 10% taxes on $200 billion in Chinese exports and a threat to explore penalties on $267 billion more in Chinese products. This would cover virtually all Chinese goods sold in the U.S. China retaliated with tariffs on $60 billion in specifically targeted American-made goods. Thus, the trade spat with China appears to be moving to trade war. The problem stems from the US administration’s perception that China has been able to generate major economic surpluses from trade imbalances with the U.S. With these surpluses, China has made significant investments in various assets around the world, including U.S. Treasuries, and expanded military and infrastructure spending.
While China prepares for an escalating trade fight with the U.S., it also has to contend with increasing challenges at home from a slowing economy. Capital spending on fixed assets such as buildings, machinery and public works projects fell to its lowest point in nearly two decades. Further, retail sales are slowing, unemployment ticked up over 5%, and rapidly escalating housing prices have fueled fear of a bubble. These are just the most recent signs of cracking in an economy that has seen growth gradually slow for the last eight years. This suggests that China is likely to avoid a direct, confrontational approach in the trade fight with the U.S. and focus on strengthening its economy first. In this regard, China has attempted numerous approaches to strengthen its economy in the short-term, including easing of credit controls, reducing individual income taxes, and encouraging more lending and spending on big-ticket government projects such as highways and rail lines. Most recently, China’s central bank announced plans to free up nearly $175 billion to encourage commercial banks to boost lending and pay off short-term borrowings by reducing the amount of reserves these banks are required to hold by 1%. These actions threaten the longer-term health of its economy, however, because China’s debt load has soared since the 2009 global recession. The trade fight with the U.S. may result in China having to put off debt restructurings.
China has allowed the Yuan to weaken relative to the U.S. dollar in the face of recently enacted tariffs and this makes Chinese exports cheaper globally. However, it does risk frightening citizens and companies into sending money abroad and possibly worsening the currency decline. The confluence of trade worries, the strong U.S. dollar against emerging market currencies, emerging market turmoil and the bear market in Chinese stocks has led to the longest sell-off for Asian stocks since 2002 and battered emerging markets stocks in general. The Argentine peso and Turkish lira have been particularly vulnerable to a rising dollar, and have feared fuels of a contagion. It is important to remember, however, that while some emerging markets crises spread, others remain contained. It is still unclear which type Turkey and Argentina may be, but years of economic mismanagement, nepotism and corruption, stifling autocratic environments and aggressive foreign policy posturing have also exasperated the crises in these countries. The other major emerging markets countries do not have the serious macroeconomic imbalances as Argentina and Turkey, seemingly making it unlikely that these two countries will pass their economic vulnerability and currency volatility on to other countries.
Global inflation recently hit its highest level in four years, led by a surge in energy prices. This follows a number of years in which the rate of inflation was perplexingly low, given steady rates of economic growth and falling unemployment. While the U.S. dollar’s strength has pummeled stocks and bonds in poorer countries, it has begun to slip against some of its developed market peers like the euro and yen, even as the outlook for growth in some of these countries has started to darken. This would be an unwelcome development in Japan and the Eurozone because the gains in their currencies make exports less competitive and stifle inflation. A slowdown in inflation would be a setback to the European Central Bank who is preparing to wind down its bond purchase program at the end of the year, in part because it anticipates an improvement in inflation. Recent reports showed that while Euro-area wages are on the rise and robust economic growth and solid domestic demand has pushed unemployment to its lowest level since the global recession began, core inflation, which strips out volatile energy and food, is slowing. Other risks that threaten the ongoing Eurozone recovery are a hard Brexit, investor concern about Italian fiscal policy, emerging market turmoil and an escalating global trade war.
In a positive development, the European Union and Japan signed one of the world’s biggest free trade deals during the quarter. The deal covers nearly a third of the world’s GDP and 600 million people and contrasts sharply with the Trump administration’s protectionist trade agenda which challenges decades of a global free trade system. History has shown that, in general, countries that have remained open to trade and have not erected barriers such as tariffs have grown faster, had higher income and higher productivity than countries that have gone in a more protectionist direction.
The combination of persistently high corporate profits and quiescent inflation has driven the current domestic bull market to date. Although valuations are now on the higher side historically, particularly in the U.S., the market’s gains thus far are due to strong earnings, not to sentiment or broad multiple expansion. We all know that the good times will not continue uninterrupted forever, and in fact, equity markets have taken a step back to begin the fourth quarter as a recent surge in bond yields has led investors to revalue equities. Another strong earnings season could appease equity investors and make this recent pullback another blip in a sustained equity market rally. Or this could be the beginning of an inevitable correction, but regardless, it is important to maintain perspective and remember that market pullbacks are a normal part of investing and happen on a regular basis. The vast majority of market pullbacks are non-recessionary, recover their declines relatively quickly and are effectively managed through portfolio diversification.
The question that no one can answer with certainty is whether the correction will be longer and deeper, when it comes, because of the Fed’s intervention over the last decade. This refers specifically to maintaining short-term interest rates at unprecedentedly low levels and holding down long-term interest rates via their bond-buying program known as quantitative easing. Optimists would point to higher corporate earnings and faster economic growth driven by tax reform and deregulation under the Trump administration that will continue to carry stocks to new heights. It is not known where we will go from here, both because predicting the short-term movements of the equity markets is always difficult and because we have never experienced the kind of central bank actions employed by the Fed and followed by Europe and Japan.
The timing and severity of these periodic interruptions in the economy and equity markets is unknown and the investment policy we espouse is not immune to severe or protracted downturns. However, by conceding that market pullbacks are inevitable even when economic skies appear clear and acknowledging that we have no insight into the timing or severity of these pullbacks, we are able to take a rational, patient approach and develop an investment policy that insulates your portfolio with sufficient cash and fixed income exposure to weather these periods. This enables the equity portion of your portfolio to participate in the equally inevitable recoveries that also take shape over the market cycles.
Urban Financial Advisory Corporation – October, 2018