Highlights:
· Equity markets finally cooled off in the first quarter of the year after a prolonged period of rising equity prices with minimal volatility.
· After years of having to worry about deflation, the concern is shifting to inflation, which may be the lesser of the two evils.
· In addition, investors are now left to digest the likelihood and impact of a trade war after rhetoric between the U.S. and China escalated during the quarter.
· The timing of a trade war threat comes at a challenging time for many European nations, which just recently started to pull out from their own debt crises, and the UK, who is in the process of breaking away from their largest trade partner in the EU.
Commentary:
“You get recessions, you have stock market declines. If you don’t understand that’s going to happen, then you’re not ready, you won’t do well in the markets.”
-Peter Lynch, American investor, mutual fund manager and author
Global equity markets took a step back to begin the year, signaling investor anxiety over whether factors from restrictive trade policies to rising interest rates could disrupt the nine-year bull market. This was not surprising when you consider that stocks had risen 35% since the election and 2017 marked the first time in history the U.S. equity markets did not decline by more than 3% at least once. Thus, it was really the lack of any correction that had been an anomaly, and recent volatility is a healthy reminder that equity markets are not a one-way street.
It is also important to maintain perspective and consider that an inflation scare is an entirely different animal from the Japanese like deflation concerns that haunted economies during the past decade, including the U.S. financial crisis of 2008, Europe’s government-debt crisis of 2011 and China’s slowdown in 2015. Each of those events threatened a key economy and pushed inflation into negative territory. This time around global economic growth is strong, corporate earnings are solid and corporate and household balance sheets are likely healthy enough to withstand some increase in interest rates.
A strong labor market, rising commodity prices and fiscal stimulus from Washington are expected to boost inflation. This has investors speculating that the Federal Reserve under new chairman Jerome Powell might tighten policy at a faster and less predictable pace than before under former chairwoman Janet Yellen. In this regard, the central bank raised interest rates another quarter percentage-point at their March meeting, and recently hinted at a slightly faster pace of tightening in light of inflation fast approaching its target of 2% over the medium term. The rise in bond yields is indicative of a much healthier economy, but the risk for investors this time around is that the move from worrying about deflation to worrying about inflation will not happen smoothly. Rising interest rates generally makes bonds yield more attractive to investors, which is why investors are concerned that faster-than-expected inflation could be a headwind for equities. However, in theory at least, bigger price gains should be at worst neutral if they boost corporate earnings along the way. It is when growth softens while inflation is still rising that equity returns tend to suffer most.
Fortunately, corporate earnings, particularly in the U.S., have been solid and the global economy continues to expand. A record share of U.S. companies beat Wall Street’s revenue expectations in the fourth quarter, with earnings at companies in the S&P 500 on track to grow by 15% from a year earlier. This would be the fastest pace since the second half of 2011. Furthermore, capital spending is finally starting to show signs of picking up, buoyed by the recent federal tax overhaul that lowers the corporate tax rate, offers a chance for companies to repatriate overseas cash, and allows 100% depreciation of capital expenditures upfront. Even before the new tax package’s approval, capital expenditures were showing signs of being on the upswing due to a tightening labor market, aging U.S. factories that need to be upgraded or replaced and a fairly synchronized global recovery.
Unfortunately, President Trump’s administration recently added a new wrinkle to the economic picture when it proposed tariffs on imported steel and aluminum and threatened to slap additional measures on as much as $150 billion of Chinese goods. Higher and broader tariffs would raise the prices of those imports and potentially tame U.S. inflation and slow GDP growth. A trade war would also leave the Fed having to decide between battling weaker economic growth and rising prices. Comments from the March meeting referring to these trade policies as downside risks for the U.S. economy would seem to indicate that the growth concerns outweigh what are likely to be a one-time increase in prices that tariffs would bring.
The overwhelming majority of economists would assert that protectionism is bad for growth, destabilizes relations between nations and has negative implications for investment. Nevertheless, it can seem like an easy fix during periods of economic stress or rising inequality. The current administration was elected into office by running a successful campaign largely centered on populist and nationalistic ideologies. While mainstream politicians should shoulder much of the blame for the current political climate that has divided the country, the checks-and-balances of our democratic system will hopefully temper current anti-trade and investment aspirations as arguably no country has benefitted more from globalization over the last seven decades than the United States. Consider that U.S. exports of goods and services have increased fourfold over the last 25 years, while the U.S. economy has roughly tripled in size and manufacturing output has doubled over this period and it becomes clear that cross-border connectivity has made the U.S. economy larger, more competitive and wealthier. Without access to the world’s resources, capital and labor (white and blue collar), many U.S. firms would be shadows of their current selves in terms of market capitalization and earnings.
Only time will tell if the recent tariff threats are another example of President Trump’s unconventional negotiating tactics or if his administration is truly bent on risking a large-scale global trade war. Few would disagree that a full-blown trade war would leave both the U.S. and China worse off. For that reason alone, many expect China and the U.S. to find a solution that would result in fairer, but still free trade. China threatened to match dollar-for-dollar U.S. tariffs by issuing its own list of U.S. products of comparable value, focusing especially on politically sensitive agriculture and aircraft that would be subject to duties if the U.S. follows through with its proposed trade sanctions. After last year’s tax cuts, the U.S. needs foreign capital to finance near term deficit increases, while China needs a long period of sustainable economic growth and a slower pace of debt accumulation to reduce leverage as it transitions from a manufacturing-based economy to a service-oriented economy. Thus, we are hopeful that President Trump’s tariff threats were made in order to gain an upper hand in talks and extract concessions from China such as cutting tariffs and opening up its service sector, which would actually raise China’s own productivity and could turn in to a win-win situation. Nevertheless, China’s government was concerned enough about the potential effects of a trade war that for the first time in two years the People’s Bank of China announced a reduction in the portion of deposits commercial banks are required to hold in reserve. This move is projected to free up $200 billion in funds to encourage banks to lend more and is being viewed as a pre-emptive action aimed at bolstering economic growth.
After dealing with lackluster economic growth for years, the European Union (“EU”) is finally coming off a year in 2017 that saw growth at its fastest pace in 10 years and economic confidence soar to a two-decade high. This led to the European Central Bank (“ECB”) dropping a long-held pledge to accelerate its 30 billion-a-month bond-buying program if the region’s economy deteriorates. Thus, the risk of trade wars could not come at a worse time for the EU, which is only recently starting to pull back from the brink of the Eurozone Debt Crisis, has banks that are still far from healthy, and is still working on a framework for centralized fiscal policy. ECB officials warned at their March policy meeting that a stronger Euro, possible trade conflicts triggered by the U.S. administration, volatile financial markets and the U.K.’s withdrawal from the European Union all pose threats to the region’s export-focused economy. Signs of weaker growth, a falling rate of inflation and wages that continue to be slow to rise even as the unemployment rate declines are all factors that support ECB President Mario Draghi’s view that the ECB will need to move cautiously as it phases out its giant bond-buying program.
The Bank of England (“BOE”) joined other central banks in warning during the quarter that recent financial market turmoil will not deter decision makers from tightening monetary policy. Citing stronger-than-expected growth and record high employment, the BOE indicated they are likely to raise rates at a swifter pace than it expected to just several months ago. This is a welcome development as a very different future was forecast when Britain voted to leave the EU in June 2016. That being said, Britain can ill afford a trade war at a time when it is in the process of withdrawing from its largest trading partner (the EU).
Japan’s central bank also trimmed back its buying of long-term government debt during the quarter, a move that markets took in stride. With eight straight quarters of expansion through the fourth quarter of 2017, Japan’s economy is in the midst of its longest growth streak since its heyday in the late 1980s, with the economy growing at a healthy pace on the back of companies accelerating their capital spending and strong domestic consumption.
Periodic pullbacks in the equity markets, while unpleasant to live through, can be healthy in that they tend to wring out some of the excesses and keep valuations reasonable. Our investment policy concedes that such periods of economic weakness and market declines are inevitable. We suggest the best manner to deal with the uncertainty of the timing and duration of such periods is through adherence to a long-term investment policy rooted in modern portfolio theory and developed with reference to your personal financial plan. We believe this approach has been successful over the longer term for the exact reason that it does not rely on prediction or sentiment. As important, it is our intent that this policy gives you some comfort and confidence when the world around us is so unpredictable and unstable.
Urban Financial Advisory Corporation – April, 2018