by Brad M. Weafer, Chief Investment Officer
Key Points:
- A disconcerting level of volatility has returned to U.S. equity markets since January
- The reaction to recent headline market news has been overly dramatic
- We are optimistic about the outlook for corporate profit growth and remain constructive on U.S. equity markets returns
The Urban Dictionary defines drama as “a way of relating to the world in which a person consistently overreacts to or greatly exaggerates the importance of benign events.” Recently, investors have fit this description particularly well. We have seen a dramatic increase in volatility in reaction to a dizzying number of market related headlines. There have been twice as many 1% moves in the S&P 500 over the last two months than there were in the prior 12 months combined. Increased regulatory scrutiny of large technology firms, talks of tariffs and trade wars, and tightening of financial conditions by a U.S. central bank has made investors particularly skittish. Like most fundamental concerns, there is some truth and risk to these developments. However, the associated market reactions have been over done and we remain constructive on U.S. equities going forward. We like to remind clients with markets there is always something to worry about. Maintaining rational emotions and focusing on key long-term variables, especially corporate profits and equity valuations, is of paramount importance. In other words, investors should not be drama queens!
To help make that easier, we will address each of the key developments in term.
Potential Trade War?
In mid-March, President Trump directed trade representative to apply 25% tariffs on between $50 to $60 billion worth of Chinese annual imports. The primarily affected industries included aerospace, technology, and machinery sectors. In addition, the President has called for acting against China at the World Trade Organization. The Chinese were quick to respond and released an initial list of retaliatory tariffs on U.S. goods with an emphasis on agricultural goods. In tit for tat fashion, the President has responded by threatening to increase the number of affected goods.
While there is certainly some rationale for levying tariffs against the Chinese, most economists agree, trade wars are a “lose-lose” proposition. Tariffs will almost certainly raise prices on domestic consumers. Inflation levels are a key concern and further price increases could spur the Federal Reserve to take action on raising interest rates, a negative for stocks.
However, we take issue with the magnitude of the stock market reaction. Since the President announced his intentions, Strategas Research Partners estimates the U.S. equity market has lost $2.7 trillion of shareholder value (as of March 31). Threats of tariffs have wiped out the entirety of the stock market gains many would associate with the passing of tax reform. The tax change is expected to provide $800 billion of the fiscal stimulus while the announced tariffs is only expected to impact $36.5 billion of goods (see Figure 1 below). It seems investors are overly extrapolating the negative consequences.
Putting the tariff numbers in context is only half the story. Investors should also consider the President’s negotiating style. We would expect the announced proposals as an opening salvo that will eventually be walked back. in his book, “The Art of the Deal”, President Trump discussed his tactics. “My style of deal making is quite simple and straightforward. I aim very high, and then I just keep pushing and pushing to get what I’m after. Sometimes I settle for less than I sought, but in most cases I still end up with what I want.” We saw a very similar example last month when the President, with much fanfare, announced punitive tariffs on steel and aluminum imports. two weeks later it was quietly negotiated to exempt Mexico and Canada as a barter within NAFTA negotiations. South Korea, which is also discussing bilateral trade agreements with the U.S., was also exempted. The weight of evidence and past precedence suggests the announced tariffs are proposals, not policy, and are likely larger than what will be consummated.
FANG gets Bitten
Technology and internet stocks were the darling of Wall Street for all 2017 and early 2018, outperforming the broader market by a wide margin. Emblematic of this leadership was the performance of the FANG stocks, Facebook, Amazon, Netflix, and Google, that had an average return of over 60% in the 12 months leading up to the market peak at the end of January. The out sized stock returns were supported by tremendous fundamental results in most cases. It is hard not to be impressed by the explosive revenue and profit growth of these companies. The sheer market dominance of these leaders reflects a “winner takes most” economic dynamic of the internet age. As if often the case, when optimism about the prospects of leading firms becomes so extreme, potential risks are often overlooked. One of those risks, a growing threat of regulatory action, came to the forefront recently. Facebook, already facing allegations of fake news proliferating on the social network, was hit with a data breach scandal. The company exposed data on 50 to 78 million users to the research firm Cambridge Analytica, who used it for targeted political ends. These events have raised material questions regarding privacy and Facebook’s responsibility with respect to monitoring content and has resulted in major criticism and unwanted scrutiny from Washington. Amazon has also been in the cross hairs, drawing the President’s ire on Twitter. The President in no uncertain terms indicated the company was putting retailers and retail jobs at risk.
In addition, the President claimed the company is taking advantage of the Post Office and the taxpayers that fund it. Several articles have been released speculating there could be regulatory action taken to limit Amazon’s growing influence. These events have helped spark a sell off in technology and internet related stocks with Facebook down 22% from recent highs and Amazon down 14%.
The correction in technology shares was swift and violent, catching many off guard. However, ahead of the sell off there were growing signs of excessive optimism in the sector. As CNBC contributor Michael Santoli recently pointed out, the price earnings (P/E) ratio of technology dominated NASDAQ 100 Index traded at 23% premium to the broader market at the end of January. This compares to an average historical premium of just over 10%, suggesting froth was mounting. That gap has re-rated with the fall in technology shares recently but is still at a premium. More importantly though, the impact on the broader market has helped bring the P/E ratio for the S&P 500 to its lowest level in over two years (see Figure 2 below). Lower valuation multiples reduce one of the key headwinds facing forward return expectations.
Fed Rate Increases
The U.S. Federal Reserve raised the benchmark federal funds rate by a quarter percentage point in March (to a range of 1.5% to 1.75%). This was the sixth such increase in the last several years. The increase was largely expected with market-based probabilities for a rate increase reaching near 100% in the weeks leading up to the announcement. In addition to the March raise, the Fed also signaled they intend to raise rates another two or three times this calendar year. Any pick up in the pace of rate increase in the future would be dependent on labor market gains to guard against increased inflation. Fed Chairman Jerome Powell indicated officials are balancing the risk of raising rates too fast and thwarting the expansion against the risk of raising rates too slowly and letting the economy overheat and inflating asset bubbles. Some market observers worry that a signaled increased pace of financial tightening will crimp economic growth. Several indicators of financial condition have started to creep up igniting these worries further.
Access and price of credit is very important for a well-functioning and growing economy. Any tightening is worth noting, but we must consider the context. The federal funds rate has increased off the zero bound but remains incredibly low relative to historical precedent (see Figure 3 below).
We also track the Chicago Fed’s national financial conditions index for signs of excessive financial tightening. It too has started to increase but remains well below historical levels associated with economic weakness (see Figure 4 below).
Earnings are the Key Market Driver
We continue to stress our view that the risk of U.S. recession is low and the economic backdrop is supportive of healthy profit growth, which is the ultimate driver of financial markets. The index of leading economic indicators continue to mark new highs. The labor market continues to tighten; the number of Americans on jobless rolls fell to its lowest level since 1973. Industrial activity remains in expansionary territory. Loan growth, a concern of ours last year, has started to increase, which is a positive signal. There are some signals the U.S. economy has entered a “late” cycle phase. Job growth has started to flatten out with the economy at full employment. The U.S. Treasury yield curve has been flattening but is still far from worrying levels. At nine years long, this expansion is already one of the longest in history. Late economic cycle phases have historically been accompanied by increased volatility but strong equity market returns. Profit growth for S&P 500 companies is expected to be 19% in 2018 and an additional 10% in 2019. The risk of missing earnings expectations has been reduced in the latest correction. First quarter reporting season begins next week. We expect this to help turn the conversation away from policy issues and back to a healthy corporate sector where it belongs. Positive earnings estimate revisions for first quarter are running higher than the last 10 years. This suggest investors should be optimistic about the results, which helps us remain constructive on the markets.
Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.