April 2, 2018
When the year began, the question on the minds of many investors was, “how much further can the stock market run?” As we noted in our 2018 Market Outlook, sustaining the current trajectory through August would result in the longest bull market since World War II. However, increasing inflation concerns, uncertainty around the administration’s evolving policy agenda and fears of a potential trade war have instilled a collective sense of caution across the markets. Investors’ consideration of these risks while trying to decipher the signals from the noise has translated into outsized market movements, which seem anomalous to the relative calm that has characterized the markets for the past few years.
The year began similarly to how 2017 ended, as improved equity indices in January were driven by strong Q4 earnings and positive economic data. In February, an unexpected increase in the U.S. national deficit heightened inflation fears, helping trigger market corrections in the U.S. and abroad. After partially rebounding in March, equities showed more volatility as international trade tensions escalated. Looking ahead, further turbulence could stem from concerns around a potential consumer spending slowdown. Investors are also tracking the Fed’s careful efforts to normalize monetary policy while keeping inflation in check as fiscal stimulus adds fuel to an already-strong economy.
The economy provided support for investors, helping to buttress equities throughout the first quarter. The February employment report saw the U.S. unemployment rate hold at 4.1%, as nonfarm payrolls grew by 313,000, easily beating expectations with manufacturing payrolls showing similar strength. In light of the tight labor market, the absence of material wage increases could seem counterintuitive. Anecdotally, however, the lack of wage inflation may underscore automation’s impact in certain job categories or signal the underemployment of a large portion of the workforce.
The impressive 60.8 reading in February’s Institute for Supply Management Manufacturing Index reflected robust growth in new orders and backlogs. Similarly, the February ISM Non-Manufacturing Index showed ongoing strength with a 59.5 reading, as all but two industries – arts and entertainment, and accommodation and food services – reported growth. The U.S. Bureau of Economic Analysis also revised its earlier Q4 reading of annualized GDP expansion upward to 2.9% based on consumer spending gains.
The economy continues to support investor confidence. Yet even as employment growth remains a positive story, market watchers are closely tracking the strength of the consumer, particularly if it becomes clearer that GDP expansion is being funded by a savings drawdown. There is also growing consensus that the U.S. is entering the later innings of an extended economic cycle. This view, however, does not yet warrant near-term de-risking strategies, but we continue to follow leading indicators that can provide added color on the state of the consumer.
U.S. Equity Markets
The S&P 500 ended the first quarter down 0.8% (Exhibit A). Geopolitical concerns and questions about the administration’s 2018 policy agenda contributed to market volatility, but stocks were buoyed by ongoing earnings momentum, which itself was spurred by continued economic strength and optimism over December’s tax bill.
Nearly three out of four S&P 500 companies (73%) reported fourth-quarter earnings that topped consensus estimates. FactSet reported that the number of companies issuing positive earnings-per-share guidance in Q1 reached the highest level since it began tracking such information in 2006. In light of the upwardly revised estimates, Q1 earnings-per-share across S&P 500 companies are now projected to grow by 22.5% year over year, with all 11 sectors expected to report positive earnings and revenue growth (Exhibit B). Despite improving economic and business fundamentals, U.S. equity markets do remain expensive relative to historic averages and to the value found in developed international equity markets. With that said, the economy remains quite strong.
The evolving political environment also introduces new risks. A year ago, when the new administration took office, we highlighted that changes to American trade policy represented one of the bigger uncertainties following the election. Fast forward more than 12 months and trade policy has reemerged as a potential headwind to global growth. At the start of March, President Trump announced sweeping tariffs on steel and aluminum. The administration later targeted China more specifically, outlining plans to impose tariffs on $60 billion in imports and suggesting potential steps to limit China’s ability to invest in U.S. technology companies to protect intellectual property rights. President Trump’s cabinet also remained in flux during the first quarter. If a common theme emerged, it was that the incoming cabinet members appear to be more closely aligned with the White House and policy proposals articulated during President Trump’s campaign.
While news out of Washington may have contributed to the quarter’s volatility, stability was found in the market fundamentals. As December’s tax legislation – reducing the corporate tax rate from 35% to 21% – works its way into corporate balance sheets, it could create a future tailwind for earnings provided the stimulus goes toward capital expenditures. Market watchers also expect tax legislation to fuel shareholder-friendly activity, such as share buybacks, increased dividends and the repatriation of offshore profits. Generally, though, we anticipate that the tax bill will be impactful for U.S. mid- and small-cap companies, which typically operate more U.S.-centric business models and have historically paid higher tax rates than their large-cap peers. The risk to domestic equities is that the extra stimulus, coming amid an extended upcycle versus a recessionary environment, creates conditions that cause the economy to overheat. This is one of the reasons the markets have become so sensitive to inflationary pressures.
U.S. Interest Rates
The 10-year Treasury yield ascended from 2.40% to 2.74% during the first quarter. While the 10-year Treasury note never moved past the psychologically important threshold of 3%, the yield curve’s flattening reflects growing caution from fixed income investors. In March, the Federal Reserve raised its Fed Funds target short-term rate to a range of 1.50% to 1.75%, representing a 25-basis point hike (Exhibit C).
One significant takeaway from the March Federal Open Market Committee meeting was that inflation continues to run below the Fed’s target of 2%. Given a strengthening economic outlook, the Committee raised its GDP forecast and increased its rate outlook for 2019, while leaving intact its 2018 projection. New Fed Chief Jerome Powell’s updated forecast calls for two additional quarter-point rate hikes this year and three quarter-point hikes in 2019.
Yields on longer-dated U.S. Treasurys could rise due to strong economic growth, heightened inflation expectations and increases in the real level of interest rates. Several variables, however, will influence the fixed-income markets, including the Treasury’s increased debt issuance coupled with the Federal Reserve’s reduced levels of bond buying. Taken together, these issues could reduce the ballast value of intermediate- and longer-dated bonds.
Outside the U.S., the Organization for Economic Cooperation and Development (OECD) indicated that the global economy continues to expand, spurred by robust investment activity, rebounding trade and higher employment. Among the G7 economies, Canada and Germany posted the fastest Q4 year-over-year real GDP growth, while the U.K. was the laggard of the group. India stood out among key developing nations in the quarter, topping even China in the latest quarterly GDP growth readings, but observers will be watching to see how unfolding corporate scandals affect India’s growth going forward.
The OECD projects that the G20 economies will expand at a 4.1% rate in 2018 (Exhibit D). The challenge, however, is whether mature economies such as those in Europe and Japan can maintain momentum absent an accommodative monetary policy. The European Central Bank, by keeping rates unchanged in March, suggested it could drop its “easing bias.” In Japan, inflation is creeping higher, but few expect Japan’s central bank to abandon its stimulus program in the foreseeable future.
As in the U.S., the global geopolitical landscape is characterized by evolving risks, although signs indicate that some of the more prominent threats may be moderating. Most notably, North Korean aggression seemed to subside in the quarter as President Trump accepted an invitation from North Korean leader Kim Jong-un to meet in the spring. Kim Jong-un’s surprise visit with Chinese President Xi Jinping in the last week of March suggested that China would exert its influence in any future talks.
Another notable development in the quarter was China’s elimination of its presidential term limits, allowing Xi Jinping to remain in power indefinitely. While this action could have long-term consequences, it could also be viewed positively from an economic perspective, positioning China’s command economy to act more decisively in addressing the country’s growing balance sheet.
Elsewhere, Italy’s March election resulted in a hung parliament and seemed to suggest that Europe’s economy could be further shaped by the continued populist movements. Similarly, after nearly six months, Angela Merkel’s conservative party was able to form a coalition with the Social Democrats in Germany, but differing views on Europe, asylum seekers and immigration policy could set the stage for ongoing tension. Silver linings could be found in news that the U.K. and the European Union reached a Brexit deal to provide for a more gradual transition. As part of that agreement, Britain will be covered by the EU common trade policy, while being able to negotiate trade deals with other countries. In Latin America, the focus in the quarter was trained on heightened political discord.
In the coming months, observers will be watching presidential elections in Venezuela, Colombia and Mexico, the latter of which could also influence NAFTA negotiations. Of course, a bigger question on the minds of market watchers is how China will respond if the U.S. follows through with its tariffs. In a statement shortly following President Trump’s trade threats, China’s commerce ministry expressed hope that “the United States will pull back from the brink, make prudent decisions, and avoid dragging bilateral trade relations to a dangerous place.”
Volatility was not confined to the U.S. equity markets. The MSCI EAFE Index, which measures the international developed markets excluding the U.S. and Canada, finished the quarter down 1.5%. The MSCI European Monetary Union Index was also down on the quarter, losing 0.5%, while the MSCI Pacific Index posted a small loss, finishing Q1 down 0.7%. Emerging market shares provided some relief, posting a gain of 1.4% (as measured by the MSCI Emerging Markets Index). The MSCI EAFE index closed the quarter with a forward 12-month P/E ratio of 13.9x, while the MSCI Emerging Market Index ended March with a price-to-book ratio of 1.8x, which remains near its 25-year average.
The rising prospect of a trade war is worrisome for the global economy. By the end of the quarter, however, global investors were able to take some comfort in the belief that the worst-case scenarios had been taken off the table. We will continue to track trade discussions closely. Given the continued strengthening of non-U.S. economies, lower international equity valuations relative to U.S. equities, and moderating geopolitical risks, international stocks remain attractive.
In spite of the renewed sense of uncertainty and our expectations for continued volatility, the economic picture and corporate fundamentals remain solid. We will continue to assess both the risks and opportunities as the year unfolds to help our clients remain well positioned in this dynamic and fluid environment.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.