An extended period of tranquility ended as the record low volatility observed in stocks over the past year gave way to a correction in February and continued higher volatility through the end of March. The February jobs report indicated not only that the economy continues to create jobs at a healthy pace, but also showed early signs that wage inflation may begin to accelerate. This sparked inflation concerns that led to the sell-off in stocks. This data was followed by signs of increasing consumer prices when the Consumer Price Index (CPI) release the following week showed one of its highest readings in several years. Although none of the data indicated rapid inflation, this was enough to make investors nervous as it could lead the Federal Reserve to more aggressively increase interest rates. After recovering most of the losses through the month, the late February announcement of tariffs on imported steel and aluminum led to the second round of volatility, returning stocks to correction levels.
Although February and March were bad months for stocks, a very strong January has kept year-to-date losses minimal, with the S&P 500 down less than 1% during the first quarter. The 10-year Treasury bond, a benchmark for long-term interest rates, reached its highest yield in several years at almost 3%. Rising long-term rates put pressure on many parts of the market typically seen as safe havens, including bonds and high-yielding stocks in industries such as utilities, telecommunications, and consumer staples.
THE FED & RATES
With the recent tax cuts, the federal government is expected to pour an extra $200 billion this year into an economy already running at full capacity. As employees become harder to find and infrastructure resources start to become strained, investors are paying very close attention to any indication that inflation could be accelerating. This heightened sensitivity drove the sell-off in markets when the January employment report was released in early February. The report indicated that wages had increased 2.9%, the strongest pace since 2009. Although this was higher than what we have seen, it is still a fairly anemic number and well below historical wage increases of over 4% that have been seen late into economic expansions. A higher than expected CPI reading the following week added to concerns over inflation. Subsequent reports have been much tamer, reducing many of the immediate concerns over inflation.
Long-term interest rates responded to inflation concerns; nervous bond investors sent the 10-year Treasury rate up to almost 3% from less than 2.5% at the beginning of the year, marking its highest rate in more than four years. Ten-year rates have since fallen back to 2.75% and are still well above government bond rates in Europe and Japan, making it unlikely rates will go significantly higher and damage the economic recovery. The Federal Reserve has direct control over short-term interest rates with its ability to control the federal funds rate. As expected, the Federal Open Market Committee (FOMC) voted in March to raise the target rate for federal funds by 25 basis points to the 1.5% to 1.75% range. Most economists believe that the FOMC will vote to raise the federal funds target rate two more times before the end of the year. Although investors get nervous about the FOMC raising rates, this is an indication of a growing economy and stocks historically peak well after they stop raising rates.
After a first year in office that focused mainly on repeal of the Affordable Care Act and tax reforms, President Trump began to focus on trade issues that his campaign highlighted leading up to the 2016 election. The most significant announcement came in early March, when it was announced that the U.S. would impose a 25% tariff on imported steel and a 10% tariff on imported aluminum. Although the largest importer of U.S. steel is Canada, it was later announced that Canada and Mexico would be at least temporarily exempt from the new tariffs as they worked to renegotiate NAFTA. The European Union announced a list of U.S. imports that would be subject to tariffs of 25% if it were not exempt from the steel and aluminum tariffs. Although China accounts for only a small portion of U.S. steel imports (2% in 2017), it may be the real target of these tariffs. Because the tariffs are being levied under a provision of trade law that applies to national security rather than dumping, it will be possible to exempt imports from military allies and focus on China. This threat to tax Chinese imports appears to be a negotiating tactic, as implementation would still be 30 days after the announcement.
Concerns over intellectual property thefts from China have been an ongoing concern for U.S. companies doing business in China. Historically, a technology company doing business in China has had to turn over its technology, which has usually ended up being used to compete against the patent holder. As a result, the Trump administration launched an investigation into China’s practices regarding “technology transfer, intellectual property, and innovation” last August. Under this section of trade law, Section 301, the U.S. would be allowed to take action against any good or economic sector without regard as to whether or not it was involved in the dispute. The dollar amount of tariffs should be equal to the amount of economic damage done to the U.S., which in this case is estimated to be in the $60 billion to $200 billion range. Announced actions would target the low end of this range, meaning all Chinese imports to the U.S. would need to be taxed at an average of 12% given the 2017 level of $500 billion in imports. Items that the U.S. runs a large trade deficit in, and could be likely targets for tariffs, include power tools, small electric appliances, sporting goods, toys, and consumer electronics. In response, China announced a number of tariffs on goods imported into the U.S. from China.
Increased volatility is likely here to stay. Investors will be very concerned over a trade war, and the direction of negotiations throughout the month is likely to have a big impact on stocks. Should negotiations fail to avert a trade war, the impact on the global economy is likely to be quite negative and could be enough to end the nine-year expansion. The best outcome for markets and the economy is an agreement that both the U.S. and China can live with, and free trade continues. In addition to China, there are currently ongoing negotiations with the European Union and around NAFTA. Negotiations over trade are likely to remain in the headlines for some time to come, keeping investors on high alert and volatility at elevated levels.
Inflation is another key concern for investors. With unemployment near all-time lows and rising job openings, indicating companies are having a hard time finding employees, wages are likely to show stronger growth. Although a breakout to much higher inflation and interest rates seems very unlikely, it will be at the top of investors’ concerns over the coming months. With concerns over inflation growing, the market will be looking at good news as bad news. For example, a report that indicates robust job growth will be interpreted as a negative for stocks, sending stocks lower.
Despite heightened concerns around inflation, there is no indication that the expansion will come to an end over the next year. Tax cuts look to produce record profit growth for U.S. corporations. Even conservative asset managers are forecasting close to 20% earnings growth in their models for all S&P 500-member corporations. Assuming these forecasts hold, it would be very difficult for stocks to end the year lower. With the correction in stock prices over the past few months, valuations are in line with historical averages and look more attractive than they have in several years. We are clearly late in the economic expansion, but we don’t believe this is the year it ends unless there is a full-blown trade war. If negotiations with China reach a successful conclusion there is significant upside to stocks from current levels.
Stephen C. Biggs, CFP®, CFA
April 9, 2018