Volatility continued into the second quarter of 2018 as trade tensions and inflation concerns persisted. Although the S&P 500 made a run at new highs in mid-June, increased protectionist rhetoric drove stocks lower, bringing most indexes back to mostly flat for the year. The Dow Jones Industrial Average was under even more pressure than the S&P 500 as the Dow’s 30 large multinational constituent companies would suffer more under a trade conflict than the average S&P 500 company, which is smaller in size. Small companies were the standout in the second quarter, with the Russell 2000 index posting a solid 7.8% return for the quarter. With a median market capitalization below $1 billion, companies in the Russell 2000 index rely on mostly domestic customers for sales and should be less affected by tariffs on exports than their larger counterparts. Smaller companies should also benefit more from the tax cuts as they have not been able to take advantage of loopholes in the previous tax code that allowed multinational corporations to leave profits overseas without taxation.
A number of interest-rate-sensitive industries, including infrastructure, utilities, and consumer staples, showed better returns in the second quarter of the year as rate increases moderated on softer economic data. Most notably, Real Estate Investment Trusts were up about 10%, bringing the full year into positive territory. Speculation of a trade war drove the value of the U.S. dollar higher relative to other global currencies. The stronger dollar hurt dollar returns of foreign investments, driving international stocks and bonds into negative territory.
Fears of increased tariffs on foreign goods and the possibility of a global trade war took center stage during the quarter, driving increased volatility in stocks. By the end of the quarter, tariffs on $55.7 billion of imported goods had already been implemented, including taxes on washing machines, solar panels, steel, and aluminum. A first round of tariffs on $34 billion of imports from China began on July 6. The U.S. has also threatened three further steps, including a 25% tariff on an additional $100 billion in goods from China, a 20% tariff on $275 billion in auto imports, and a further 10% tariff on another $300 billion from China. If all these were implemented, the total amount of tariffs would reach $800 billion. This breaks the trend of steadily declining U.S. tariff rates from about 20% in the 1930s to about 1.5% at the beginning of this year. If all the tariffs are implemented, rates would increase to levels last seen in the 1970s.
An analysis by Goldman Sachs shows that the macroeconomic effects of these tariffs by themselves are fairly modest. Assuming most countries retaliate with similar tariffs, imports and exports should be reduced by similar amounts, making the net impact to Gross Domestic Product (GDP) minimal. Economic simulations show a negative impact on global growth by about 0.1% to 0.2%, not enough to tip the U.S. into a recession with a current growth rate of more than 2%. The biggest impact of the tariffs will be higher inflation, which will require higher interest rates and tighter financial conditions that could have a more meaningful impact on the economy down the road.
While this is true, there are other retaliatory measures that could do more damage to the economy than increased tariffs. Most notably, China could reduce its holdings of U.S. Treasuries, which would further increase interest rates and tighten financial conditions. This is probably unlikely as it would also be damaging to China because it reduces the value of its remaining U.S. Treasuries. China could also depreciate its currency, helping its economy offset some of the damage from increased tariffs at the expense of slowing the global economy. China could focus on companies that do a significant amount of business in China--such as Apple and others that are exposed to Chinese regulators--and make it harder for them to do business in the country. Another potentially more damaging scenario could be that a global trade war escalates and stock markets sell off as a result. Lower stock prices would further slow economic activity because a higher cost of capital leads businesses to constrain spending and individuals to lose confidence and reduce spending. Finally, any increased uncertainty regarding trade could lead corporations to delay hiring and spending plans, which would also lead to a slowdown in growth.
The U.S. economy, despite trade concerns, remains very strong and poised to accelerate into 2019. Corporations are still feeling the benefit of much lower taxes and increased earnings, which promote very high levels of business optimism. First quarter earnings per share (EPS) growth for S&P 500 companies increased 27%, driven mainly by improving net income margins from the lower tax rate along with healthy revenue growth. This level of growth should continue through the rest of 2018 as a full year of lower taxes works its way through. GDP growth reached 2.8% in the first quarter, above the current expansion average of 2.2%, as well as above the long-term historical GDP growth average of 2.7%. Employment is historically strong, with the unemployment rate hovering below 4% and likely to reach one of its lowest levels in 50 years. Fiscal stimulus from the federal government is further boosting the economy and is expected to pour an additional $170 billion into the economy through tax cuts this year, with an $833 billion deficit versus the $665 billion deficit in 2017. The deficit will grow even more in 2019 when it is expected to near $1 trillion.
Although strong economic growth and inflation had been notably lacking in the current expansion, this is no longer the case. Not only is growth above its long-term trend rate, inflation indicators are starting to rise above the Federal Reserve’s target rate of 2.0%. The Consumer Price Index (CPI) hit 2.7% in May, or 2.2% excluding the impact of food and energy. Economists expect inflation to accelerate in the second half of the year even before taking into account any increase in tariffs on imported goods. The result would likely be a more aggressive monetary policy response from the Federal Open Market Committee (FOMC) and bigger hikes to short-term interest rates than currently anticipated. Wage growth has also been upwardly trending and it would be hard for unemployment to fall much below the mid-3% level.
Without additional workers to add to production, economic growth will be naturally constrained. Demographically, the U.S. is in a challenging time as large numbers of Baby Boomers are retiring and Millennials are entering the workforce in numbers only large enough to replace them and keep workforce levels steady. An increase in the labor participation rate would help, but at this point most nonparticipants are over the age of 65 and not likely to re-enter the workforce, or they have other issues such as felony convictions that are keeping them out. A survey by the National Federation of Independent Businesses (NFIB) showed that 63% of businesses are hiring or trying to hire, with 55% of firms reporting few or no qualified applicants for the open positions. Labor shortages are particularly acute in home building, which also contributes to a shortage of new homes and higher home prices. With firms still trying to hire, the survey showed that 31% of firms needed to raise wages to hire and keep employees. We should expect employment growth to slow at some point in the not too distant future, a negative sign for future growth.
Another negative sign for future growth is the flattening of the yield curve. The yield curve measures the gap between yields on short- and longer-term Treasury bonds, which is currently at an 11-year low, a sign that investors are cautious about long-term growth. The current gap between two- and 10-year government bonds is 0.279%, the lowest level since August 2007. If this number goes negative, meaning two-year Treasuries have a higher yield than 10-year Treasuries, the yield curve would be considered “inverted.” An inverted yield curve has preceded every recession since 1975. Although there is no indication from the data that the current expansion should end before mid-2019, there are indications that we are late in the business cycle and trouble could be on the horizon by late 2019.
Economic data and earnings reports for the second quarter should be very strong. However, it is important to remember that this information is backward looking and not reflective of the current trade conflict. We still feel that economic growth should continue for at least 12 months. With a growing economy, stocks are unlikely to experience a significant pullback of 20% or more. The potential for a damaging trade war certainly dampers some of this enthusiasm and increases risks going forward. Trade rhetoric should keep volatility levels elevated compared to levels in the low volatility environment of 2017. Our most likely expected forecast of the current trade conflict is a minor slowdown in economic growth. While some industries, such as agriculture, will feel a much more negative effect, the overall impact should be small. There is a risk, however, that the trade conflict shows up in the economic data through falling confidence, slower spending, rapidly accelerating inflation, and/or higher unemployment, which could end the expansion prematurely and lead to a recession and a bear market in stocks.
On a positive note, stocks should get some support as valuations look reasonable compared to other market peaks. At current levels the S&P 500 is trading at 16.1 times estimated forward 12-month earnings, the 25-year average earnings ratio. By comparison, this metric was over 24 times forward earnings during the 2000 peak. As a result, the current average earnings valuations should cushion part of the blow of a market downturn or recession.
Timing the market is always difficult, even more so in today’s environment. Frequent reversals in direction and the corresponding increase in volatility are likely to continue as trade tensions persist and increases to trade tariff announcements occur. We feel it is important to maintain exposure to stocks as they continue to offer the best potential for long-term growth and are an effective holding to combat inflation given low return outlooks for other asset classes. This is an important time to manage risk through diversification into bonds and other noncorrelated assets, a strategy we have employed in our clients’ portfolios during the past few years.
Stephen C. Biggs, CFP®, CFA
July 17, 2018