Accounting On Us
2018 2nd Quarter market outlook
Trade war, corporate earnings + more
Michael Carlin, AIF
The first quarter of 2018 has not disappointed with new market volatility, economic surprises and data for us to pour over. If you look back at the numbers over the first three months of the year, you’ll see the sharp reversion from what 2017 provided. Last year, virtually every area of the market seemed to do very well across the board. However, in the first quarter, those same areas largely changed course and sold off in the first three months of the year. Even continuing through the beginning of May 2018, the market is still relatively flat for the year.
All eyes are turned toward the Federal Reserve. Regular listeners of our Mange the Funds Podcast know that we watch the Fed’s actions very closely. The big question looking forward is how many interest rate increases will the Federal Reserve do? Market expectations call for another rate increase through the remainder of the year, which would put short-term interest rates greater than 2%! This is important for a few reasons:
- Long-term interest rates have not jumped significantly higher when compared to short-term interest rates – this is making the yield curve quote unquote flatten out. The last two times the yield curve went flat was 2000 and 2007 and the stock market performed very poorly after both. While we aren’t saying a flat yield curve is the end of the world economically, we do take it as a sign of concern.
- As the Fed raises rates, they are going toward a more restrictive money policy. The chart below shows the Federal Reserve easing after the financial crisis. You can see the market moves higher with continued Federal Reserve help. Conversely, if the Federal Reserve is more restrictive with money policy, it is not only likely not to be helpful to the economy, but, in fact, a negative. Keep in mind, lower rates helped keep borrowing costs low for businesses and consumers which helps consumer spending stay high – particularly auto and home sales. As rates rise, look for some other areas of the market to struggle.
Publicly traded companies, boosted by tax reform, posted blow out earnings in the first quarter of the year. As the numbers are still trickling in, the expectation is they will be as much as 30% higher year over year. The earnings were so good, in fact, that the often discussed and scrutinized PE Ratio fell from 20.0 to 16.9. Here’s why that’s important. The 20-year average PE Ratio of the U.S. Blue Chip companies as measured by the S&P 500 is 16. 7. If earnings continue to rise, and this mythical PE Ratio continues to fall, it will make many very confident about stock market prices and our ability to grow moving forward.
However, one thing to be careful of is future earnings estimates and how that translates into stock market performance. We have a chart that goes back from 2018 through 1998. On the chart, it shows the previous two recessions starting in 2001 and 2008. The detail that raises a sign of caution for me is how the earnings estimates continue to go up as companies make future forecasts and they didn’t see a recession coming. With this chart, it’s easy to see how even higher future earnings estimates may very well be missed – much like they have been in the past because companies can’t always forecast economic traumas.
Now, we’ll go into our special breakdown – the trade war! Rarely does a week go by without an update on relations between China and the Trump Administration. Much focus and attention is put on this news story; we are very aware of the reasons why and the potential implications of this situation becoming worse. Here are some things to know about the Chinese economy to gain a greater understanding of what this trade war is all about:
- China is the largest share of global GDP growth in the world. In fact, they make up more than 35% of all the world’s growth every year.
- Overall, China is working hard to become the largest share of the world’s annual TOTAL GDP which is a title that the United States held for a couple of decades. Looking back, China hasn’t been the world’s largest share of GDP in about 200 years and they’d obviously be excited to regain this crown.
- As much as China is hoping to grow, their year over year growth rate has been slowing since 2008 and many expect it will slow for the next few years. China pushes to grow while fighting anti-corruption campaigns, continued financial and fiscal reforms at the same time abolishing the one child policy.
- Our largest area of concern is the amount of corporate debt in China. Many people scoff at the U.S. debt because it is roughly equivalent to our annual GDP – it’s like saying 100% debt to GDP. Yet, if you look at the amount of debt that Chinese companies have on their balance sheet, it is 165% debt to GDP – even more disproportionate than here in the U.S.
As a result, we have some concerns about Chinese growth and the country’s ability to push forward as they look to become the world’s largest economic power. With China being so close to achieving this goal, President Trump’s tariffs only seek to slow their ability to achieve this objective. Right now, only small measures have been thrown about between Trump and China, including duties on steel and aluminum, with China duties on luxury foods. There could be cause for concern if bigger measures were taken, such as the Trump Administration blocking real estate purchases, or if China unloaded its stock pile of U.S. treasuries.
We’re watching this situation closely while trying to find the data to reveal what may happen. There’s historical precedence that a prolonged and intense trade war with heavy tariffs would be detrimental to the U.S. economy and the job market. As long as there are reduced measures without more severe economic battling, we believe that a favorable trade deal will be worked out. Don’t be surprised that if this situation changes, institutions start to look to become more defensive very quickly, creating a signal for the rest of the investing world to rethink taking on high risk investments.
If you want more information on our 2018 2nd quarter market outlook, listen to our Manage the Funds podcast.