Our Retrospective on Tumultuous March
The global economic expansion is starting to peak. Economic surprises are decidedly disappointing in Europe, Japan and the U.K., while the U.S. is trending sideways. EM’s continue to remain strongly positive, as trade continues to power their expansion. Interestingly, the economy is powering down as economists are continuing to revise up year-end growth expectations, setting the stage for disappointment later in the year.
2018 earnings expectations in the U.S. will be challenging to beat. Significant potential for earnings disappointment exists as the year progresses, amid a continued backdrop of volatile, protectionist headlines out of Washington. International and EM earnings expectations are much more attainable.
Inflation hawks in the U.S. are sounding the alarm bells. Global yield curves are bear flattening, while 10-year break even inflation rates are falling in the U.S. and global inflation remains benign.
Figure 1: Market Performance as of March 29, 2018
Market Review: Tariff War?
The stage was set for a trade war early in March when the U.S. hit foreign steel and aluminum manufacturers with import tariffs. The European Union immediately warned of retaliation, stating it would target iconic American brands with tariffs in-kind. Near month-end, the U.S. announced it would impose tariffs on $60 billion in Chinese goods over intellectual property violations. China retaliated by unveiling tariffs on $3 billion in U.S. imports, making the prospect of a trade war very real. At a time when the world economy seemed to be running on a full tank of gas, an otherwise uplifting outlook is now clouded by the uncertainty of a potential trade war.
This potential tariff war moved U.S. equities downward in March. The S&P 500 Index fell 7% from March 9th to March 23rd, as investors weighed the effects of a global trade war on multi-national companies. Further exacerbating the equity decline was the prospect that Facebook founder, Mark Zuckerberg, would testify in front of Congress over user privacy violations during the 2016 election and possibly face regulation, which took the air out of the technology sector’s bubble. Stocks rebounded modestly late in the month as investors began to judge the selloff as potentially overdone. The S&P 500 Index finished the month down 2.7%. Investors largely rotated into smaller cap companies believed to be more insulated from global trade effects. The S&P Small Cap 600 Index finished the month up 1.9%.
The 10-year treasury yield dipped below 2.80% mid-month, while the yield curve flattened in March to a two and a half year low. The 10- to 2-year Treasury spread fell from 62 bps to 47 bps during the month end as investors weighed the potential for faster rate increases with uncertainties over the global growth outlook. Bond investors pointed to a growing mismatch between the current economic environment and potential for decreasing future growth. The Fed’s move to cap inflation through accommodation removal combined with a bumpy month for Treasury issuance and the prospects of a global trade war, left bond investors less than enthusiastic about rising global growth potential, leaving the long end of the curve lower at month end and the short end higher.
The Fed voted to raise interest rates .25% at the March meeting to a range of 1.50% to 1.75%. The market has three more rate hikes priced in for this year, while the Fed expects two. The Federal Open Market Committee (“FOMC”) raised the GDP outlook two tenths to 2.7% for this year, with core inflation expected to remain tame at 1.9% this year and 2.1% in 2019 and 2020. February core PCE posted at 1.6%.
The Senate averted a government shutdown by passing a $1.3 billion spending deal, which President Trump approved with some tax revisions. The revisions included a fix in a glitch in the new tax code, expanding the low-income housing tax credit, and providing funding for the Internal Revenue Service. President Trump fired Secretary of State Rex Tillerson in March and named CIA Director Mike Pompeo to replace him. Attorney General Jeff Sessions fired the FBI’s former deputy director, Andrew McCabe, after the FBI’s Office of Professional Responsibility recommended McCabe’s dismissal for not being forthcoming about authorizing discussions with a reporter about a pending investigation. By month-end, Trump fired VA Secretary and cabinet member, David Shulkin.
U.K. officials stated that they don’t expect to clinch a Brexit deal until two months before exit day, increasing the chances of chaos for executives and lawmakers. British Prime Minister Theresa May threw out 23 Russian diplomats in retaliation for the poisoning of a former spy and his daughter on U.K. soil. Russia then ordered the expulsion of 23 British diplomats in retaliation. The U.S. followed by expelling 60 Russian diplomats and closing the Russian consolidate in Seattle, to which Russia expelled 60 U.S. diplomats and closed the U.S. embassy in St. Petersburg.
Germany’s Social Democrats voted to join Chancellor Angela Merkel’s next government, clearing the last obstacle to her fourth term and restoring a feeling of political stability in Europe’s biggest economy. Italy’s anti-establishment groups rose in the beginning of the month’s election as voters penalized the mainstream parties for years of economic decline, rising taxes and a surge of immigration, casting doubt on the country’s future political direction. Projections based on ballot counting suggested the two groups with the biggest gains, the Eurosceptic Five Star Movement and the Anti-Migrant League, could reach a majority of the vote.
The Bank of Japan gave new insight into when it might slow its stimulus program. Governor Haruhiko Kuroda’s remarks that the central bank will begin to think about how to complete its unprecedented easing around the fiscal year starting April 2019, was the clearest indication yet that a conclusion might be coming.
China stepped up its push to curb financial risk at the beginning of the month, cutting its budget deficit goal for the first time since 2012, and setting a growth objective of around 6.5%. China’s crackdown on financial risks and trade tensions with the U.S. threaten to undermine a stronger-than-expected start to the year for the Chinese economy. Factory output and investment in fixed assets exceeded economists’ expectations in the first two months of this year as Chinese exports surged.
Poland doubled down on rate-pause policy this month taking a dovish turn after new economic projections and forecasts showed inflation remaining around its 2.5% goal.
Vladimir Putin took an easy victory in the Russian presidential elections to land a fourth term that will keep him in power through 2024.
Going Forward: Tariffs Trump Growth
As we look across the investment landscape, we take note of the fact that the expansion has been fueled by global trade and low borrowing rates, which has broadly benefited emerging market equities and debt. As the Trump administration unnerves markets with protectionist U.S. trade policies, emerging markets continue to rally on the volatility. Typically, with a high beta asset class, the MSCI Emerging Markets Index has returned +1.4% year-to-date, while the MSCI US Equity and EAFE Indices have fallen .8% and 1.5%, respectively, in dollar terms. On a local currency basis, the MSCI EAFE Index is down 4.3% year-to-date, while the MSCI EM Index still remains up 70 bps, reflecting the erosion of the U.S. dollar relative to foreign currencies and the tailwind that erosion is providing to emerging market economies, particularly those that are big commodity exporters and hold significant U.S. dollar-denominated debt, such a Brazil.
European equities stand to be the biggest loser in a trade war. Interestingly, despite the trade tariffs imposed against China in particular, EM Asian equities have also packed a solid punch all year, supporting the idea that the Chinese century may be dawning. U.S. equities remain somewhat supported by tax stimulus and the promise of fiscal stimulus; however, the reality of the tax stimulus is still yet to be fully understood and 2018 corporate earnings expectations are through the roof. All in all, potential for disappointment in the U.S. market is the greatest risk facing investors today.
Perhaps the big question on everyone’s mind is what will happen to inflation. Economic theory tells us that massive monetary expansion in a tight labor market should produce inflation, yet we have seen little evidence of it. In 2008, unemployment increased from 5% to 10% and wage growth dropped from 3.5% to 1.5%, which set the stage for the nascent inflation experience of the past decade. As the unemployment rate dropped back to 5% from 10% by 2017, wage growth increased to 2.4%, leaving a 1.1% gap in wage growth. Without wage growth, there are no increases in disposable income, leaving it hard to envision higher levels of consumption and thus, inflation.
Tariffs, however, can cause inflation simply by raising the price of goods by the amount of the tax levied. They also result in less consumption, i.e. higher prices equate to less goods demanded, and artificially benefit domestic producers and governments at the expense of consumers. Trump’s protectionism thus could leave the Fed in an awkward spot, vis-à-vis rate hikes in what appears to be a fragile recovery.
Rising Interest Rates
What remains quite clear is that interest rates, at least in the U.S., will continue to rise. While the long end of the yield curve transiently trails the short end, inflationary pressures continue to mount, just as the U.S. government is preparing to issue a swell of debt. While there is doubt on the part of bond market traders that stronger growth will come to pass is justified, longer term Treasury issuance is set to rise from $13 -$15 billion per auction this year, to $20 – $25 billion per auction next year to pay for fiscal stimulus. This places considerable pressure on the long end of the Treasury curve over the next year. Moreover, China, whose current $1.2 trillion dollars in U.S. debt is drifting downward, could retaliate against US tariffs by reducing purchases of U.S. debt going forward. Spreads in investment grade corporates and high yield continue to widen as the equity outlook sours, though not dramatically. On the whole, policies remain favorable to corporations, while growth expectations continue to fall over the near term. Thus, credit should perform better relative to equities, particularly at the higher quality end of the spectrum.
The dollar will continue to be weak as volatility remains high, and threats of protectionism continues to rattle investors. A weaker dollar supports oil and commodity prices and thus, emerging market economies. Interestingly, it also plays into the hands of gold as a safe haven, particularly as geopolitical risk is rising. Typically, rising U.S. interest rates relative to global rates support a stronger dollar; however, the weak inflation picture and potential for increasing capacity acts as a moderator, supporting continued investment into EM equities.
We remain overweight in EM equities relative to U.S. and International equities. We continue to prefer less interest rate sensitive fixed income instruments at lower credit ratings within the bond market. Lastly, we continue to believe in alternative sources of income such as asset based lending, and cash flow real estate deals.
–Your investment team at Lido Advisors