By Thomas Dillman
The financial markets experienced significant swings in both directions during the first quarter as uncertainty about continued economic growth in the United States and across the globe rose. Mutual of America Capital Management LLC explores some of the contributing factors, including rising interest rates in the U.S., trade agreement tensions among various countries – especially between the U.S. and China – and the concern that geopolitical events could rear their ugly heads.
After hitting a cycle peak of 2,872 on January 26, the S&P 500® declined by 10% over the next 10 days, while volatility returned with a vengeance. The precipitating event was a report that average hourly earnings jumped from 2.5% to 2.9% over the previous two months. The threat of accelerating inflation and uncertainty about the Federal Reserve's response rattled markets. During the previous year, the index rarely varied by more than plus or minus 1%. Since the peak in market prices, it has varied by more than 1% almost daily.
What changed? The Tax Cuts and Jobs Act passed by Congress at the end of 2017 promised a jump in corporate earnings and cash flow, usually viewed as good news. It seems, however, that the market already incorporated the positive benefits during the year-end rally prior to the passage of the Act. Looking forward, investors face a variety of uncertainties ranging from the economic to the geopolitical.
Quantitative Easing Impact
Throughout most of this long economic expansion, Federal Reserve policy was the central issue for our economy, as well as the global economy. The series of progressively larger quantitative easing (QE) programs employed by the Fed over a six-year period were a radical departure from any prior central bank policy – except a tepid initiative by the Bank of Japan in the late 1990s. As other central banks followed the Fed's lead, the amount of liquidity plowed into the international financial system was staggering. At its peak, more than $12 trillion of incremental liquidity was added to the world's economy, more than half the size of U.S. Gross Domestic Product (GDP) and about equal to that of China.1 The aim was to stimulate borrowing and spending to preclude a global deflationary disaster threatened by the collapse of the housing market in 2008 and the subsequent Great Recession.
Critics argued the policy would inevitably lead to uncontrollable global inflation, yet inflation remained dormant until recently, showing a modest though steady increase. Instead of liquidity flowing to the real economy (e.g., borrowing for capital equipment, expansion and inventory), it appears most of it went into financial assets such as stocks, bonds and exchange-traded funds (ETFs). In retrospect, QE programs must be credited with avoiding a global economic meltdown. However, the goal of stimulating economic growth was disappointing. U.S. GDP was barely able to maintain a 2% average growth rate over most of the recovery, while Europe spent most of the period in recession and Japan struggled to generate even modest growth. China, largely through internal measures such as massive lending programs, was only able to arrest the decline in its growth, at one time as high as 11% on an annual basis, to about 6.5% over the past several years.
However, over the past two years the Fed began scaling back QE and raising short-term interest rates, attempting to anticipate inflationary tendencies threatened by an unemployment rate nearing historical lows and the expectation of an accelerating economy. The latter became reality in the last three quarters of 2017, as GDP jumped to an average 3% from the expansion average of 2%.
How High Will Interest Rates Rise?
The key question for investors going forward is how high the Fed will raise short-term rates, and how quickly. Since the end of 2015, the Fed has raised the Fed Funds rate six times, from a range of 0%–0.25% to a range of 1.50%–1.75%, and has indicated there could be at least two more rate hikes this year and three in 2019. That would take the Fed Funds rate to 3%, a level not seen since late 2013 and slightly higher than the current 10-year Treasury bond. More important is that the 2-year Treasury is only 50 basis points lower than the 10-year Treasury. Historically, when 2-year Treasuries rise above 10-year Treasuries (referred to as an "inverted yield curve"), recession usually follows 9 to 12 months later. Assuming the 10-year Treasury rate remains as is, an inverted yield curve is only two Fed Fund increases away unless 10-year rates rise further.
Investors are also concerned about how the new composition of the Federal Reserve Board will affect the pace and magnitude of Fed Funds rates. Jay Powell succeeded Janet Yellen as Chairman and three new Board Members were appointed by President Trump. Preliminary assessments based on the past positions of each individual suggest that current policy will remain unchanged unless warranted by a meaningful change in the economic data.2
In summary, the reversal of QE, concerns about how high and how quickly the Fed will raise short-term rates, and the effect of an essentially new Federal Reserve Board on current policy represent a heightened uncertainty, something the markets do not like.
Global Trade Issues Come to Forefront
While concern about Fed policy has been constant throughout this expansion, albeit with varying levels of intensity, the issue of a global trade war has just recently come to the forefront as a major source of uncertainty. Trump made it clear during his presidential campaign that he intended to make significant changes in U.S. trade policy. Shortly after taking office, he announced the U.S. withdrawal from the Trans-Pacific Partnership (TPP). At around the same time, he insisted upon renegotiating the terms of the North American Free Trade Agreement (NAFTA), threatening to pull out of the agreement with Mexico and Canada unless adjustments were made to accommodate U.S. interests. He also nixed the idea of a trade agreement with Europe, favoring bilateral rather than multilateral treaties because he felt the latter tend to lead to subsidization of other signatories by the U.S. The consistent theme of his trade policy is "fair trade," not a repudiation of free trade. As supporting evidence, it was easy to cite U.S. trade deficits with most of our trading partners, especially China.
However, not until the Trump administration placed an across-the-board 25% tariff on all steel imports and a 10% tariff on all aluminum imports in early March did investors focus on the realities of what such a dramatic action could have on global growth. Over the next two weeks, the S&P 500® declined to the same level it reached in the February correction. Almost immediately after the imposition of these tariffs, the administration granted exemptions to most of our allies from which we import these products.
The key exporter of steel and aluminum to the U.S. is China, and no exception was made in its case. In the weeks that followed, the administration implemented $50 billion of tariffs against a broad array of Chinese goods, to which China responded in kind. Trump threatened another $100 billion in tariffs against China. However, both sides suggested that serious negotiations were in progress on the issues of most concern to the U.S., whose trade deficit with China alone is more than $300 billion annually. China doesn't import enough U.S. goods to retaliate against the full $150 billion of threatened tariffs even if it wanted to. The Trump theme of "fair trade" is evident in all these recent actions. His specific goals are to get China to open sectors of its economy that have remained closed to foreign competition, to eliminate the forced transfer of U.S. technology as the price of entry into other sectors and to get China to respect intellectual property rights as opposed to ignoring them. All these objectives have the broader goal of increasing "fair trade" with China, the tangible measure of which would be a significant shrinkage of the U.S. trade deficit with China.
Interestingly, as the trade imbroglio with China expanded, the U.S. sent out signals that NAFTA negotiations seem to be leading to some type of resolution acceptable to the three parties involved. And most recently, Trump suggested the possibility that the U.S. might rejoin the TPP trade group. This latter ploy appears designed to put more pressure on China to negotiate better terms of trade.
As on most issues, it is difficult to follow the twists and turns in President Trump's policies as he keeps everyone guessing and off-balance. On several occasions he has surprised even his closest advisors and cabinet members with his off-the-cuff pronouncements. Most observers expected Trump to become "more presidential" once in office, and to alter his business methods summarized in his book, The Art of the Deal. So far, his tactics seem consistent with those employed throughout his business career, tactics that obscure the underlying strategy. That said, he has taken steps toward fulfilling many of his presidential campaign pledges, including those involving taxes, immigration and trade. Nevertheless, what he will or will not do next has added to the uncertainty confronting market participants.
Eye on the Economy
Then there is the economy. Last year, economists and investors celebrated the "global synchronized economy." This year, that harmony is beginning to sound some notes of discord. Specifically, the European recovery seems to be faltering, mainly because of the relative strength of the euro. Exports constitute a significant portion of European GDP, and European exports have become more expensive. More broadly, the Purchasing Managers Indexes (PMIs) have begun to soften across most countries, after advancing to historically high levels last year, although they remain at elevated levels. Nevertheless, the direction of change is negative, a reason for caution if not concern.
In the U.S., GDP for the first quarter of 2018 is currently expected at about 2.0%, a disappointing result given the 3% rate generated in the last three quarters of 2017. Retail sales have been especially weak. Year-over-year the trend is +2.1%, +0.9% at an annual rate over the past six months, and now running at -1.2% at an annual rate on a three-month basis.3 Housing remains sluggish, mainly because mortgage rates are rising, supply remains tight and home prices are rising. The good news is that pent-up demand is strong. The bad news is that homebuilders lack the confidence to buy land or build houses, remembering the devastation from 2007–08 that left them with excess inventory, at prices well below anticipated selling prices. While surveys suggest corporations have raised their plans for more capital spending as a result of the tax cuts, it is too soon to see such spending show up in economic statistics. As for net exports, the U.S. continues to show growing monthly trade deficits despite the weak dollar. This is a negative contributor to GDP.
Whether growth will reaccelerate over the remainder of the year depends on how tax cuts are used by consumers and businesses. So far, consumers don't seem to be rushing to spend their additional income, as suggested earlier, and the expectation that businesses will substantially increase capital spending remains to be seen.
Geopolitics Present Real Concerns
Outside the economic realm, geopolitics remains an ever-present concern that at any moment could erupt and take center stage. The world powers are going through a process of realignment. Saudi Arabia, with the full backing of the U.S., is emerging as a potentially more forceful opponent of rising Iranian influence in the region. Syria is the flash point, a military quagmire, a diplomatic nightmare and a humanitarian disaster. It is difficult to envision an end to the crisis as Russia, Turkey, Iraq, Iran, Israel and the U.S. are each playing active roles in a scenario of shifting alliances in which no one trusts anyone else. North Korea remains a primary threat to world peace as it maintains its commitment to the development of its nuclear military capability. Recent apparent thawing of hostilities between North and South Korea, including rumors of a possible treaty to formally end the Korean War that first broke out in 1951 and preparations for a meeting between President Trump and Kim Jong-un, is a hopeful sign. However, given the history of broken promises by North Korea, it is reasonable to remain skeptical of any permanent resolution.
Russia's more muscular foreign policy under President Putin, including his invasion of the Ukraine and seizure of the Crimea, military support for the Assad regime in Syria, use of the internet to meddle with the 2016 U.S. presidential election, and purported poisoning of former Russian operatives living in Great Britain, met with an international campaign of increasingly onerous economic and personal sanctions. Putin's goal seems to be to play the disrupter to ensure a seat at the table of the superpowers. Russia's nuclear capability combined with a more aggressive military posture remains a threat to world peace.
However, the evolving relationship between the U.S. and China involves the greatest risks. While not currently matched evenly, the two nations are the first and second largest economic and military powers in the world. China made clear its plans to become the dominant power on the world stage. The appointment of Xi Jinping as president for life is clearly reminiscent of China's famous and enduring empire of the past, as well as of Chairman Mao's one-man rule of Communist China. China and the U.S. are currently engaged in a variety of tactical maneuvers to test each other. On the military side, China's construction of a number of man-made islands in the South China Sea represents a brazen statement that it aims to control the most important Pacific sea routes for international trade while providing potential military outposts beyond its borders. On the diplomatic side, the current tit-for-tat on trade may or may not lead to compromises to diffuse tension. But there is no doubt that the relationship between these two nations will dictate the direction of world affairs in the coming decades. How the relationship evolves over time will remain an overhanging uncertainty for many future generations.
Keeping Watch on Domestic Issues
A near-term uncertainty regards the upcoming U.S. congressional midterm elections. It is historical fact that the incumbent party generally loses seats in the House of Representatives. Current polls suggest that the Republicans could lose control of that chamber. Also, the Republican majority in the Senate is only one seat, unless there is a tie vote, in which case the vice president has the deciding vote. Some commentators suggest that Democrats are more energized than Republicans and that turnout could favor the Democratic Party. However, such gaps generally close as the actual election approaches. But if the Democrats do take the House, future Republican initiatives could be stymied with a split Congress or, worse from the Republican perspective, result in some reversals in Republican accomplishments.
Finally, corporate earnings for the first quarter have just begun to be reported. The passage of the tax cut act at the end of 2017 prompted analysts to dramatically raise estimates from a 13% to an 18% year-over-year advance for the S&P 500®. It is highly unusual for earnings estimates to rise between the end of a quarter and their announcement a month-and-a-half later, but that is exactly what happened this time. The risk to the stock market is that such elevated expectations could be disappointed. It is too early in the season to ascertain whether on-balance surprises will be positive or negative, but if it's the latter, stocks would be vulnerable to the downside.
Despite the issues discussed here, both the domestic and global economies remain in growth mode, inflation seems relatively well contained, corporate earnings and cash will be very strong whether or not they beat estimates in aggregate, and the stock market's valuation is a bit more reasonable. Ultimately, the outlook is much cloudier than last year, and end-of-cycle risks are rising. We continue to believe that stocks have room to rise further, but not as dramatically as and with greater volatility than over the past several years.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.