Highlights:
· Domestic equity markets inched up during the quarter, while trade tensions, a strong U.S. dollar and rising oil prices pressured international equities.
· The current tariffs between the U.S. and China that have gone in to effect are not expected to have a material impact on either countries GDP growth, but escalating tensions between the two countries remains a concern.
· The Federal Reserve has started raising interest rates to try to prevent the U.S. economy from overheating. Conversely, Europe and Japan continue to maintain expansionary policies due to lackluster consumer price growth.
Commentary:
Impressive corporate earnings, strong economic growth fueled by a record level of mergers and acquisitions, stock buybacks and capital spending abetted by a new tax law that is freeing up cash and encouraging companies to bring back money held abroad, helped push domestic equity prices higher during the quarter despite tightening monetary policy. Conversely, continued fears of a trade war, a strong U.S. dollar and rising oil prices hampered international equity markets last quarter, with emerging and frontier markets enduring the majority of the losses.
Whether you believe that President Trump is intent on starting a trade war, or, to his point, responding to a trade war that the U.S. has been losing for years, the trade standoff between the U.S. and China continued to exacerbate concerns among investors that the world’s two biggest economies could descend into a full blown trade war. Concerns about the fate of the North American Free Trade Agreement (NAFTA) and tariffs that the Trump administration imposed on European and Canadian allies, which were subsequently countered, are also adding to investor anxiety. The highlight, or perhaps lowlight depending on your point of view, of the quarter was President Trump’s approval of tariffs of 25% on about $34 billion of Chinese goods. This prompted an immediate retaliation by Chinese officials to levy penalties of the same rate on U.S. goods of the same value. Just recently, the U.S. unveiled plans to assess additional tariffs on $200 billion more in Chinese imports, which is bound to be met with threats of retaliation from Beijing. The U.S. and China are expected to continue to talk, but so far the two sides have not come close to resolving the dispute and there are no negotiations scheduled at this time. Rising frictions in international trade have instilled uncertainty in the global equity markets, bringing about one of the most volatile stretches in years. How this situation resolves may not be known for some time and is a prime example of why a long-term portfolio orientation must be maintained.
Property investment, government spending on infrastructure and a boost from exports to the U.S. and Europe has allowed the Chinese economy to remain in a growth mode. This allowed the current administration to focus on curbing the growth of debt. However, with growth now showing signs of slowing amid an intensifying trade brawl with the U.S. and corporate defaults rising, China’s central bank recently freed up more than $100 billion for commercial banks to boost lending and restructure debt. The People’s Bank of China also reduced the amount of reserves banks are required to keep with the central bank by half a percentage point to encourage lending. China cannot directly match the $234 billion worth of goods that the U.S. has in its sights because it does not import enough American goods, but can make life more difficult for American business interests in China with more aggressive action by regulators such as safety inspections or financial investigations. China could also attempt to force its currency lower to gain competitiveness.
These conditions have spiked volatility, however, equity prices have held up generally well outside of emerging and frontier markets. This is likely reflective of the perception by investors that these tariffs are less the reincarnation of Smoot-Hawley and more as President Trump’s unorthodox negotiating tactics. This may be because the majority of the products currently slated for tariffs are old-economy staples that constitute a small percentage of the impacted countries GDP. Although the direct economic impact from new tariffs is minimal at this time, the longer-term implications for the global supply chain, corporate earnings and an escalation of tensions in general between the U.S. and China is more concerning. The U.S. has long been one of the world’s least protectionist countries, alongside the members of the European Union. We remain hopeful that the current administration will not dramatically shift trade policy at the risk of disrupting domestic economic growth given our country’s long history of lowering trade barriers and realizing the benefits of economic integration.
While trade war rhetoric grabbed all the headlines, the news on the monetary front was equally as important. As expected, the Federal Reserve raised its key policy interest rate 25 basis points during the quarter. Fed Chairman Powell also went out of his way to point out that the last two recessions did not follow flare-ups in inflation that forced rate increases, but rather it was financial-market plunges that fractured the economy. The message here seemed to be that busts invariably follow bubbles and so long as the U.S. economy keeps growing robustly and inflation remains at the central bank’s 2% target, the Fed is likely to stay on its current path of normalizing interest rates despite trade war worries and equity market volatility. In fact, Fed officials signaled at their June meeting that they might raise interest rates over the next year to a level that no longer is intended to spur growth, which would formally end the post-financial crisis era in which the central bank rewrote its policy playbook to provide unprecedented economic stimulus. Fed rate increase have been pushing up short-term yields, while trade tensions have been weighing down long-term yields, resulting in a flattening of the yield curve where the spread between short- and long-term rates narrows. Investors monitor the yield curve closely because an inverted yield curve, where short-term rates exceed long-term rates, is often indicative of a pending recession. Fed officials have indicated they could slow down interest rate increases if this phenomenon occurs.
With an unemployment rate at an 18-year low of 4.0% and average hourly earnings up 2.7% from a year earlier, the recent increase in consumer prices not seen in over six years is likely to drive the Fed toward one or two more rate increases over the next year. U.S. companies are likely to respond to inflationary pressures, including rising wages, by passing on cost increases to consumers. This would come on top of gas prices that have already risen to levels not seen in the last four years. With wages in the U.S. climbing, American consumers have so far been able to weather higher prices, but a broad-based increase to consumer prices and even higher gas prices could eat into disposable income and spending. This is a possible headwind for domestic economic growth and corporate earnings that have been growing at a blistering pace and kept equity valuations from being too stretched. However, while earnings growth will inevitably slow following a one-time boost from the federal tax overhaul that does not necessarily mean earnings growth cannot remain near current levels assuming demand remains firm.
The pickup in inflation, the Fed raising interest rates and reducing their bond holdings, and the recent tax-cut package and surge in government spending has boosted short-term growth expectations and the supply of Treasury bonds. This has driven bond prices down and yields higher, with the yield on the benchmark 10-year Treasury note topping out at 3.1% during the quarter, its highest level in almost seven years. U.S. government bonds are yielding more than debt from other developed countries for the first time in almost two decades which has fueled a rally in the dollar as growth abroad has abated while U.S. growth has remained strong.
A surging dollar and rising oil prices is pressuring emerging market countries to support their currencies by halting rate cuts or tightening monetary policy. A stronger U.S. dollar pushes down the value of other countries’ currencies, makes dollar-denominated debt more expensive to repay and increases the cost of commodities and other goods priced in dollars. Low oil prices and last year’s weakness in the dollar had allowed many developing countries to cut rates and boost growth without having to worry about sparking higher inflation, which is often a consequence of loose monetary policy. The rally in the dollar and oil prices have forced central banks of many of these developing countries to rethink that strategy. The dilemma now facing policy makers in less-developed countries is whether to try to keep pace with the Federal Reserve, which is on pace to raise interest rates four times this year. Higher rates could help stem the tide of capital outflows from emerging markets, but the danger is that such moves would constrain their own domestic growth prospects.
European equity markets have also come under pressure, as investors seem to be concerned that trade frictions could dent an already fragile economic recovery in a region heavily exposed to international trade. This likely influenced the European Central Bank decision to maintain its policy rates, which are zero or below, until at least the summer of 2019. This forward guidance from the ECB was likely done to avoid a rerun of the notorious “taper tantrum” of 2013 when the Fed disclosed its intention to reduce its bond purchases and disturbed the global equity markets for months. Given that trade tensions between Europe and the U.S. are high, inflation remains stubbornly low and behind the U.S. and U.K. despite years of strong expansion, and Italy’s new populist government has toyed with exiting the common euro currency to fix their economic problems, it’s not surprising that the ECB wants to maintain stability and not raise interest rates for some time. Inflation was one of the missing ingredients in the U.S. economic recovery until only recently, so perhaps lackluster consumer-price growth should not come as too much of a surprise. Nevertheless, many European companies remain upbeat about their prospects despite slower profit growth due to higher raw material costs and currency headwinds.
The Bank of Japan also said it would maintain its expansionary policy on the heels of its longest stretch of economic growth in 28 years. Weak private consumption and business investment led to the world’s third largest economy shrinking 0.6% in the first quarter of the year in a setback for Prime Minister Shinzo Abe’s economic platform known as Abenomics. The economic decline is expected to be temporary if wage growth continues to help private consumption recover. Similar to what is happening in Europe, most economic indicators have been strong, with the exception of the weak performance of prices (i.e. inflation).
The Bank of England also left rates unchanged after it experienced a slowdown in economic growth during the first three months of the year. This slowdown is also expected to be temporary and the BOE expects to raise its key interest rate over the coming years. England’s pending departure from the European Union (EU) and the ultimate impact this will have on its economy could complicate this plan. In the midst of a cabinet upheaval, UK Prime Minister Theresa May recently warned the government that the UK must prepare for the possibility that it exits the EU without a “Brexit” trade deal, although May’s goal is to safeguard the integrated supply chain between the U.K. and EU.
There has been a marked shift out of “risky” assets over the last several months. However, it is important to maintain perspective and remember that performance should not be judged solely based on returns during the height of a period of risk aversion itself, but over the full cycle of the market. While equity market downturns and aversion to certain asset classes are inevitable, the investment policy we espouse allows you to also participate in the subsequent recoveries by only allocating capital not needed for at least the next 10 years to equities and to diversify such exposure extensively and effectively. This policy ensures that your short-to-intermediate portfolio withdrawal requirements are met with less risky cash and fixed income investments. There will always be uncertainty, and as is the case now, it may seem heightened, but over the longer term we continue to believe that the global economy’s best days lie ahead and long-term, patient investors who stance their portfolio appropriately will continue to receive a meaningful return premium from the equity portion of their portfolio.
Urban Financial Advisory Corporation – July, 2018