Investing is a delicate balancing act, weighing the good news against the bad. Fortunately, for most of the last year and a half, we didn’t hear a lot of really damaging news. Unfortunately, that has changed recently and escalated this past week. Investors usually can handle one challenge fairly effectively, but when the pace of concerns picks up and multiple challenges appear, investor confidence tends to deflate very rapidly. The S&P 500 is down 10% since its high at the end of January. It fell 6% this past week, the biggest weekly drop in more than two years.
Before we get to the negative news, let’s talk about the positive. It is important to note that the factors that drove last year’s rally remain in place. In fact, some aspects of the optimistic story have actually improved. Take earnings. On January 1, 2018, according to Fundamentalis, consensus earnings estimates for Q1 were 12.2%. As of last week, that number had risen to 18.1% (aided by the passage of the Tax Cuts and Jobs Act passed in late December). In corroboration, FactSet confirmed this past week an estimated earnings growth of 17.2% for Q1. This compares to a 14.8% growth rate for Q4 (Thomson Reuters).
In other words, businesses (the equity that you own) should continue to benefit from healthy profits, at least in the near term. Global growth has also been strong over the last year and a half and although it may have peaked in some regions, most notably the European Union, synchronized growth is still boosting expectations.
There is other good news: low inflation, moderate interest rate increases that still provide stimulus, and very low unemployment. In addition, high stock valuations have come down slightly and markets themselves are moving sideways allowing earnings to catch up with prices. Overall, the underlying economy is strong and likely to remain so for the rest of the year.
In recent weeks, the sunny picture is being challenged by a potential trade war, a hawkish Federal Reserve and regulatory turbulence in the high flying tech sector. It is important to remember that many market concerns are future risks. The fear is what could happen, often not what has actually happened.
The most immediate threat to the global economy is the establishment of tariffs that turn into trade wars. This past week’s announcement by President Trump of (up to) $60 billion of new tariffs on Chinese goods and services sent the global markets reeling. While tariffs have been around for a long time and countries constantly try to negotiate better terms of trade, tariffs that escalate into trade wars can cause serious economic damage. Tariffs impose a tax on goods or services coming into a country. As such, they usually result in higher prices paid by consumers and businesses. At the same time, the equivalent protected goods and services within the country can raise prices also impacting consumers and businesses. In other words, tariffs are often associated with price increases (inflation), which hurt profits and pocketbooks.
China has already threatened retaliatory tariffs on agricultural products such as soybeans, which can harm an already fragile farm belt that is very dependent on exports. China has also singled out individual companies, such as Boeing, which could impact the economy in Seattle. At issue is when will retaliation end? Few leaders are willing to appear weak when threatened economically by another country. Yet most leaders accept that escalation can be harmful to global growth and their own national interests.
Interest rates also played into this week’s fears. Jerome Powell’s first open market committee meeting resulted in a quarter point increase in the federal funds target rate, as expected. Short term rates now stand at 1.50-1.75%. At the same time, the Fed acknowledged challenges to some short economic conditions while upgrading the outlook going forward. Specifically the Fed raised its expectations for 2018 US economic growth to 2.7%, up from 2.4% and predicted that unemployment would drop to 3.6% in 2019. This improvement in the outlook allowed the Fed to increase its anticipated number of interest rate hikes in 2019 and 2020. It also signaled that inflation increases are expected, especially in 2019 and beyond.
Taken together tariffs and a more Hawkish Fed could mean an earlier tipping point of when rising interest rates actually cause harm to the economy. We are not there yet, but the markets aren’t waiting around to register their distress.
And finally, Facebook’s revelation of abuse of its personal data increased the odds dramatically that it (along with other technology platforms) could soon be subject to costly regulation. (Facebook’s price has fallen 13.8% since the news broke). This does not mean the end of Facebook but rather potential higher costs and lower profit margins. It also means that price to earnings ratios for Facebook and other technology superstars may need to come down from the stratosphere through the lowering of stock prices.
What can we expect from here? A good scenario would be for markets to churn sideways while they digest economic threats and how likely these threats are to inflict lasting damage. In the interim, if the underlying strength of the economy is maintained or increased, markets are likely to resume an upward trend, albeit a more modest one than in 2017. If however, a trade war ensues or more economic or geopolitical uncertainty is introduced, the market’s patience will be tested and we could see further downside to stock prices over the near term. The key indicator for us is whether consumer and business confidence is sustained. If so, market turmoil can be seen as normal volatility – unnerving but not alarming.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.