Let’s hope March of 2018 was an anomaly. Just as signs of spring were beginning to appear, folks living in the northeast and mid-Atlantic encountered what was likely their first ever cyclone bomb. Exhausted from shoveling snow, they were then clobbered by three more nor’easters in a three week span. It could be we need to place more trust in Punxsutawney Phil’s early February predictions.
The unpredictable nature of these storms reflects closely the unsettled activity in Washington, which is becoming so chaotic it looks to be finally having the effect on financial markets many had feared back in November 2016. Stock prices, measured by the S&P 500, have begun to mimic both the unforgiving nature of recent weather – and the chaos inside the beltway. Stocks fell in March by 2.7%. This is on the heels of a 3.9% decline in February. Year to date, stock prices are down 0.76%.
For some context, over the last 30 years, the S&P 500 has produced an average return of 12.2%, with an annual standard deviation of 17.3%. There have been 5 years (17% of the time) when the return to stocks was negative, and in those years, stock prices fell on average 16.6%. After a larger than average 21.8% return in 2017, stock prices may be reverting to the mean.
On a more granular level, the stock market looks to be attempting to assess the potential damage from a trade war. Old school protectionism is the latest contrivance out of Washington in hopes of making America great again. Restrictive trade, whether it leads to a trade war, will put the brakes on the positive effect foreign competition has on holding down price inflation.
The recent stock price volatility highlights the concern that fractured global supply chains may negatively impact US corporate margins. Free trade is proven to stimulate economic growth. Higher tariffs will eliminate the process of comparative advantage that allows all parties to benefit from globalization. If the root of the problem is infringement of intellectual property rights, then that needs to be addressed directly, without the random and damaging effects of trade warfare.
Recent economic data has not been compelling and the nine year expansion is long in the tooth. Employment levels are high, so high investors have been on alert for signs of inflation. The brutal stock sell-off in early February was ignited due to clear signs of inflation based on reports of increasing wages. Stock investors are well aware, if a cycle of higher inflation has begun, the Fed will continue to raise interest rates.
The yield curve has shifted upward, and flattened. This is a mixed signal. It may well be telling us growth expectations have deteriorated. The Federal Reserve has raised rates now for the sixth time since the first 0.25% hike in mid-2015. Expectations are for 3 hikes this year and 3 more in 2019. Ambitious fiscal spending, at this late point in the economic cycle, will support the Fed’s hawkish position. The ballooning deficit, continued deficit spending and higher interest rates will raise the probability of a slowdown (recession) sometime in the near future.
The other curiosity I’ve discussed before is the perpetual weakness in the US$. It has been in a steady decline since the November 2016 election. The higher interest rates available in the US would support buying dollars. On the contrary, global investors have been selling US$s, and buying yen and euros. It’s not clear what is causing this, though it’s likely related to increased tariffs, restrictive immigration and rising deficits. The persistent US current account deficits are spurring talk the US$ may not be the safe-haven it once was.
The current backdrop is mixed. Earnings estimates remain high and stocks are not excessively expensive with the forward P/E multiple in the 16x range. Volatility has risen, making stocks harder to own. From a contrarian perspective, this is constructive. Yet, if the earnings forecasts falter, for whatever reason, this will spell trouble for stock prices. With the high level of volatility, and two successive down months in stock prices, we are taking a more constructive stance, and will become more cautious if conditions persist. Please feel free to call us if you would like to discuss further or if your investment parameters have changed since we last spoke.
Bruce Hotaling, CFA