Q2 2018 – Tightening and Tariff Tantrums
The major indices performed much better in the second quarter than the first as very positive earnings reports produced gains of 3.44% for the S&P 500. Bonds, as measured by the S&P US Aggregate Bond Index were down only 0.12% for the quarter and commodities as measured by the Dow Jones Commodity Index were up 1.06%. Finally, Bitcoin recovered a little bit in April and May before continuing its 2018 swoon (we haven’t gotten a call from anyone wanting to invest in Bitcoin or other Crypto currencies in several months).
While market volatility as measured by the VIX was nothing compared to the first quarter, the second quarter gains were not at all smooth and the number of one-day moves, up or down, of 1% or more was 26 out of 64 trading days in the quarter.
In our Q1 Letter we noted that, “There are four major factors driving the market. The factors are growth, trade wars, geopolitics and regulation of technology. “, and that opinion has not changed although trade wars and growth (and interest rates in particular), are having the greatest short-term impact on the markets.
In March, all eyes were on the Federal Reserve Bank and their monetary policy in the face of strengthening economic data. After a two-day meeting, the Federal Open Market Committee unanimously voted to increase its benchmark fed funds rate by 25 basis points, to a range of 1.50% to 1.75%. The Fed signaled two more rate hikes in 2018 amid speculation that it was considering adding a third increase. It did, however, raise its forecasts for hikes in 2019 and 2020, citing a stronger outlook on the economy. And then, in June, they voted to lift the target range for the federal funds rate by another 25 basis points to between 1.75% and 2% and signaled plans to do so two more times this year. That would be more than originally projected for this year, based on the risk of faster projected economic growth and low unemployment driving inflation beyond their 2% target.
We see these Fed moves as the #1 driver of the overall volatility in the market for several reasons:
The strategy of using interest rates to fight inflation is called “Contractionary Monetary Policy” and usually results in the Fed over-tightening by squeezing the buying power of households without a corresponding increase in wages. This, of course, can negatively impact revenue growth for businesses which can lead to negative earnings growth which, in turn, is a negative influence on stock prices.
As interest rates rise, savers have the opportunity to earn more interest on their debt instruments. Typically, higher rates draw money out of stocks and into interest bearing investments, adding another negative influence for stocks.
Higher rates also increase borrowing costs for businesses which may curtail business investment. Business investment is a driver of economic growth. Slowing economic growth would be, yet again, negative for stocks.
In their June statement, the Fed said that “In determining the timing and size of future adjustments to the target range for the federal funds rate, the Committee will assess realized and expected economic conditions relative to its maximum employment objective and its symmetric 2 percent inflation objective. This assessment will consider a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
We tend to live in the camp that economics is more art than science and believe we are all at risk when a governing body (Fed members are called “governors” after all) treats economics more like a science, believing that it can move levers and adjust the economy with scientific precision. Since the June 13 meeting, the S&P 500 has dropped approximately 2.5%. We don’t believe that this is coincidental and will continue to monitor Federal Reserve policies.
Regarding trade, the rhetoric is heating up as additional tariffs have been announced by the administration beyond those announced on Chinese imports. These new tariffs include a 25% tariff on imports of steel, and a 10% tariff on aluminum, from the European Union, Canada, and Mexico.
The tariffs angered U.S. allies, and have resulted in retaliatory measures taken by these countries as well as India. As these various measures and counter measures have been announced, we have seen brief market sell-offs in those sectors most likely to be affected. These sell-offs have been called “Tariff Tantrums” by some market pundits because of the panicked reactions to what could happen as opposed to reasoned action based on the fundamental data of what is actually happening. A recent article in USA Today went so far as to say that the tariffs in total will add over $5,000 to the price of every car sold in America! Interestingly, however, the article contained no analysis of actual cost data to support this claim.
We still do not think a full-scale trade war is in the cards as the risk of real economic slowdown is too high for all players involved. On July 2nd, Bloomberg ran an article showing how China is zooming to a record year of corporate-bond defaults in 2018. The article states, “Corporate profits have worsened this year and are unlikely to improve against the backdrop of an economic slowdown…” Therefore, it is not in China’s best interest to prolong any uncertainty regarding trade agreements with the US. Meanwhile the EU’s growth continues to disappoint. In 2017, the 19-country zone showed a decade-high rate of growth of 2.5%. By first quarter 2018, though, their growth had slowed to just 0.4 percent and Q2 results are not expected to pick up enough to sustain the 2017 performance.
We believe that the economic risks of a prolonged trade war are far too great for politicians to gamble with. How this gets resolved is still anybody’s guess. In June it was reported that President Trump proposed to the United States’ closest allies the idea of completely eliminating tariffs on goods and services. Apparently he did not get a very encouraging response. It may be that we start establishing separate trade deals with individual countries that contain better (but surely far from perfect) terms for the United States.
Concerning geopolitics in general and North Korea in particular, President Trump did meet with North Korean leader Kim Jong Un and the pair signed a document stating that Pyongyang would work toward (emphasis ours) “complete denuclearization of the Korean Peninsula.” While this is a far cry from final and ever-lasting peace, it is nonetheless a significant step forward. It must be noted that missile test launches and underground bomb tests in North Korea have ceased for the time being and there is certainly less concern around the possibility of an imminent nuclear world war than there was a year ago at this time.
Finally, we continue to watch the potential collision course between the FAANG companies (Facebook, Amazon, Apple, Netflix and Google, or it’s parent, Alphabet) and Washington D.C. While we are concerned that any legislation will create an increase in volatility of the major indices which are market cap weighted (the FAANG stocks make up 27% of the 2,595-security Nasdaq Composite), our bigger fear is the longer-term ramifications of legislation on growth and innovation.
For example, the Supreme Court’s decision on South Dakota versus Wayfair (now known as the “Wayfair Decision”) over South Dakota’s application of its sales tax to internet retailers who sell into South Dakota but have no property or employees in the state could have a chilling effect on the further development of e-commerce. Regardless of any opinion about whether this decision is right or wrong, we note that sales taxes, which exist in 41 states, apply to most purchases of retail goods within the state. The seller has the responsibility to collect the tax and forward the money to the state. E-commerce businesses will now have to collect the same sales tax collected by all other retailers. As e-commerce’s strengths over brick-and-mortar are more about convenience, wider selection, and lower costs, it’s unlikely this decision will hurt the larger e-commerce firms. As sales tax collection on e-commerce grew from almost zero to half of all sales, e-commerce has continued to grow sharply.
Our concern, however, is the ability of small e-commerce sellers to collect and pay sales taxes in a simple way. So, while the Amazons of the world will be able to absorb the costs of complying with sales tax initiatives, smaller retailers, as Amazon once was, may ultimately get squeezed out of the e-commerce channel. While this is just one example, one can see how government regulation can serve as a moat for the large, established tech companies to protect their market share from competition, whether it be in e-commerce, social networking, or healthcare.
During his March 2018 testimony before Congress, Facebook founder Mark Zuckerberg made clear that he was open to the government regulating Facebook in some way. “The question isn’t, ‘Should there be regulation, or shouldn’t there be?’ It’s ‘How do you do it?’” Zuckerberg told Wired.com. Zuckerberg knows that any legislation would not only impact Facebook but would also impact any small firm trying to compete with them and when it comes to business and regulation, the firms that can afford the best lawyers, accountants and technology will have a clear advantage over anyone else.
In conclusion, we continue to be cautiously optimistic, especially regarding US equities. A modestly bullish path forward is most likely. Net profit margins, fueled by the reduction in the corporate tax rate due to the recently passed tax reform, were at ten-year highs in 2017 according to FactSet. It is important to note, though, that net profit margins were improving on a sequential basis during all of 2017, prior to the tax bill becoming law. In any event, it appears the lower tax rate is more than offsetting any impact of higher wages and other cost increases, and many analysts expect even higher net profit margins for the S&P 500 for the remainder of 2018.
We believe that the best approach is to assess incoming data and update our opinions accordingly, stick with higher quality investments in correspondingly suitable allocations based on each investor’s financial and emotional tolerance for risk, and stay nimble.