April 11, 2018
Markets got a little choppy in the first quarter due to an uptick in inflationary pressure and a Federal Reserve determined to raise rates in response. The prospect of rising rates caused investors to reappraise risk because they well-know that economic activity as well as asset prices are supported by low rates. Piling onto the list of investor concerns, President Trump also announced new tariffs for imported steel, aluminum, and 1,300 consumer goods from China in what many regard as an opening bid in a potential trade war.
Stock market volatility increased last quarter, but back to more normal levels from extremely low levels. Most types of investments, however, were flattish with US stocks (as measured by the S&P 500) ending the 1stquarter slightly down at -1.0%, but emerging market stocks up 2.5%. Bonds were also down a bit in the 1stquarter with the 10-year Treasury total return of -1.7%, yet gold increased by 1.7%. Interestingly, policy uncertainty and Administration reshufflings have unnerved markets a bit, but not dramatically. The dual themes of synchronized global growth and tightening in global monetary policies, continue to dominate markets and will likely remain intact for the foreseeable future.
The economic recovery in the US has broadened out and non-farm payrolls have been very strong this year. But even though there is broad strength in the US economy, the government still eased fiscal policy through spending increases and tax cuts. This combination increases the risk that the economy will overheat and bring inflation. Paradoxically, an overheating economy can often challenge financial markets and prompt investors to reposition toward investments that benefit from a weakening dollar and inflation (as evidenced by gold and emerging markets outperforming last quarter). Gains in stocks might be tougher to come by if that happens.
A great time to own stocks can be while the employment situation improves, and the so-called output gap narrows (see chart on the next page). The output gap is the difference between actual GDP and potential GDP (as measured by capacity). If we mapped stock returns over that chart we would see a high degree of correlation. But if the economy overshoots and operates beyond full capacity, asset prices can get overextended or inflation can occur, followed by a recession. That can be a tough period to own stocks, but resetting excesses is a healthy process for the economy. The market tends to sniff this out ahead of the data coming in, signaled by increased volatility and stocks struggling for gains.
None of this is a prediction for investment markets, but there are indicators that broader changes may be afoot. We have already seen a potential change in leadership with the so-called FAANG stocks (Facebook, Amazon, Apple, Netflix and Google) falling out of favor during the latter part of March. What this means, if anything, remains to be seen, but it will probably be much more difficult for those stocks to replicate the spectacular returns they have experienced over the last ten years in the next ten years since they have become very expensive (see the chart on the next page that shows the market value of the company as a ratio to the book value, or accounting equity value of the company).
Again, high valuations do not necessarily predict tough times ahead for equities. They just indicate that better opportunities are likely to be outside of today’s most popular stocks (Facebook, Amazon, Apple, Netflix and Google). In fact, if history is a guide, during times of concurrent easy fiscal policy and tightening monetary policy the stock market has done well by rising on average 16.7% over a period lasting an average of 16 months. If history repeats, this would take us through the middle to end of 2019 -- so stocks have a bullish factor in their favor. It is difficult to imagine, however, that multiple expansion (PE ratios, etc. getting larger) would increase significantly from current levels, so earnings growth will have to do the heavy lifting to propel stocks much higher. The challenge to earnings growth is that producer prices have increased, including wages, which shrinks profit margins (absent a pickup in volume and pricing for US businesses).
In the press, there is much wailing and gnashing of teeth about the unpredictability of the Trump Administration and its pronouncements. We believe the fears of a trade war are unfounded and more likely to simply be Trump playing to his base on the policies that got him elected. While Trump certainly has unorthodox views on trade, he is pragmatist enough to know that a trade war will be terrible for stocks, which is how he measures himself. This is why he trotted out Larry Kudlow the day of the tariff proposal announcement to calm markets, which worked.
To take a politically neutral view, the reality is that the announced tariffs on steel and aluminum do not matter in and of themselves but might matter in terms of signaling. The US imported $39 billion of iron and steel in 2017 and $18 billion of aluminum. That’s 2% of total imports and 0.2% of GDP. If import prices went up by the full amount of the tariff (which they likely won’t), it would only add 0.05% to the inflation rate, and that would be a one-time increase in the price level, not a permanent increase in the rate.
So, the trade issue is most likely to be a media/political issue. But if it’s not, the US still has more to gain from a trade war than it does to lose since it has such a large trade deficit (we import much more than we export). However, a trade war would probably cause losses in stock market value and Trump does not want to go there. This is why the market rallied on April 4 when China announced retaliation for the US’ threat of tariffs on $50 billion of exports to China - the reality that it is unlikely to actually happen began to sink in. The prospect of a trade war is enough to get the media worked into a lather, but traders and investors are likely to see through that.
What ismore important will be what happens in the bond market and with interest rates. There are significant deflationary pressures that should keep longer maturity bond interest rates low, but with the Fed now selling bonds to shrink its balance sheet and a large fiscal deficit that needs to be funded (since we now have lower taxes and increased spending), there is potential for rates to rise from the new bond supply. The wild card will be China and the prospect of it buying up our new supply of Treasury bonds, which it has a political incentive to do.
It is all very complicated and impossible to predict, especially the impact on markets. Highgate will remain conservative by avoiding speculative investments, keeping the allocation to equities on the low side and in great businesses that we think we own at a fair price. We will keep bond maturities short. And since there is inflation pressure we will include investments that tend to do well inflationary environments. Because of high valuations in US stocks, we will also own global companies and foreign stocks outright – again in great businesses that we can own at a fair price.
The best advice we can give is to ignore the day-to-day fluctuations in the prices of stocks or bonds. A bad day does not predict another bad day, nor does a good day predict another good day. Much of the daily trading is done by computer algorithms instead of human beings and usually there is no reason in particular for any dramatic movements. The operating performance of most publicly traded companies change glacially, but the big movements in prices generated by computer and human reactions suggest that they don’t.
It is best instead to focus instead on owning companies that are likely to make a lot of money in the long run (because they have great businesses), and the stocks of those companies that can be bought at a fair price today. And it is especially best to ignore the financial press. It is important to remember that the financial press (and the press in general) exists to get people worked up…even when they don’t need to be. At all.
Thank you for considering Highgate Securities Investments to help you manage your investments and your personal finances. If you would like more information, feel free to call us at 303-968-1230 or to visit our web site at www.highgatesi.com. Our ADV (disclosure document) may be accessed through our web site, or sent to you via email per request.
We hope to hear from you soon!
John Goltermann, CFA, CPA, CGMA
Source: BCA Research