July 13, 2018
The second quarter saw an increase in stock price volatility as the Trump Administration began to make good on its campaign promise of trying to make the US’ terms of trade fairer. Inflammatory rhetoric and announcements of protectionist tariffs (mainly on products from China) naturally caused consternation among traders. Accordingly, many repositioned for a more unfavorable global economic environment. For the quarter the S&P 500 was up 3.6% and the 10-year Treasury was down slightly at -0.5%. Emerging markets and gold prices were down 9.7% and 4.1% respectively.
As new tariffs were announced, investor sentiment shifted from wide belief that synchronized global growth would continue (a theme which had been in play for all of 2017 and the first quarter of 2018) to believing that global growth would slow. As this shift began, foreign stocks (particularly emerging markets) underperformed US stocks despite foreign stocks being much cheaper than US stocks. The chart below shows the PE ratios (the lower the number the “cheaper” the market) of emerging, developed foreign (EAFE) and US. What this decline in emerging markets tells us is that even though those stocks are cheap investors currently prefer to have their equity investments in the US -- most likely because the US has the deepest and most active markets, with the strongest rule of law and high levels of liquidity. In other words, outperformance of US stocks vs. foreign stocks represents a form of risk aversion.
When money flows out of foreign markets and into US markets, the dollar tends to strengthen because investors need to buy dollars to make US investments. This can have a negative economic effect on foreign companies and governments whose debt is sometimes denominated in dollars. If the dollar rises say 5% against their own currency, they’ll have to pay back 5% more on their interest and principle payments. These increased payments come out of their profit and can cause investors to sour on foreign stocks. So, in the end, a rally in the dollar due to investor repositioning can all-by-itself have a real economic consequence abroad creating a negative feedback loop. This in large part explains the significant difference in 2nd quarter performance between US and non-US shares.
As shown in the chart below, however, there is an ebb and flow to how the dollar trades vs. other currencies. The chart shows the dollar index (DXY), which is an index that indicates its strength/weakness vs. other currencies (upward moves means dollar strengthening). The chart also shows the relationship between the dollar and emerging market stock prices. We inverted the emerging market stock index to show this relationship – dollar strength brings emerging market stock weakness, which is exactly what happened in the 2nd quarter. But despite this relationship, big changes in the dollar do not predict future changes -- big moves in the dollar tend to be short-lived.
There is a strong case for the recent dollar rally to be short-lived because three of the factors that drove it higher in the second quarter are, in our opinion, not permanent: 1) the one-time tax reform and increase in fiscal spending by the Trump Administration provided a jolt to an already strong economy; 2) interest rate increases in the US (and foreign interest rates staying mostly unchanged) will not last forever; and 3) trade concerns are likely to abate in the longer run because they are destructive and the Trump Administration knows this. Tariffs are bad for consumers because they lead to higher prices, hence bad for the economy, and, as a result, bad for stock prices (the Trump Administration’s #1 self-evaluation yardstick). We see the tariff announcements as mostly being a negotiation tactic and political strategy.
Because the vast majority of investors are short-term oriented, they tend to overreact to headlines and recent developments. Given this and the fact that emerging market equities are already down 10% in the 2nd quarter, it is probably best to ride out the volatility. This is especially true because the valuations of foreign stocks, as shown previously, are much more attractive than US stocks and investors are already quite negative toward them.
While most of the worry nowadays is centered on a strong dollar, increasing interest rates and trade wars, I want to put any fear of an imminent crash to rest. US real estate, being a huge part of the real economy, can be one of the most reliable predictors of recession or a much more difficult stock market ahead (in 2007/2008 it was both). Despite a 10-year recovery from the crash in 2008, real estate is still fundamentally strong, which means that banking and the system of credit is generally healthy. As shown in the chart on the next page, housing starts were slow to recover from the Great Recession and today are still 40% below their 2006 peak, which produces a very low vacancy rate at 1.5%, the lowest level since 2001.
This slow recovery in housing starts happened despite the fact that today the 30-year US prime mortgage rate is 2.5% below where it stood in 2006 (around 7.0%), and the low vacancy rates should underpin continued demand for housing. The Fed therefore has room to increase rates by a significant amount without affecting housing much. Moreover, the Fed now wants to head off a potentially overheating economy because labor markets are very tight. The point is that interest rates in the US likely have room to increase a lot in the longer-run, unless lending standards tighten, which would slow things down all by itself. Higher rates, or tightening lending standards could present problems for US stocks at some point, but we are not there yet.
This is not to say that we don’t worry about a lot of things, but it is to say that the source of problems in stock prices in the future is not likely to come from excesses in residential real estate. It is more likely to be from interest rates rising more than people expect, which could cause stocks to struggle for further gains due to high valuations (at least in US stocks).
To sum it all up, there is a lot of complexity and unpredictable factors at work that will affect stock prices in the shorter-run. Foreign stocks underperformed US stocks in the 2nd quarter, but for good reasons. Those reasons are not likely to remain in force, which means that the recent underperformance will not likely be permanent and now presents a long-term opportunity in emerging market and foreign shares. Despite all the forces at work, no big change in investment strategy is warranted at this time.
While we cannot predict macro events, but we do still want to understand the investment environment in order to guide how much and what types of risks we should be taking. The current environment argues for more caution due to high overall valuations in US stocks, the prospect for higher interest rates (even though the economy can stand it) and the risk of a worse-than-expected trade war. The most important element to long-term investment success is to own great businesses at fair prices (preferably more than fair), and this is what we spend the bulk of our time examining.
Thank you for considering Highgate Securities Investments to help with your investments. If you would like more information about us, please visit our web site at www.highgatesi.com or call us at 303-968-1230. We are happy to make an appointment to meet and provide a no obligation consultation and evaluate how we might be able to help you. In addition, our ADV (disclosure document) may be accessed through our web site, or sent via email per request.
John Goltermann, CFA, CPA, CGMA