The bull market that started in March 2009 marches on. Should the current economic expansion make it to August 22, it will become the longest bull market on record going back to 1932. However, as I must remind myself, age does not depend upon years, but upon temperament and health. For the first half of 2018, the S&P 500 index peaked at 2,875 in late January and fell to a low of 2,532 at the bottom of the February correction. Since that point, stocks have remained in that broad trading range and it is likely that this range may well continue to represent the market’s low and high for the next several months. Near-term headwinds comprised of mid-term election uncertainty, trade-related tensions, and yield curve flattening chatter are contrasted by massive tailwinds of strong corporate earnings, robust employment data, and a healthy global economic backdrop. Ultimately, we believe a breakout to the upside is likely in the fourth quarter of the year.
Garnering an increasing amount of attention over the past few months has been talk of tariffs and trade disputes. We understand that it may be confusing to understand which parts are just threats and which are in place. To recap: Back in January, the US imposed tariffs of 30% on solar panels and 20% on residential washing machines. On March 8, the White House announced 25% tariffs on steel and 10% on aluminum in the name of national security. Under general backlash, these tariffs were suspended for certain countries until May 1. By the end of May, a 25% tariff on $50 billion of industrially significant technology imports from China was announced. In early July, the tariff went into effect for $34 billion of those goods. On June 19, it was announced that the US was looking for an additional $200 billion of goods that would be taxed at a rate of 10% if China did not change its trade practices. Not surprisingly, key US trading partners, including Canada, Mexico, the EU, and China, have retaliated with countermeasures of their own and most have filed complaints with the World Trade Organization (WTO) against the US.
We are of the mindset that heightened tensions are more about negotiating ploys and politicians pandering to their base, but this remains a risk worth monitoring. Furthermore, it is our belief that the trade actions thus far do not rise to the level of a “trade war” given that the tariffs enacted are a drop in the bucket for a nearly $20 trillion economy. We do recognize, though, that prolonged tit-for-tat actions could affect the economy in three channels: First is the impact on confidence, which could lead companies to delay investment and spending. Second is the direct impact of tariffs as they increase inflation and depress demand. Third is the relocation of resources by businesses seeking to minimize the cost of tariffs leading to some loss of scale, specialization, and efficiency. A recent lesson from the United Kingdom’s Brexit experience is that separating and attempting to re-draw markets that are globally intertwined is an incredibly complex feat. In the most probable scenario, trade tensions will present a near-term fluctuating headwind, but not a significant long-term threat to global growth. America’s trade partners appear to be torn between a desire to send a strong message in protest against protectionism and a wish to refrain from taking actions which could exacerbate the conflict. Governments abroad may judge that it is best to preserve what remains of the global free-trade system for a post-Trump world. A full trade war shock seems doubtful, but in the event of greater protectionism, entities most at risk are the countries, industries, and companies that are most dependent on global trade, investment, and supply chains. For example, small, open economies such as Mexico, South Korea, and Taiwan are generally more vulnerable than larger, highly dynamic closed economies like China or the US. This is not to minimize the impact on specific US companies highly dependent on internationally sourced revenue or real-world effects on people’s lives. A best-case scenario is that we end up with freer trade than when we started, but the fact that contentious trade negotiations are being played out so publicly means that trade-related market volatility will linger.
A story that will gain momentum over the upcoming months is the flattening and potential inversion of the US Treasury yield curve. A flat yield curve means that bonds with shorter maturities pay almost as much interest as much longer-term maturity bonds. An inversion means that the short-term bonds pay more than those further out in time. This indicator is monitored because inverted yield curves are a sign that the business cycles has matured and inversion has repeatedly preceded recession. As you may have noticed, short-term interest rates at your bank have risen a bit in the past year alongside Federal Reserve interest rate hikes. For the first time in several years, short-term interest rates in the US are above the rate of inflation, with the two-year Treasury note yield at 2.55% as of June 22, compared with the core inflation rate of 1.8% through the end of April. The spread between the 2-year and 10-year Treasury bonds has fallen to less than 0.5%, its lowest since 2007. This spread compression is a normal development when the Fed is tightening, as tighter policy signals less inflation pressure longer-term. There are reasons why today’s yield curve flattening may be less informative than in previous cycles, as it was the explicit engineered intent of global quantitative easing and negative interest rate programs. In addition, financial markets are more integrated today than in the past and higher short-maturity Treasury issuance has contributed to the flatter curve recently. The Federal Open Market Committee (FOMC) does not appear concerned, as guidance forecasts two more rate hikes in the second half of 2018 and three more in 2019. Jerome Powell, the first non-economist Fed chair in over 40 years, plainly stated: “Growth is strong. Labor markets are strong. Inflation is close to target.” We know that the curve can remain flat without inverting for an extended stretch, just like the 1994-98 period, so this is not to say that a recession is just around the corner. Should the yield curve invert, it is important to remember that the lead time between inversion and the peak in stock prices is typically between nine months and seventeen months. We would also see other major recession signals flashing warning signs, such as mounting credit issues or an overheating economy, prior to experiencing a meaningful economic slowdown.
Putting the focus back on fundamentals, we are seeing that the global economy remains in expansion and in very good shape, but the pace of overall activity is likely past its peak. Domestically, the US economy is strong, but the cycle is becoming more mature. Nevertheless, corporate tax cuts and restrained wage growth have allowed margins to stay high and corporate profit growth to remain firm. Estimated 2018 earnings-per-share (EPS) for S&P 500 companies stands at 20.1% year-over-year. Revenue growth is also impressive, with anticipate gains of 9% year-over-year. If expectations are met with the current corporate earnings season, it will shape up to be the best back-to-back quarters for growth since late 2010. During this period, we are watching for more cautious tones or any scaling back of capital spending plans, although ample cash balances, easy financing, and reduced regulation should keep guidance on track. From the consumer side, personal income is increasing at a healthy pace and consequently fueling retail sales, which grew in May at the fastest pace in six months. The data also shows that, for the first time since records have been kept, there are more job openings than unemployed workers. As a result, unemployment dropped to 3.75% in May, its lowest level since 1969. All of this shows us that the US economy continues to expand and that equities can still make additional gains. Even if earnings are peaking, that does not mean that the equity bull market is ending. Historically, from a peak in earnings-per-share growth, stock prices are still higher six months later 74% of the time and higher 12 months later 68% of the time.
The bull market is aging on its own terms and strategies that worked in earlier stages of the cycle are not appropriate now. Rather than stretching for yield or seeking speculative companies with negative earnings, it is a time to demand quality companies with healthy balance sheets, growing free cash flow, and the ability to execute shareholder friendly dividends and stock buybacks. A portfolio diversified globally and across asset classes is recommended for those looking to keep short-term volatility in check and long-term financial plans on track. Additionally, our active management approach generates increasing benefits in uncertain environments such as this, with the ability to showcase superior stock selection and the flexibility to quickly respond to market changes. While macroeconomic uncertainty could increase further in the later stages of the economic cycle, we feel that we will get through the noise and positive fundamentals will bring the stock markets to new highs in the fourth quarter.