Quarterly Letter 2Q 2018

A number of crosscurrents have been affecting the markets this year, including the strong U.S. economy, Federal Reserve policy, geopolitical developments, and the threat of trade wars.  Before discussing these factors, we will briefly review the events of the second quarter. 

Review of Second Quarter

As the second quarter began, the major market indices were retesting their February lows (as seen in the chart above).  Stocks were roughly flat in April, as strong corporate earnings reports were offset by a trend of rising interest rates. 

In May, the market was able to advance due to good news on the economy as well as hope for a peaceful settlement of the North Korea situation.  However in late May, stock markets around the world sold off sharply on news of political turmoil in Italy, as a rising tide of populism appeared to threaten the stability of the European Union and raised questions about the health of the European banks.

In June, stocks rose in the first half of the month, with the Nasdaq breaking out to a new high, driven by strength in the so-called “FANG” stocks (Facebook, Amazon, Netflix and Google).  Investors were encouraged by the historic summit meeting of President Trump and Kim Jong Un, implying a peaceful resolution to the North Korea situation, a risk factor which had been hanging over the markets for months.  However, stocks pulled back in the second half of the month amid uncertainty over trade disputes with China and the European Union, and many foreign equity markets plunged and broke down to new lows in late June. 

Trade Wars

One of the main issues that has been affecting the stock market and causing volatility in recent months has been the issue of tariffs and international trade, particularly with China.  Economic theory shows that free trade is a win-win situation because it provides access to cheaper goods and a higher standard of living for all involved.  However, if countries disrupt the free trade system with tariffs on each other’s products, they could cause a global trade war, as countries retaliate against each other by imposing more tariffs.  This would cause higher prices, disrupt global supply chains, and potentially cause a recession in the entire global economy, which would be very bearish for the stock market.

The President and his economic team have pointed out that the current global trading system is not free and fair, as many foreign countries already have large tariffs on goods from the U.S., while we have very low tariffs on their products.  This has led to the U.S. running huge trade deficits each year (i.e. importing much more than we export), and the loss of millions of American jobs.  In addition, China has been stealing U.S. technology and intellectual property for years, posing a risk to national security.

The Trump administration wants equal access to foreign markets and a level playing field, which would help bring back jobs to America.  The administration has been holding trade talks with many countries, and may be using the threat of tariffs as a negotiating tactic.  In recent months, the stock market has been falling whenever there is news that the U.S. is considering new tariffs, but then a few days later, the market rallies when trade tensions ease.  The U.S. recently announced tariffs on steel and aluminum, and Canada and the European Union have threatened to retaliate.  Also NAFTA is being renegotiated.  These issues are likely to remain a risk factor for the markets in the months ahead.  However, with the midterm elections coming up in November, the administration is unlikely to do anything that would cause serious damage to the economy. 

The U.S. Economy

The U.S. economy has been very strong lately.  Over three million jobs have been created in the past 18 months, and the unemployment rate has fallen to only 3.8%, its lowest level since 1969.  Consumer confidence and business confidence are at their highest level in years.  While GDP growth was only 2% in the first quarter, many economists estimate that the second quarter of 2018 will show a growth rate of well over 4% when it is reported later this summer.

According to President Trump’s economic advisor Larry Kudlow, there are several reasons for this economic strength.  First, a lot of job-killing regulations have been eliminated.  Second, the tax cut package has resulted in a more competitive tax code, with a corporate tax rate that is closer to the rates in other countries.  This competitive tax and regulatory climate has led to companies staying in the U.S. and investing in this country, instead of building plants in places such as Mexico. 

Also, the lower tax rate on the repatriation of foreign earnings has led multinational corporations to bring back hundreds of billions of dollars in overseas profits that have been held abroad for years, meaning that capital is flowing into the U.S.  Finally, the tax reform package also contained provisions for accelerated expensing of new plant and equipment.  These factors have resulted in a capital spending boom, which has led to stronger job creation.

Federal Reserve and Interest Rates

A strong economy is usually accompanied by worries about rising inflation.  In this environment, the Federal Reserve normally pursues a tighter monetary policy, by raising interest rates to slow the economy and prevent inflation from building up.  Thus far inflation remains under control, at an annual rate of roughly 2%.  As long as the economic data continues at a “Goldilocks” pace (not too fast, not too slow), and inflation remains low, the Fed should raise interest rates at a gradual, measured pace.  The Fed’s current target for short-term rates is a range of 1.75% – 2.0%.  A quarter-point rate hike is widely expected in September and another may occur in December. 

Long-term interest rates, as shown by the ten year Treasury bond yield, have come down since May.  The bond yield had risen to roughly 3.10% by mid-May, but then the political turmoil in Italy caused a “flight to safety” into U.S. Treasury bonds, bringing bond yields down to the 2.80% range.

As short-term interest rates have been rising while long-term rates have come down, the yield curve has become more flat (short-term rates have risen to almost the same level as long-term rates).  This has raised worries that the economy may fall into a recession next year, because historically a flat or inverted yield curve has been a leading indicator of recessions.  However, long-term rates are now abnormally low, so this yield curve indicator may not be accurate in the current environment. 

Stock Market Technical Position

As seen in the chart above, in each of its recent selloffs, the S&P 500 has stopped its decline at the 200-day moving average, which tends to act as a major technical support level.  Other indices such as the Nasdaq have been stronger than the S&P 500, and are well above their 200-day moving averages.  Market breadth (advances vs. declines) has been fairly strong and many other indicators are in the neutral range.

Conclusion

In summary, the U.S. economy is booming, inflation is under control, interest rates are low, and earnings growth is healthy.  The S&P 500 is expected to have earnings of $161 this year.  Based on its recent price of 2718, the P/E ratio is 16.9 times this year’s earnings.  This is a moderate level by historic standards, and shows that stocks are not overvalued, especially with low interest rates.  Second quarter corporate earnings will be reported throughout July, and should be quite strong, given the fast pace of the economy. 

On the domestic political front, the November midterm Congressional elections may become more of an issue for the markets in the months ahead, and political tensions remain high.  On the geopolitical front, while the recent summit meeting in Singapore has de-escalated the situation, there is still a possibility of renewed tensions with North Korea.  The recent turmoil in Italy has raised questions about the stability of the European Union as well as possible systemic problems with the European banking system.

Thus, as we look forward to the remainder of the year, the economic fundamentals remain strong and market valuations are reasonable.  However, market volatility is likely to continue, as risks remain high due to factors such as trade negotiations and other geopolitical issues.