- As the market reaches a historic milestone, trade war uncertainty and rising inflation raises questions about the longevity of this bull run.
- U.S. equities continued their impressive performance, reaching all-time highs in August, while international stocks and commodities have lagged significantly.
- We are concerned about the upcoming effects of quantitative tightening, as the decreased liquidity may have spillover effects across global markets.
- Despite the headline risks, positive factors such as growth in corporate earnings suggest there could be more gains ahead.
What Piqued Our Interest
What a ride it’s been! The U.S. stock market rally is now officially the longest bull market in history, surpassing the previous record which ran from 1990-2000. There have certainly been some peaks and pits along the way, but for the most part we have experienced a long steady climb with sustained periods of low volatility, due mostly to the massive amount of monetary stimulus around the globe. But how much longer can this market continue to rally? On one hand, strong corporate earnings, a pro-business administration, low unemployment, and multi-decade-high sentiment indicators suggest that we could have months or even years left to go before a recession. On the other hand, evidence of the economy peaking is starting to mount, and concerns about global trade and rising inflation could indicate that we are nearing the end of the cycle. Weakness in emerging market currencies is back on the radar, particularly Argentina, Turkey, and most recently South Africa. Fear of contagion that could spread across global markets has investors concerned, but for now appears to be somewhat contained.
Here in the U.S., analysts at Goldman Sachs projected that stock repurchases will reach $1 trillion this year, up 46% from 2017, on the back of tax reform and strong corporate cash flows. Many have claimed that buybacks are one of the primary reasons why the stock market is so strong. However, a closer look shows that the real reason might just be earnings growth, and not just the reduction in publicly traded shares. For example, an analysis by JP Morgan concluded that only 7% of this year’s market gain is due to share reduction, and that earnings growth of 14.4% in the S&P has driven returns. One can also look at the exchange traded fund PKW as a proxy for how well companies with stock buybacks have performed versus the overall market. PKW is an ETF that only invests in companies which have reduced their shares by 5% or more over the past 12 months. While the S&P 500 is up around 9.5% this year, PKW is up only 3.66%, which shows that not all stock buybacks are generating higher returns.
In trade news, the U.S. reached a deal with Mexico to replace key provisions of NAFTA but failed to meet a self-imposed deadline with Canada on September 1. The noted deal would require 75% of auto content to be made in the US and Mexico, up from the prior requirement of 62.5%. It would also require 40-45% of auto content be made by workers earning at least $16 an hour. The markets generally rallied upon the news of this agreement, but it remains to be seen what this means for Canada, and if this deal will pass congressional approval. Separately, President Trump announced in August that he plans on moving forward with $200B in China tariffs, potentially within the next few weeks.
Finally, annualized Core Inflation (ex Food and Energy) was up 2.4% annualized in July, which marks the highest level in over a decade. Wage growth is finally showing signs of strength, while food and energy costs are on the rise as well. Should we enter into an all-out trade war with China and our other global trade partners, higher prices on household goods will likely be next. All of this could lead to an overheating economy, and the potential for the Fed to raise rates faster than anticipated. The Fed is all but certain to raise rates to 2.0-2.25% on September 26, and the current probability for a 4th rate hike in December is 70.5% (according to CME Group futures). The market has priced in these rate hikes, and 2-3 more next year, but if inflation continues to surge the Fed may surprise us with additional interest rate hikes which would likely rattle the markets.
August was once again a strong month for U.S. equities, while worries about global trade, politics, and foreign exchange rates have plagued international stocks. Leading the way in the U.S. were small cap stocks, which climbed by 4.1% in August for an impressive 14% gain on the year. U.S. large caps increased by a respectable 2.3%, as both the Nasdaq 100 and S&P 500 reached new all-time highs this month. Regarding U.S. sectors, technology stocks climbed 6.6% in August, while Consumer Discretionary stocks were close behind at 5.09%. Meanwhile the worst performing sector was energy, which fell by 3.53%. In the international arena, concerns around emerging market countries have continued to mount, most notably in Turkey, Argentina, and Venezuela who are all dealing with their own political crises which have weighed on markets. The emerging market index declined by 2.29% in August and is now down 7.95% on the year. Overall, international stocks are -3.9% year to date, compared to +10% for the Russell 3000, a whopping 14% discrepancy over the first eight months of the year.
Fixed income securities were generally positive in August, though the Bloomberg-Barclays U.S. Aggregate Bond Index is still negative 0.96% on the year. While rates on the short end have continued to climb, the 10-year U.S. treasury has held steady between 2.85-3.0% for most of the summer. Credit has outperformed lately, as High-Yield bonds are now up 2.0% on the year after a shaky 1st quarter. Municipals also continue to outperform taxable bonds, albeit slightly, partially due to decreased supply after changes from last year’s tax reform. Short-term bonds have outperformed long-term year-to-date, but over the past three months as rates have stabilized, longer maturity bonds have prevailed.
Commodities have had an up and down year, driven largely by the increasing fear of trade wars and the impact it could have on global demand. The Bloomberg Commodity index was up 5% in mid-May, but since then has fallen by 8.97% and is now negative 3.87% on the year. Crude oil is still well into positive territory, but both precious and industrial metals have taken it on the chin this year. Copper, which is often used as a proxy for demand due to its wide use across industries, is now in bear territory down 20.65% YTD. Gold, which is viewed as a safe haven asset, is down 8.72%. Gold’s decline can certainly be associated with the strength of the U.S. dollar, which continues to climb and is now up 3.27% on the year after a slow start in Q1.
As the European Central Bank (ECB) winds down its bond purchases this fall, the net asset purchases by the three main central banks will drop to zero by the end of the year. If the synchronized quantitative easing by the Fed, ECB, and Bank of Japan helped support and propel this long-running bull market, it is logical to assume that quantitative tightening may have the opposite effect. The repercussions will likely ripple across all financial markets but could have an especially profound effect on emerging markets. The easy money which chased high growth opportunities across EM over the past decade will no longer be as readily available, and with higher interest rates the cost of servicing existing debt will rise. Add to this the effects of a stronger U.S. dollar, which increases the total debt burden owed by many EM countries and corporations.
While the threat of a US-Mexico trade war has diminished, it remains to be seen how the dispute with Canada will be resolved. Prime Minister Trudeau has stated that he will not bend on key demands for Canada, including the retention of a dispute-mechanism that allows member states to challenge one another. And of course, President Trump has made it very clear that he doesn’t intend on conceding any of the U.S.’s key demands, including greater access to Canada’s dairy market. However, since each country is each other’s largest trading partner, it is hard to imagine that an agreement won’t happen eventually. We feel the greater threat lies in China. As we have mentioned in previous commentaries, if we enter an all-out trade war, the overall impact to GDP should be limited, however, inflation will likely rise, and the protectionist rhetoric will likely continue to make waves in financial markets.
Since the equity bull market began in March 2009, it has been one of the most unloved and distrusted in memory. This September marks the 10-year anniversary of when Lehman Brothers defaulted and went bankrupt, one of the signature failures of the global financial crisis. The U.S. market has remained remarkedly resilient in the face of multiple geopolitical events, which can essentially be chalked up to strong corporate earnings alongside solid job creation and fiscal stimulation.
Is a September swoon ahead? Historically September has been the worst month of the year for the S&P 500, however in strong years such as this the results have not been as bad. We continue to favor U.S. equities over other asset classes, including international stocks, as well as bonds in general. Our models continue to have a slight tilt towards growth-oriented and small/mid-cap stocks, as both have benefited from the strong economy and fiscal stimulus. We think that global trade wars pose a viable threat to this economic expansion but are equally, if not more concerned, about rising inflation, the flattening yield curve, and the risk of a Fed policy mistake. For now, we remain optimistic that equities, at least here in the U.S., might still have some fuel left in the tank.