Financial markets globally are in a grinding battle between bulls and bears, aided respectively by the positive impact of US tax reform and the negative effects of rising interest rates.
Entering the second quarter this week, markets, particularly in the United States, are stuck between familiar opposing forces:
1) Economic growth, where gradually rising demand will meet limited supply. Real US GDP grew by 2.6 percent year-over-year in the fourth quarter and could, due to a strong inventory build, achieve 2.9 percent year-over-year growth in the first quarter. Moreover, it should maintain a close to 3 percent pace for the rest of this year and into early 2019, as the recently passed US tax law boosts both consumer and investment spending. However, the US economy is severely supply-constrained. A lack of supply should slow growth in 2019 and beyond.
2) Conflict between low inflation and a less dovish US Federal Reserve. Inflation should only rise slowly and there is little evidence of accelerating wages. Moreover, in the first quarter, inflation was boosted by a 22 percent year-over-year rise in oil prices and a 9 percent year-over-year decline in the dollar. These forces should abate in the year ahead, leaving inflation pretty much stalled at the Fed’s 2 percent target.
However, even without an inflation scare, the Federal Reserve is likely to continue to tighten policy. At their latest meeting, they forecast three rate hikes for both this year and next. However, seven of the 15 members providing forecasts projected four rate hikes this year. Perhaps more importantly, their forecasts of economic growth, while reasonable in themselves, suggest a higher unemployment rate than is plausible and, if the labor market continues to tighten more than they expect, they should feel emboldened to normalize policy.
3) For equities, the battle is between valuations and earnings growth. On valuations, the good news is that the forward operating P/E ratio on the S&P500 is now just 16.4 times, not significantly higher than its 16.1 times 25-year average.
Analysts have only recently calculated the full impact of tax reform on 2018 earnings and the story is very positive. Moreover, there is a strong argument that P/E ratios shouldn’t have to fall back to average levels. After all, we expect below-average inflation and interest rates in the long-run – this should make the case for below-average earnings yields for stocks, and thus, above-average P/E ratios.
However, the real challenge facing stocks concerns margins. The 2018 backdrop is about as positive as it could be for earnings with year-over-year gains in oil prices, a year-over-year decline in the dollar and a big corporate tax cut. In 2019 and beyond, the outlook for margins could be far more difficult with higher interest rates and wage costs hurting the bottom line. As a general slowdown in earnings growth comes more clearly into view, it will be important for investors to focus on stocks and sectors that can thrive in a rising interest rate environment.
4) Finally, there is the perennial battle between volatility and principles. Volatility did rise in the first quarter with the VIX index climbing to a level of 37 in early February before falling back to 20 by the end of the quarter. However, it is worth noting that volatility isn’t unusually high – the average level of the VIX over the past 11 years has been 19.8, essentially where it was at the end of last quarter. Rather, we are just coming out of a period of unusually low volatility.
Be that as it may, some investors may have considered throwing in the towel in the face of volatility. This would have been a mistake. The ability to absorb market shocks starts with diversification so you are not too vulnerable to particular negative events. However, it may also be useful to use more obviously defensive strategies either by increasing exposure to high-quality fixed income or investing in more direct hedges against equity market declines.
It was a challenging first quarter and the second quarter may not be any easier for investors to navigate. However, in long-term investing, a respect for the fundamentals and a good eye for both tactics and strategy should lead to positive results.
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