Our Perspective on Recent Market Volatility

04.05.2018 - Ronald J. Sanchez, CFA

  • While it is difficult to quantify the impact of tariffs on the economy or corporate earnings, markets have responded to the threat with elevated volatility. 
  • As long as negotiations continue, none of the proposed tariffs will be implemented. 
  • Both China and the US have too much to lose by engaging in a full-blown trade war, which gives us some confidence that the worst-case scenario is unlikely to come to fruition.
  • The combination of higher earnings expected from tax reform and recent market volatility has compressed S&P 500 P/E multiples, which now sit at their lowest level since early 2016 when markets were digesting fears of a "hard landing" for China's economy and a global recession.
  • While the market has been driven largely by trade-related headlines, earnings season may shift the focus back to fundamentals.
Markets Forced to Digest Policy Uncertainty

After years of government paralysis and an unusually calm market in 2017, investors are now struggling to sort out the implications of an ever-changing policy landscape—including tax reform, government spending, and more recently, trade tensions. Fundamentals remain strong, but uncertainty over government policy has triggered elevated levels of market volatility in 2018.

The equity market surged higher in January on the heels of tax reform and pulled back sharply on concerns around rising inflation, interest rates and monetary policy. After recovering, the market was challenged once againthis time by US trade policy.

Since the first mention of possible tariffs on steel and aluminum imports on March 8th, the S&P 500 Index has fallen nearly 3.3%, including six daily declines of more than 1% and three days when stocks fell more than 2%. This is in stark contrast to 2017, when daily declines of more than 1% happened only four times throughout the entire year.

Tariffs Are Proposed, but Not Implemented

What we know so far is that the US has announced a series of proposed tariffs on imported products from China in response to the widening trade deficit and disregard by Chinese firms for US intellectual property laws. At this point, the US has proposed tariffs on 1,333 Chinese products. In response, China has threatened to increase tariffs on 106 US products, most notably airplanes and soybeans. In our view, if these actions remain limited in scope, the risk of a global trade war remains low.

So far, the US and China have only proposed tariffs—not implemented them. And even if they are eventually enacted, these proposed tariffs would not go into effect any time soon because a public comment process would delay action until this summer. Given the potential collateral damage, we believe implementation would only happen in a worst-case scenario if negotiations break down.

For the time being, the implementation of tariffs is unlikely as long as the US and China are negotiating intellectual property issues at the heart of the dispute—something that is in the best interest of both countries to resolve amicably.

Economic Implications

While it is difficult to predict the true impact of a trade war, we do know that the retaliatory actions by China and the US at this point account for $31.5 billion of potential tariffs. However, the damage of a trade war could be more than offset by the fiscal policy enacted over the past three months, which dramatically outweighs the size of the proposed trade actions. Congress has unleashed $200 billion of tax cuts along with $100 billion of new spending, and recent guidance from the Treasury Department indicates between $500 and $700 billion of cash will return to the US through repatriation.

Nonetheless, in the unlikely event that a global trade war develops, it would have significant implications for economies through a multitude of channels. First, global trade volumes would be impacted, which would curtail economic growth. Additionally, input costs would rise, which could push consumer prices up and ultimately hurt global consumption. 

While the net effect of such a situation would undoubtedly be a headwind to global growth, we do not see a trade war as a likely outcome because it is not in the best interest of either country.

Market Implications

Ultimately, there is a high degree of uncertainty around the future of US trade policy, which has translated into higher equity volatility and multiple compression.

But it is important to keep in mind where we came from. Last year, the S&P 500 returned nearly 22% as pro-growth fiscal policies propelled earnings and multiples higher in tandem. This year, we have seen domestic equities fall 0.6%, which means the market is still more than 20% higher over the course of the last five quarters. 

Market Reaction Has Not Been Broad-Based

What’s more, despite all the noise surrounding trade tensions with China, the reaction has been relatively limited to equity markets. Traditional safe haven assets that typically benefit in times of market turmoil have not done as well as would be expected in a true “risk-off” event. 

In fact, since early March gold has rallied just 0.9% and the 10-year US Treasury yield has come down only 10 basis points, from 2.90% to 2.80%. We interpret these modest moves as a signal that investors remain convicted in the underlying economic and corporate fundamentals.

Our Outlook Remains Positive for Equities

In conclusion, we remain constructive on equities over the next 12 months as both economic and corporate fundamentals remain on solid footing, with the impact of pro-growth policies still to come.

This communication is intended solely to provide general information. The information and opinions stated are as of April 5, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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