If Everything is so Good, why Does it Feel so Bad?

06.19.2018 - Ronald J. Sanchez, CFA

  • Keep Policy Uncertainties in Perspective 
    While geopolitical tensions, trade policy and rising rates are generating sensational headlines and present real risks, we do not expect a worst-case scenario.
  • Focus on Macro and Micro Fundamentals 
    Over the long term, valuations are determined by fundamentals, not headlines. The economy is growing, earnings are strong, and the benefits of tax reform are still ahead.
  • Look to Risk Assets for Growth Potential
    Despite recent volatility, we believe the health of the economy and US balance sheets support risk assets. But a high degree of selectivity is essential.


As we wrote in our 2018 Outlook, it was our belief that the extraordinarily low volatility and strong returns for US stocks and bonds in 2017 were unlikely to repeat this year. In many ways, our expectations played out in the first half of 2018 as the market profile flipped. What was a near- ideal environment of easy financial conditions, strong economic and corporate fundamentals in 2017 has given way to a tug-of-war between pro-US policies and pro-growth fiscal policies.

While many benefits of the pro-growth policies enacted last year are still to come, headlines referencing forthcoming stimulus have been replaced with ones about the administration’s pro-US trade policy.

At the same time, we got our first indication of the impact of the recent tax overhaul in first quarter earnings. Corporations in the US grew profits at an astounding 23% year over year, with an estimated 7% of that coming from the benefits of tax reform. Even without the temporary lift from business-friendly tax changes passed last year, first quarter earnings ranked near the top for any quarter this cycle.

However, markets were forced to grapple with the escalation of geopolitical risks, trade policy rhetoric and concerns about rising inflation and tighter monetary policy—none of which were major factors in 2017. As a result, valuations in the US have adjusted meaningfully downward, largely wiping out the impact of strong corporate earnings on equity market returns. Also, in stark contrast to the tranquil environment in 2017, equity volatility has roared back as trade policy headlines have roiled markets throughout the year.

Distracted by Policy Uncertainty 

Due to heightened policy uncertainty, there has been a notable uptick in equity volatility and a subsequent recalibration of US equity valuations in 2018. The price-to-earnings (P/E) ratio for the S&P 500 dropped below 17x at the end of May, down from roughly 20x last December. At the same time, headline risks have led to a period of significant market gyrations with only marginally higher equity prices despite the strong fundamental backdrop. 

While traditional safe-haven assets did not materially benefit over the first part of the year, our interpretation of the trading behavior is that investors are demanding a greater level of compensation for owning equities. Uncertainty over government policy appears to be causing a disconnect between market returns and fundamentals.

Trade Tensions Unsettle Investors 

Investors do not like uncertainty. So, this combination of trade tensions between the US and several major trading partners, along with the unpredictability of the Trump administration’s next move, have been unsettling. Driven by government rhetoric and newspaper headlines (CHART 1), it has become relatively common for the US equity market to swing by more than 1% over the course of a single trading session. After 2017, which was devoid of any market volatility, this feels unfamiliar and uncomfortable to investors, even though the average level of S&P 500 volatility this year has been near its historical mean.

As the landscape shifts, US equity investors appear to be caught in the middle of a standoff between policy uncertainty and constructive fundamentals. Eventually, we believe fundamentals will prevail, although it may take time for headline risks to fade into the background and for greater clarity around the future of trade policy to emerge.

Treasury Bond Yields Move Higher 

An additional risk being weighed by market participants this year is the prospect of higher inflation leading to tighter monetary policy. The recently enacted fiscal stimulus package comes at a time when the unemployment rate is below 4%. This could increase the risk of continued inflationary pressures, which is beginning to be priced into bond markets.

Headlines about monetary policy may have been less alarming than those about a possible trade war, but interest rates are still a powerful influence on markets. As the Fed has continued to raise rates and unwind its balance sheet, yields on six-month Treasuries have eclipsed the dividend yield of the S&P 500 for the first time since 2008 (CHART 2).

This, combined with the perception that equity markets have become “riskier,” has led income-oriented investors who have been searching for yield away from dividend-paying stocks.

The Fed is forecasting two more quarter-point interest rate hikes in 2018 and another three increases in 2019, aiming to slowly push the fed funds rate closer to 3%. In addition, the Treasury Department is expected to issue an additional $1 trillion in bonds in 2018 and again in 2019 to finance tax cuts and the government’s new spending-heavy budget, which could also contribute to higher yields for Treasuries.

An Evolution, Not a Revolution

The concerns drawing the attention of equity investors today are valid, but it appears to us that many investors have begun to price in a less favorable outcome for some trade and foreign policy uncertainties. With respect to the path of monetary policy, we believe the Fed will continue to take a measured and data-dependent approach in an attempt to tighten without constraining the economy. 

Financial Conditions Have Moved from Ideal to Supportive

While we may have departed from the “Goldilocks” environment that propelled markets in 2017, we do not see financial conditions moving to a place that is problematic for equities in the near term. The shift we have seen to date is from a backdrop that was favorable for equities to one that is just supportive. We are in the midst of an awkward transition away from benign inflation and record-low interest rates, but both are still low in a historical context. We remain mindful of the potential for a policy error on the Fed’s part, but we expect policymakers to proceed slowly and cautiously in their approach to normalization. 

While pressures on inflation are building, we do not believe there will be an inflationary shock, mainly because the structural forces that have kept inflation muted to this point—globalization, technological innovation and demographic shifts—are still in place and appear likely to persist for some time. The Fed seems to concur, indicating that it expects inflation to oscillate around its long-term target over the next few years. 

In the Long Run, Headlines Don’t Determine Valuations 

In our view, the trade tensions we are experiencing represent an effort by the administration to level the playing field for global trade, not to enact destructive trade barriers. When all is said and done, we believe the posturing between the US and our trading partners will end with a negotiated resolution rather than a full-blown trade war, the latter of which would be damaging for all countries involved. 

In the short term, we expect volatility in equity markets to continue as trade negotiations progress. But in the long run, valuations are a product of economic and corporate fundamentals—an area where we see continued strength—not government rhetoric or newspaper headlines. Having said that, should the current environment give way to restrictive trade policies, there is a risk of constraining the global economy. 

Fundamentals Support Risk Assets 

Despite slightly softer economic data in the first quarter, we maintain our positive outlook on the economic cycle. We expect that this, in conjunction with the robust corporate backdrop, will continue to support risk assets. Even amid the volatility in equities to start the year, flows into global stock ETFs and mutual funds were significantly positive, indicating that sentiment has shifted, but demand for equities has not (CHART 3).

Finally, it is worth pointing out that US trade policy, rising interest rates and inflation can affect different sectors of the equity and fixed income markets, as well as individual securities, in vastly different ways—some for the better and some for the worse. In our view, this distinctly different and more challenging backdrop is precisely the type of environment in which our active approach to investment management and high degree of selectivity can add value.

This communication is intended solely to provide general information. The information and opinions stated are as of June 18, 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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