A key issue for investors is that the business cycle is moving into an increasingly mature phase. The U.S. economy is now in its ninth year of expansion, is one of the longest periods of growth on record. At the same time, some of the world’s most important central banks are shifting away from an extraordinarily accommodative monetary policy. Given these factors, risks are starting to rise, and are becoming more skewed to the downside, especially given asset price gains in recent years.
There has also been a notable increase in volatility. In the first quarter, the high-to-low range of the S&P 500 was 10% (Figure 1), while the yield on the 10-year U.S. Treasury bond declined 18 basis points in just seven trading days in late March, falling from 2.91% to 2.73% (Figure 2).
Figure 1: S&P 500 Price: 2018 Year-to-Date
Figure 2: Yield on 10-Year U.S. Treasury Bond: 2018 Year-to-Date
Volatility is likely to continue for the foreseeable future. As we discuss below:
- Equity valuations are high.
- Politics and policies continue to weigh on markets, including fears of a trade war between the U.S. and China.
- There is an ongoing tightening of monetary policy in both in the U.S. and other developed economies.
Earnings and Valuations
Stock price volatility has increased in 2018, and equity valuations are high by historical standards. All the same, the U.S. equity outlook remains fundamentally sound. Corporate profitability is exceptionally strong — nine of the 11 sectors in the S&P 500 are currently forecast to post double-digit earnings gains this year.
Political and Market Risks
In the opinion of some observers, a major exogenous risk currently is a disconnect between the political environment and the performance of financial markets, which, despite increased volatility, have been relatively resilient. These risks include (i) trade and tariffs, (ii) heightened regulatory scrutiny of tech companies, and (iii) the ongoing Russia investigation in the U.S.
Current U.S. foreign policy has been characterized as a “Doctrine of Withdrawal.” Observers point to the U.S. leaving the Paris climate-change accord, exiting the Trans-Pacific Partnership free-trade agreement (although this may be under review), ending American membership in UNESCO, as well as threats to withdraw from NAFTA and the Iran nuclear deal.
In addition, the U.S. has imposed tariffs on certain Chinese products. A first wave of U.S. tariffs, focused on steel and aluminum imports, was followed by a separate 25% tariff on $50 billion of specific Chinese imports. That sparked a retaliatory response, in which China presented its own list of products worth an equal $50 billion that will be subject to a 25% tariff. Steel and aluminum tariffs have already gone into effect for Chinese products, as have China’s retaliatory tariffs on U.S. pork, fruit, nuts, ethanol and other products. On top of fears about an escalating trade war, another concern is that China’s large holdings of Treasuries could be used by the Chinese government as a tool to cause disruptions in U.S. financial markets.
Separately, the key technology sector was hit by regulatory investigations into Facebook, prompted by the revelation that personal data had been improperly accessed, as well as by a salvo of tweets by the U.S. president against Amazon.
Turning to the fixed income markets, a tightening of global monetary policies is expected to continue, with seven advanced economy central banks likely to raise policy rates this year, in addition to the European Central Bank (ECB). 75 basis points of hikes are expected in the U.S. and Canada, and 25 basis points each in the U.K., Norway, Sweden, New Zealand, and Australia. Furthermore, central bank net asset purchases will likely continue to fall sharply, reflecting a gradual normalization of monetary policies after the global financial crisis of 2008-09.
Central bank policies reflect that global growth remains solid. For the first time since the 2007-08 financial crisis, all the world’s major economies are growing: Canada, U.S., Mexico, Brazil, U.K., Euro Area, Russia, Turkey, India, China, South Korea, Japan, Indonesia and Australia.
Cautious Outlook Amidst Volatility
The strength in global economies is a positive for equities, but will likely continue to put pressure on interest rates and, therefore, P/E multiples. In addition, an unpredictable political environment could continue to cause volatility in asset prices. Overall, U.S. equities will likely post gains of 5-10% in 2018 while bond prices will likely decline further (and interest rates rise), although it may be a bumpy ride for both asset classes.
In this report, which may be downloaded here:
Equity Outlook …p. 5
Fixed Income Outlook … p. 11
Alternatives/Commodities Outlook … p. 13
Tactical Asset Allocation…p.16
Market and Global Sector Performance…p. 18
Key Economic Indicators…20
Michael Geraghty is Executive Director, Equity Strategist for Cornerstone Capital Group.
Jennifer Leonard, CFA is Director, Asset Manager Due Diligence for Cornerstone Capital Group.