The last week’s market highlights:
Quote of the week:
“For all sad words of tongue and pen, the saddest are these: ‘It might have been.’” – John Greenleaf Whittier
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Midyear Outlook:
- U.S. economy: Running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Central banks aren’t all on the same wavelength.
- Fixed income: Starting to prefer higher-quality assets.
- Equities: Earnings are supporting prices, but expect plenty more volatility.
- Asset allocation: Remain risk on, but focus on quality.
Equities: Have tariffs hurt U.S. equities? Probably.
In the 1998 movie “Sliding Doors,” Gwyneth Paltrow, unexpectedly fired from her job, takes a morning train home only to find her husband with another woman. How would her life have changed had she missed that train? We find that out, too.
Using a similar, “parallel universe” approach, it’s natural to wonder how U.S. stocks would have fared without this year’s global trade concerns. One prominent investment firm reckons that tariffs have trimmed about 3% from S&P 500 Index performance. While our estimate of foregone gains is not quite as precise, we think trade has likely taken a “hidden” toll on stock prices via reduced valuations. The index has seen its price-earnings ratio drop from 18.2x forward earnings in January to 16.7x last week, even as its price level has risen only marginally over that eight-month period. Consequently, investors may not have been fully rewarded for the last two quarters’ worth of blowout earnings.
Indeed, it’s hard to imagine that trade issues have helped equity markets. All told, S&P 500 firms generate nearly half their profits overseas. Moreover, a number of bellwether companies, including General Motors and Whirlpool, lowered their full-year 2018 earnings forecasts due to the higher costs of steel and aluminum. Lastly, ETFs tracking the U.S. steel sector have lost about 15% since late February, just before the U.S. imposed its first round of tariffs.
What’s certain is that U.S. stocks have performed well this year—and with little volatility to boot. Through September 14, the S&P 500 was up over 10%, while the VIX—or Wall Street’s “fear index”—has been mostly flat. And since U.S.-China bilateral tariffs went into effect in early July, the S&P 500 has yet to move by 1% in either direction on a single trading day.
In our view, there are three possible reasons behind the stock market’s relative resilience:
- Most of the previously discussed or announced taxes on Chinese goods have yet to go into effect. These include separate levies on Chinese imports for $200 billion and$267 billion.
- Investors have thus far underestimated the extent to which tariffs might dent 2019 earnings.
- The trade disputes are taking place against a backdrop of solid U.S. and global growth. The International Monetary Fund projects the global economy to grow at a 3.9% rate in 2018, with emerging markets expected to deliver growth of around 5%.
Equities/Global economy: Don’t equate poor equity-market performance with sluggish economic growth
Over the past few months, equity investors have likely winced when reviewing their monthly statements comparing U.S. and international developed-market (DM) stocks. From April through August, the S&P 500 Index has returned a cumulative 11%, versus a 1.2% loss for the MSCI EAFE Index, a common DM benchmark. That outperformance has continued in September, with the S&P ahead, 0.2% to -1.2%.
Such a disparity may suggest that DM economies are also struggling mightily. But that’s not the case. Eurozone manufacturing and service-sector activity remained in growth mode, with Markit’s (final) Composite Purchasing Managers’ Index (PMI) coming in at 54.5 in August. (Readings over 50 indicate expansion.) In addition, GDP for the region grew at a reasonable 2.1% year-over-year pace in the second quarter. Although that represents a deceleration from the 2.7% rate in 2017 and was just half the 4.2% growth generated in the U.S. last quarter, the eurozone economy—unlike that of the U.S. —hasn’t been boosted by massive fiscal stimulus and tax cuts.
Meanwhile, Japan’s economy, the world’s third-largest, grew at a 3% clip in the second quarter of 2018 amid a surge in business spending. This marked its best GDP performance since 2016. Japanese service-sector PMIs hit a four-month high in August, and manufacturing activity has remained in expansion mode for two straight years—the longest stretch since the global financial crisis.
So why consider investing in DM stocks given their dramatic year-to-date underperformance? Attractive valuations are one reason. The MSCI index is trading at 13.1x next 12-month earnings, close to its largest discount to the S&P 500 since 2008. Also, the U.S./DM earnings gap should narrow. MSCI’s expected earnings growth rate for 2018 stands at a solid 9.4%, trailing the S&P 500’s tax-reform-fueled 17.1% anticipated increase. Next year, MSCI earnings are forecast to register a still-healthy 7.7%, which compares more favorably to an anticipated 10.3% for U.S. companies.
On the other hand, several factors point to keeping your investment capital at home. Chief among them is that trade risks tend to weigh more heavily on large, open economies such as the eurozone and Japan. Another potential headwind for DM shares: if the currency woes and political uncertainty currently gripping the emerging markets intensifies, leading to worsening economic conditions in the developing world, the MSCI EAFE may well continue to lag the S&P 500. That’s because earnings of DM companies are far more exposed to EM economies than are U.S. firms.