Last month sure felt like March Madness, except there was hardly any Cinderella story. It was a “risk off” month to be sure – equities fell and credit spreads widened. Equities first recovered from the February sell-off only to fall again and retest the February lows. So, what caused the pullback and increased volatility in the stock market? Well, the list is long and we will cover several of the reasons for the changed market conditions in this installment of Capital Insights.
The increased volatility and stock market pullback starts with the recent increase in interest rates. The 10-year Treasury yield rose 55 basis points from 2.40% at the end of last year to 2.95% in mid-February. Some investors saw this as a harbinger of inflation. While we are sympathetic to this view given where we are at in the economic cycle, we don’t believe inflation is a big concern at the present time. Interest rates are expected to trend higher as the Fed continues to normalize the Fed Funds Rate and unwind its massive balance sheet. Inflation, however, is rather subdued. February Core PCE (Core Personal Consumption Expenditures excluding food and energy) increased 1.6% year-over-year. Core PCE, which is the Fed’s favorite indicator for inflation, has been trending higher lately, but is still below the Fed’s target of 2.0%. Since the peak in mid-February, the 10-year Treasury bond yield has declined 21 basis points to 2.74%. The fact that the 10-year Treasury bond yield did not rise above the widely watched 3% threshold suggests that the bond market is having doubts about the return of inflation.
Potential Trade War with China
President Trump announced tariffs on $50 billion in imports from China, but we don’t know exactly which products will ultimately be impacted. The products are expected to be in aerospace, information technology, communication and machinery. The US Trade Representative Office has published a list of Chinese products which will be affected by tariffs and the proposed tariffs will be subject to a comment period that ends May 22nd. Just like the 25% tariffs on steel, there will be exemptions and carve-outs. China has responded with 25% tariffs on $50 billion in imports from the US on products such as soybeans, vehicles, aircraft and chemicals. The market fears the uncertainty over tariffs and a long and costly trade war, which could be harmful to trade and capital flows for the US, China and the world, but at this point no one knows how this will play out.
A trade war with China certainly may look scary to the markets, but we don’t know if tariffs are just a negotiation tactic to resolve trade disputes with China or a political move to attempt to bolster the President’s approval rating ahead of the midterm elections. The Chinese retaliation so far has been very modest, compared to the overall trade balance with the US and both sides have left wiggle room for further negotiations. Our base case remains that the tariffs likely will not escalate into a full-blown trade war which could hurt US and global economic growth.
Another big obstacle facing the market is the stumble in leadership by the technology sector. Technology has increased its weight in the S&P 500 from 18% in 2009 to 25% today. (In comparison, technology accounted for 32% of the S&P 500’s total market capitalization at the peak of the dotcom bubble.) Technology was a key driver for the S&P 500’s earnings growth and total return in 2017. Unlike the dotcom bubble, there are secular trends that power real earnings in the tech space – mobile devices, e-commerce, software as a service, social media, cloud, big data analytics and the Internet of Things. Technology has become a very important part of the portfolio for many investors. There is no question the recent volatility and pullback with tech stocks has shaken investors’ faith in the technology sector, which was probably overinflated to begin this year. The potential legislation and regulation of social media companies and technology in general could impact their future earnings growth and valuations. That said, technology still has strong secular tailwinds and one of the best revenue and earnings growth projections in 2018 and 2019. While we don’t know how long the sell-off in technology will continue, we remain bullish on technology long term.
Facebook & Social Media Stocks
It is disappointing that Facebook did not do a good job in protecting user information and after the recent story about how Cambridge Analytica misused Facebook’s user data came out, the company failed to get in front of the news cycle in a timely manner. While the backlash against Facebook’s data policy and some regulations are worrisome, the company continues to maintain a dominant position in digital advertising. Its platform has the scale and reach which makes it a very important channel for advertisers to reach their target consumers. We don’t believe the data leaks will change in a material way how people interact with their friends and family on Facebook, unless a better social platform came along to replace it, which we believe is highly unlikely given Facebook’s dominant market position. The lack of protection of user data raises another headwind for social media stocks, which is the potential for regulation of this relatively new industry. It will be important to watch how the data leaks impact Facebook’s user growth, the time spent by users and the digital advertising dollars spent on its platform and whether earnings estimates will hold for this year and next, as well as the potential regulatory backlash from politicians in the US and Europe. We will be watching for these signs in other social media stocks as well. For now, we remain positive on the social media sector.
The market psychology has changed from last year and investors have been hesitant to buy on the dips. Given the volatility we’ve seen so far, it’s safe to say that the market is not likely to return to a low-volatility environment any time soon. If history is any guide, the current correction may run a few more months. However, given the lack of inflation and continued accommodative financial conditions, the prospect of a recession and a cyclical bear market is still low and the prospect of a structural bear market even lower. Earnings season will begin soon and S&P earnings are expected to be up 17% year-over-year in the first quarter, thanks in part to tax reform. Management commentary on their earnings and future guidance will give us a clue on what lies ahead in 2018.
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