Rising Interest Rates & Trade Threats Bring Long-Anticipated Correction

Following a stellar 2017, investors saw plenty of reasons to extend the two-year rally: business confidence, earnings growth expectations, consumer sentiment, labor demand and synchronized global growth all registered their highest readings in many years.  US equity markets, buoyed by optimism posted a 7.5% rise in the first 28 days. Not since early 2016 had we experienced more than a 5% drawdown and the sailing forward looked smooth.  Then the Correction.

With heightened expectations for inflation, 10-year Treasury Note yields rose significantly from 2.45% to 2.94%. The resulting prospect of our Federal Reserve accelerating interest rate hikes to cool the economy choked this newfound optimism and spawned an initial retreat in the markets.   The coup-de-gras was the surprise announcement of US tariffs on imported steel and aluminum, triggering a two-week, 10% correction.  Markets initially recovered, gaining back all but 2.5% of losses, when further tariff announcements by the US and China sent markets reeling again.  As of this writing, we are bouncing along the bottom of this recent range.

The administration is attempting to level the business playing field - primarily with China over unfair trade practices – and the market hasn’t taken issue with its negotiating style.  What concerns financial markets is the uncertainty of outcome.  The fear of a global trade war sent almost all international markets into a tailspin.  We do not view a trade war as likely.  China has eased some trade restrictions on US goods and services but until this issue dissipates, markets remain on edge.

It is important to note this corrective process is not currently perceived as stressing the economy.  If it were we’d see a widening yield difference (credit spread) between quality bonds vs. high yield.  Virtually no movement in the cost of credit indicates that markets are not viewing trade as a major threat.  Yet.

The Fed and Volatility

With the Federal Reserve raising interest rates and reducing its balance sheet, an important backstop for financial markets is being withdrawn. For several years markets went up knowing that the Fed stood ready to add stimulus if markets tumbled.  This has changed.  The Fed is removing stimulus and likely to raise rates three more times this year.  So, expect higher interest rates and volatility going forward.  Longer term we’re watching Fed policy for risks of raising too fast and squelching momentum. 

In our 4th Quarter Commentary, we stated that we’d have a correction at some point and were afraid our clients had forgotten what one felt like.  We’d like to thank you for remembering that as we have received fewer than a handful of calls regarding this correction.  But we remind you that “normal volatility” means averaging one correction of 10% every year and five other drawdowns of at least 5%.  So, our mantra remains the same: if the news gets too scary, turn off the television.  The media knows fear and sex are what sells.  You won’t see much sex on CNBC, but they sell fear like nobody’s business.

Performance and Positioning

For the first quarter of 2018, the S&P 500 Index finished down 0.75%, broad foreign markets (EAFE Index) were down 1.5%, and US bonds (Barclays Aggregate Index) lost 1.5%.  Most of this giveback was focused on large companies with international exposure (i.e. tariff related). US small-caps finished unchanged and emerging markets were +1.4%.  Suffering the most were interest rate-sensitive sectors and the assets we have warned about most; bonds and high dividend stocks.  Once again there was wide disparity as the growth discipline outperformed the value discipline across companies of all sizes.

Seeing better valuations and opportunities, in the past week we’ve reduced our US equity exposure and increased foreign exposure, particularly in emerging markets.  Emerging markets offer the best values of any major asset class and until last year underperformed the US for five straight years.  With a growing global economy and weak US Dollar, they enjoy the best possible backdrop going forward and offer significant upside potential. 

We maintained our overweighting of Consumer Discretionary, Technology, Financials, Industrials, and the Health Care sectors. Once again, they were the best performing sectors of the quarter.  We have long avoided the most overpriced and rate sensitive sectors, (Utilities, Consumer Staples and Telecom) each of which were down 6% - 7.5% for the quarter. 

Each of our clients has a unique blend of various Integras Strategies.  In January we took the opportunity to rebalance for clients taking monthly income to ensure an optimal amount invested in our most conservative Liquid Assets Strategy.  Not attempting to time a correction, our moves turned out quite fortuitous as just days later the correction began.  In our planning and investment process, aligning assets with needed cash flow timeframes is the first order of operation.   Unless client short-term needs require conservative assets, we intend to remain invested given the many positives in the global investment environment.

Economy and Markets

This will be the first quarter of earnings reflecting the new lower corporate tax rates.  Forecasts indicate the highest earnings growth since 2009 – depending upon the source, up between 15% to 20%.  Since 1990 there have been eleven years when earnings growth was above 10%.  The market finished higher every year, with an average gain of 15%.  Additionally, due to the new tax laws, US business surveys indicate capital expenditures (CAPEX: factory expansions, property and equipment, etc.) will increase over 10% - the highest level since 2004 and an additional boost to economic growth.  This year could be different, but we expect to end 2018 solidly in the black.  Should earnings fail to live up to these expectations, we’ll likely see continued short-term weakness in equity markets.

Moving Forward

Going into 2019 however, the sledding gets tougher.  It will be difficult to surpass this year’s earnings growth and with higher wages and interest rates, margin growth will likely compress.  At the same time, 2019/2020 will see a wave of corporate bonds mature.  These bonds must either be refinanced at higher rates or paid off, which is unlikely.  Growing interest expenses will further compress profits.  While this is not currently actionable we are acutely watching for early signs of the next recession on the horizon.