April 2018

bbt-perspectives-market-monthly-april-2018-feature

“Stay in your seat come times of trouble. It’s only people who jump off the roller coaster who get hurt.”

Paul Harvey

One of the great radio broadcasters of our time, Paul Harvey always had a way with words. Markets have taken investors on a daily roller coaster ride like we’ve not seen in years, but this is typical for late-stage bull markets. The logic in Harvey’s statement above suggests investors should remain seated but buckled up for bouts of volatility. In this edition of Market Monthly we refresh our outlook for 2018 and briefly discuss the daily roller coaster of volatility. Rising interest rates, tariff tantrums and mid-term elections represent potential headwinds to the economy, but our base case assumes tax-reform aided economic growth will prevail. Our outlook remains cautiously optimistic but stops short of saying the path will be easy. As Harvey always said so eloquently: “and now…for the rest of the story.”

Volatility: What a Difference a Day Makes!

Volatility is a natural by-product in the later stages of a bull market. Clearly, a switch has been flipped from the 2017 low-volatility regime. The chart below tells a contrasting story of two markets between the low-volatility market we had in 2017 and the high-volatility experience of 2018. We asked how many days experienced a +/- 1% price change within a given trading day (intraday) since January 2017. We found:

  • Of the 251 trading days in 2017 only 12 days experienced a +/-1 % price change within the day
  • Of the 66 trading days so far in 2018, 46 days experienced a +/- 1% price change within the day

bbt-perspectives-market-monthly-2018-dow-jones

Here’s the Thing: The volatility we have seen so far in 2018 is far more normal than the extreme streak of low volatility we saw in 2017. Furthermore, 300-point swings in a Dow Jones at 24,000 is far less damaging than it was years ago with a Dow Jones at 10,000. This fits with the theme we introduced in December 2017 where we anticipated a shift from a “steep-return/flat-volatility regime to a flat- return/steep-volatility regime.” For additional commentary on market volatility refer to our recent Market Spotlight articles on our BB&T Perspectives website. Links are provided below.

Looking Past the Sell Off                                    March 26, 2018
Still a Bull Market but Volatility Persists              March 7, 2018
Rising Yields Begin to Bite                                  Feb. 5, 2018

Trade Truce?: The most likely outcome from the recent headline wars between President Trump and President Xi of China is to skip the war and go straight to a truce. Any impact from tariffs is dwarfed by the positive impact from fiscal stimulus. Yet, headline announcements of “proposed” tariffs by both the U.S. and China are having an exaggerated effect on the markets considering the small scale of their “proposed” economic impact. Consider the chart below, which contrasts the potential economic impact from tariffs with the anticipated economic impact from fiscal policy.

bbt-perspectives-market-monthly-2018-china-trade

The left side of this chart reflects the anticipated revenue impact from tariffs while the right side reflects the anticipated impact from fiscal policy. The rough math suggests the pro-growth fiscal policy ($800 billion) impact dwarfs the tariff impact ($81 billion) by a factor of roughly 10 times. This is significant, but why is the market not listening to the positive message from tax reform?

There are two primary reasons:

  1. The expected thrust of economic-activity tax reform has only just begun to make its way into real economic data but is off the headlines and investors radar.
  2. Tariff tantrums and trade wars have stolen the headlines despite their economic irrelevance. The real risk markets fear most is Chinese retaliation or a drawn out process that could deteriorate business confidence enough to delay capital investment plans and derail economic growth.

Bottom Line: Late-stage bull markets are often hypersensitive to jittery news headlines. The stock market has paused as it tries to decipher likely outcomes from trade war fears, but remember, the stock market is also the public-opinion poll of choice for this White House rather than the traditional opinion polls of past administrations. We anticipate additional market uncertainty around the disruptive dialogue between the U.S. and China, but ultimately we think trade-war fears will yield to a trade-truce reality. A swift resolution to the trade debate should tame market volatility especially with mid-term elections right around the corner.

Mid-Term Elections: Mid-term election speculation is only starting to gather steam but has yet to become an explicit market factor. Current trends suggest a 70% chance Democrats will take the House from Republicans (see chart below), but Republicans have a 60% chance to keeping the Senate. Part of the election calculus is rooted in history where first-term presidents have lost 28 House seats on average since 1900 at mid-term elections. Additionally, several House Republicans have chosen not to run for re-election in 2018 with the most prominent being Wednesday’s retirement announcement by House Speaker Paul Ryan.

bbt-perspectives-market-monthly-2018-midterms

Our focus here is to follow those trends for the potential policy shifts that could impact portfolios. For example:

  • Policy uncertainty and therefore volatility tends to peak in the months leading up to mid-term elections.
  • Under a divided government, policy shifts could result in a passive unwind of recent fiscal stimulus efforts later in 2019 resulting in economic contraction.
  • Policy priorities could pivot toward more centrist issues such as infrastructure spending and prescription drug pricing.

We will have more extended coverage of mid-term elections and its potential market impact in the months to come. Until then, the chart below is a snapshot of S&P 500 trading patterns in the last six mid-term election years, which reveals a sideways trading pattern up to election day as markets digest possible outcomes.

bbt-perspectives-market-monthly-2018-S&P-500

The Fed and Interest Rates: At Chairman Powell’s March 1st testimony before the Senate Banking Committee he hinted he “is going to be carefully considering” an increased communication frequency after FOMC meetings. This added transparency could become important to calm markets if necessary. The Fed continues to see sustainable economic growth and a pick-up in inflation to support its path to as many as three more rate hikes in 2018.

Early this year we characterized the last 10 years of economic evolution as the Three R’s. (Repair, Recovery, Reflation). We stated we are in the late cycle of recovery and that 2018 will focus on reflation as we have seen inflation slowly grind higher. Perhaps noticeably absent from our case was any mention for a fourth “R,” which would be recession. Data suggests we may have passed our peak in this economic cycle earlier this year, but there remain no signs of recession on the horizon for the next 12-18 months. We will watch this closely for signs of either improvement or deterioration in the months to come.

Two key indicators to foreshadow a recession are an inverted yield curve (short-term rates higher than long-term rates) or an employment 4X4 where unemployment less than 4% accompanied by wage growth of 4% has historic accuracy in foreshadowing recession. Neither case exists today.

Bottom Line: For now, firm inflation, sustainable economic growth, low unemployment and fiscal policy thrust should anchor the Feds path toward a 3% Fed Funds rate in 2020 absent any unknown economic or geopolitical shocks. The yield curve has flattened, but is not setting off any alarms.

U.S. Stocks: We anticipate a robust Q2 earnings season with results beginning to roll in this week. Much of the incremental earnings gains are expected to come from the recent corporate tax cuts. What is most remarkable this earnings season is the expected top-line sales revenue growth of 7-10%. This amplifies the underlying strength of the economy and healthy business conditions. For all of 2018 earnings are expected to grow by 18.5% while revenues are expected to grow 6.7%.

bbt-perspectives-market-monthly-2018-growth-projections

While this would continue the recent streak of robust earnings growth we must add a caveat. It would be a mistake to simply extrapolate earnings growth into an expectation for stock market performance. History has a mixed record of S&P 500 performance correlating with EPS performance. In the last 90 years of market history we have had 21 down years, yet in half of those instances, earnings actually grew at a double-digit pace. This is not a prediction but simply a point of awareness. We continue to think earnings growth in 2018 will exceed stock market performance, but market returns should moderate from last year’s pace.

Quarter at a Glance: Global equity markets started the year strong in January only to see returns fade due to concerns about rising rates and inflation after the Feb. 2nd employment report. Only U.S. growth stocks and emerging market stocks notched marginally positive returns for the quarter. The chart below illustrates global equity performance as of March 31, 2018.

bbt-perspectives-market-monthly-2018-equity

Equity Highlights:

  • We expect stocks to outperform bonds over the balance of the year, but it will be a bumpy ride.
  • Earnings growth is likely to surpass market performance in 2018.
  • PE valuations based on expected earnings have contracted from 18.7 in January to 16.1 today, making valuations much more attractive.
  • Robust earnings strength in Q1 should relieve some of the near-term pressure on stocks.
  • Small caps did relatively well in part due to their relative benefit from tax reform versus large caps.

International Stocks: The case for international stocks continues to be a two-part story. In the chart below we show 1-year performance for a variety of international regions to capture the role currencies play over a longer time frame. To refresh:

  • Local Returns reflect the returns on the stock markets without respect to currencies.
  • USD Returns reflect the returns a U.S. investor would have earned in the international markets, including the conversion of those regions currencies back into U.S. dollars.

In this scenario, when the dollar is weak, U.S. investors reap a windfall return like they did in 2017 when money was made in both stock markets and foreign currency translation gains.

bbt-perspectives-market-monthly-2018-equity-returns

As an example, the chart above shows that, for a U.S. investor, the 1-year return for the MSCI EAFE Index of developed international markets was 14.8%. Broken down, 5.3% was earned from the actual return of the markets and 9.5% was earned from currency return.

Bottom Line: International equities deserve a prominent place in portfolios for their return opportunities, lower relative valuations and diversification properties; however, investors should remain “currency aware.” Broadly speaking, international equity returns in the next 12 months are unlikely to have the kind of “wind-aided” returns from a weakening dollar that we saw in 2017. A stronger dollar would also benefit European equities whose earnings are 40% U.S. dollar denominated.

Bond Market Update: Bonds have served a primary role in 2018 as a risk stabilizer to equities. Sticking with high quality corporate and municipal bonds has been the best way to reduce overall investment portfolio risk but still get paid. Yield curves have flattened, but the danger of an inverted yield, which often signals recession, is not an imminent threat. The grid below reflects a flattening yield curve, which is something to monitor not fear.

Instrument Interest rate
4-11-17
Interest rate
4-11-18
1 Year Change
2 Year Treasury Note 1.27% 2.3% +1.03%
10 Year Treasury Note 2.37% 2.77% +.4%
10yr – 2yr Spread +1.1% +.4% -.7%

 

Ten-year Treasury yields have come down from 2.91% to 2.77% during this most recent bout of market volatility as investors have sought safe havens. We continue to see 3%-3.25% yields on the 10-year by year-end as the market continues to underestimate the expected impact of tax reform.

Municipal issuance remains tight as suspected with the change in tax status for pre-refunded bonds, which have historically accounted for almost a quarter of all new issuance. This strong demand with a diminished supply has been a source of stability for muni bond buyers during the recent correction.

Credit spreads (yield difference between corporate bonds and government bonds) remain controlled. We will watch to see if the combination of limited interest deductibility under the new tax bill and rising LIBOR rates impacts the financial health of higher risk borrowers. This is not an imminent risk but the peak in the credit cycle has likely passed. Stick with high quality.

Bond indices were slightly down across the board as 10-year Treasury rates climbed higher during the quarter. Only global bonds generated positive returns with all of it generated by dollar depreciation.

bbt-perspectives-market-monthly-2018-bond-returns

Final Thoughts:

  • The Fed remains on path for quarterly rate hikes in 2018.
  • Existing economic growth with an incremental fiscal impulse should nudge inflation and interest rates modestly higher.
  • Stocks should outperform bonds for the remainder for 2018 but with elevated volatility.
  • First-quarter earnings are expected to be strong supporting valuations for those meeting expectations but punishing those who don’t.
  • Price earnings valuations have contracted making valuations more tolerable.
  • As corporations go into “buyback blackout” during earnings season, diminished buyer demand could add to near term volatility.
  • Bond yields should continue to rise making 2018 a “keep your coupon” best case scenario.
  • Tariff tantrums should morph into a trade truce.
  • Geopolitical unrest remains a known unknown with Syria unrest and a potential meeting between the U.S. and North Korea.
  • Mid-term elections will shift to front burner in the next 60 days.
  • We remain in a bull market for now. Stay invested and buckled up.

April 2018

bbt-perspectives-market-monthly-april-2018-feature

“Stay in your seat come times of trouble. It’s only people who jump off the roller coaster who get hurt.”

Paul Harvey

One of the great radio broadcasters of our time, Paul Harvey always had a way with words. Markets have taken investors on a daily roller coaster ride like we’ve not seen in years, but this is typical for late-stage bull markets. The logic in Harvey’s statement above suggests investors should remain seated but buckled up for bouts of volatility. In this edition of Market Monthly we refresh our outlook for 2018 and briefly discuss the daily roller coaster of volatility. Rising interest rates, tariff tantrums and mid-term elections represent potential headwinds to the economy, but our base case assumes tax-reform aided economic growth will prevail. Our outlook remains cautiously optimistic but stops short of saying the path will be easy. As Harvey always said so eloquently: “and now…for the rest of the story.”

Volatility: What a Difference a Day Makes!

Volatility is a natural by-product in the later stages of a bull market. Clearly, a switch has been flipped from the 2017 low-volatility regime. The chart below tells a contrasting story of two markets between the low-volatility market we had in 2017 and the high-volatility experience of 2018. We asked how many days experienced a +/- 1% price change within a given trading day (intraday) since January 2017. We found:

  • Of the 251 trading days in 2017 only 12 days experienced a +/-1 % price change within the day
  • Of the 66 trading days so far in 2018, 46 days experienced a +/- 1% price change within the day

bbt-perspectives-market-monthly-2018-dow-jones

Here’s the Thing: The volatility we have seen so far in 2018 is far more normal than the extreme streak of low volatility we saw in 2017. Furthermore, 300-point swings in a Dow Jones at 24,000 is far less damaging than it was years ago with a Dow Jones at 10,000. This fits with the theme we introduced in December 2017 where we anticipated a shift from a “steep-return/flat-volatility regime to a flat- return/steep-volatility regime.” For additional commentary on market volatility refer to our recent Market Spotlight articles on our BB&T Perspectives website. Links are provided below.

Looking Past the Sell Off                                    March 26, 2018
Still a Bull Market but Volatility Persists              March 7, 2018
Rising Yields Begin to Bite                                  Feb. 5, 2018

Trade Truce?: The most likely outcome from the recent headline wars between President Trump and President Xi of China is to skip the war and go straight to a truce. Any impact from tariffs is dwarfed by the positive impact from fiscal stimulus. Yet, headline announcements of “proposed” tariffs by both the U.S. and China are having an exaggerated effect on the markets considering the small scale of their “proposed” economic impact. Consider the chart below, which contrasts the potential economic impact from tariffs with the anticipated economic impact from fiscal policy.

bbt-perspectives-market-monthly-2018-china-trade

The left side of this chart reflects the anticipated revenue impact from tariffs while the right side reflects the anticipated impact from fiscal policy. The rough math suggests the pro-growth fiscal policy ($800 billion) impact dwarfs the tariff impact ($81 billion) by a factor of roughly 10 times. This is significant, but why is the market not listening to the positive message from tax reform?

There are two primary reasons:

  1. The expected thrust of economic-activity tax reform has only just begun to make its way into real economic data but is off the headlines and investors radar.
  2. Tariff tantrums and trade wars have stolen the headlines despite their economic irrelevance. The real risk markets fear most is Chinese retaliation or a drawn out process that could deteriorate business confidence enough to delay capital investment plans and derail economic growth.

Bottom Line: Late-stage bull markets are often hypersensitive to jittery news headlines. The stock market has paused as it tries to decipher likely outcomes from trade war fears, but remember, the stock market is also the public-opinion poll of choice for this White House rather than the traditional opinion polls of past administrations. We anticipate additional market uncertainty around the disruptive dialogue between the U.S. and China, but ultimately we think trade-war fears will yield to a trade-truce reality. A swift resolution to the trade debate should tame market volatility especially with mid-term elections right around the corner.

Mid-Term Elections: Mid-term election speculation is only starting to gather steam but has yet to become an explicit market factor. Current trends suggest a 70% chance Democrats will take the House from Republicans (see chart below), but Republicans have a 60% chance to keeping the Senate. Part of the election calculus is rooted in history where first-term presidents have lost 28 House seats on average since 1900 at mid-term elections. Additionally, several House Republicans have chosen not to run for re-election in 2018 with the most prominent being Wednesday’s retirement announcement by House Speaker Paul Ryan.

bbt-perspectives-market-monthly-2018-midterms

Our focus here is to follow those trends for the potential policy shifts that could impact portfolios. For example:

  • Policy uncertainty and therefore volatility tends to peak in the months leading up to mid-term elections.
  • Under a divided government, policy shifts could result in a passive unwind of recent fiscal stimulus efforts later in 2019 resulting in economic contraction.
  • Policy priorities could pivot toward more centrist issues such as infrastructure spending and prescription drug pricing.

We will have more extended coverage of mid-term elections and its potential market impact in the months to come. Until then, the chart below is a snapshot of S&P 500 trading patterns in the last six mid-term election years, which reveals a sideways trading pattern up to election day as markets digest possible outcomes.

bbt-perspectives-market-monthly-2018-S&P-500

The Fed and Interest Rates: At Chairman Powell’s March 1st testimony before the Senate Banking Committee he hinted he “is going to be carefully considering” an increased communication frequency after FOMC meetings. This added transparency could become important to calm markets if necessary. The Fed continues to see sustainable economic growth and a pick-up in inflation to support its path to as many as three more rate hikes in 2018.

Early this year we characterized the last 10 years of economic evolution as the Three R’s. (Repair, Recovery, Reflation). We stated we are in the late cycle of recovery and that 2018 will focus on reflation as we have seen inflation slowly grind higher. Perhaps noticeably absent from our case was any mention for a fourth “R,” which would be recession. Data suggests we may have passed our peak in this economic cycle earlier this year, but there remain no signs of recession on the horizon for the next 12-18 months. We will watch this closely for signs of either improvement or deterioration in the months to come.

Two key indicators to foreshadow a recession are an inverted yield curve (short-term rates higher than long-term rates) or an employment 4X4 where unemployment less than 4% accompanied by wage growth of 4% has historic accuracy in foreshadowing recession. Neither case exists today.

Bottom Line: For now, firm inflation, sustainable economic growth, low unemployment and fiscal policy thrust should anchor the Feds path toward a 3% Fed Funds rate in 2020 absent any unknown economic or geopolitical shocks. The yield curve has flattened, but is not setting off any alarms.

U.S. Stocks: We anticipate a robust Q2 earnings season with results beginning to roll in this week. Much of the incremental earnings gains are expected to come from the recent corporate tax cuts. What is most remarkable this earnings season is the expected top-line sales revenue growth of 7-10%. This amplifies the underlying strength of the economy and healthy business conditions. For all of 2018 earnings are expected to grow by 18.5% while revenues are expected to grow 6.7%.

bbt-perspectives-market-monthly-2018-growth-projections

While this would continue the recent streak of robust earnings growth we must add a caveat. It would be a mistake to simply extrapolate earnings growth into an expectation for stock market performance. History has a mixed record of S&P 500 performance correlating with EPS performance. In the last 90 years of market history we have had 21 down years, yet in half of those instances, earnings actually grew at a double-digit pace. This is not a prediction but simply a point of awareness. We continue to think earnings growth in 2018 will exceed stock market performance, but market returns should moderate from last year’s pace.

Quarter at a Glance: Global equity markets started the year strong in January only to see returns fade due to concerns about rising rates and inflation after the Feb. 2nd employment report. Only U.S. growth stocks and emerging market stocks notched marginally positive returns for the quarter. The chart below illustrates global equity performance as of March 31, 2018.

bbt-perspectives-market-monthly-2018-equity

Equity Highlights:

  • We expect stocks to outperform bonds over the balance of the year, but it will be a bumpy ride.
  • Earnings growth is likely to surpass market performance in 2018.
  • PE valuations based on expected earnings have contracted from 18.7 in January to 16.1 today, making valuations much more attractive.
  • Robust earnings strength in Q1 should relieve some of the near-term pressure on stocks.
  • Small caps did relatively well in part due to their relative benefit from tax reform versus large caps.

International Stocks: The case for international stocks continues to be a two-part story. In the chart below we show 1-year performance for a variety of international regions to capture the role currencies play over a longer time frame. To refresh:

  • Local Returns reflect the returns on the stock markets without respect to currencies.
  • USD Returns reflect the returns a U.S. investor would have earned in the international markets, including the conversion of those regions currencies back into U.S. dollars.

In this scenario, when the dollar is weak, U.S. investors reap a windfall return like they did in 2017 when money was made in both stock markets and foreign currency translation gains.

bbt-perspectives-market-monthly-2018-equity-returns

As an example, the chart above shows that, for a U.S. investor, the 1-year return for the MSCI EAFE Index of developed international markets was 14.8%. Broken down, 5.3% was earned from the actual return of the markets and 9.5% was earned from currency return.

Bottom Line: International equities deserve a prominent place in portfolios for their return opportunities, lower relative valuations and diversification properties; however, investors should remain “currency aware.” Broadly speaking, international equity returns in the next 12 months are unlikely to have the kind of “wind-aided” returns from a weakening dollar that we saw in 2017. A stronger dollar would also benefit European equities whose earnings are 40% U.S. dollar denominated.

Bond Market Update: Bonds have served a primary role in 2018 as a risk stabilizer to equities. Sticking with high quality corporate and municipal bonds has been the best way to reduce overall investment portfolio risk but still get paid. Yield curves have flattened, but the danger of an inverted yield, which often signals recession, is not an imminent threat. The grid below reflects a flattening yield curve, which is something to monitor not fear.

Instrument Interest rate
4-11-17
Interest rate
4-11-18
1 Year Change
2 Year Treasury Note 1.27% 2.3% +1.03%
10 Year Treasury Note 2.37% 2.77% +.4%
10yr – 2yr Spread +1.1% +.4% -.7%

 

Ten-year Treasury yields have come down from 2.91% to 2.77% during this most recent bout of market volatility as investors have sought safe havens. We continue to see 3%-3.25% yields on the 10-year by year-end as the market continues to underestimate the expected impact of tax reform.

Municipal issuance remains tight as suspected with the change in tax status for pre-refunded bonds, which have historically accounted for almost a quarter of all new issuance. This strong demand with a diminished supply has been a source of stability for muni bond buyers during the recent correction.

Credit spreads (yield difference between corporate bonds and government bonds) remain controlled. We will watch to see if the combination of limited interest deductibility under the new tax bill and rising LIBOR rates impacts the financial health of higher risk borrowers. This is not an imminent risk but the peak in the credit cycle has likely passed. Stick with high quality.

Bond indices were slightly down across the board as 10-year Treasury rates climbed higher during the quarter. Only global bonds generated positive returns with all of it generated by dollar depreciation.

bbt-perspectives-market-monthly-2018-bond-returns

Final Thoughts:

 

  • The Fed remains on path for quarterly rate hikes in 2018.
  • Existing economic growth with an incremental fiscal impulse should nudge inflation and interest rates modestly higher.
  • Stocks should outperform bonds for the remainder for 2018 but with elevated volatility.
  • First-quarter earnings are expected to be strong supporting valuations for those meeting expectations but punishing those who don’t.
  • Price earnings valuations have contracted making valuations more tolerable.
  • As corporations go into “buyback blackout” during earnings season, diminished buyer demand could add to near term volatility.
  • Bond yields should continue to rise making 2018 a “keep your coupon” best case scenario.
  • Tariff tantrums should morph into a trade truce.
  • Geopolitical unrest remains a known unknown with Syria unrest and a potential meeting between the U.S. and North Korea.
  • Mid-term elections will shift to front burner in the next 60 days.
  • We remain in a bull market for now. Stay invested and buckled up.

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.