“Trade wars are good. And easy to win!”
President Trump
It is not just your imagination. Market volatility returned with a vengeance in early February. While 2017 was very orderly if not even a tad boring, the first quarter of 2018 witnessed some of the craziest gyrations in recent years. During the month of February, the Canadian stock market had 3 trading days in which the losses were greater than 1.50%! This compares to last year when our market had only 2 trading days during the entire year in which losses were greater than 1.50%!
Enthusiasm over the Trump tax cuts that passed into law just before Christmas carried over into January with broad markets peaking around January 26th. Then all it took to sour the market’s mood was a spike in interest rates that came about when some stronger wage inflation showed up in an economic report. Rising interest rates are not unexpected at this point in the economic cycle but the rapidity of the increase put markets on edge very quickly. This development was quickly followed up by trade war fears when President Trump and China traded punches by proposing import tariffs back and forth. Suddenly, protectionism fears that had been simmering since the US presidential election campaign became a reality. Increases in trade tariffs not only slow global trade but they have the potential to increase the price of goods moving around the world and therefore could prove inflationary in nature.
Markets had to digest fears of increased government regulations in the technology sector after Facebook announced a massive data breach that was more complex than initially disclosed. Suddenly, all markets were on their back foot with bonds selling off due to spiking inflation concerns and stocks selling off for the same reason as well as an imminent trade war and technology distrust. Closer to home, our energy names continued lower on our pipeline “wars” with a civil war threatening to break out between British Columbia and Alberta! And our bank stocks gave up ground on the perennial fears of a housing bubble! Not many sectors and no asset classes to hide out in during the first quarter.
It took most global indices just a couple of weeks during the waning days of January and early February to confirm official market correction territory by dropping just over 10% from their respective highs. As the old market expression goes, “markets take the stairs up and the elevators down”! Sadly, the Canadian market had one of the worst showings in major global markets (yet again) by posting a loss of 4.5% in the first quarter.
That said, the quarter ended with promise as the market lows from early February were successfully retested at the end of March. Markets often like to revisit their lows to confirm support and this happened in an almost textbook fashion. Markets probed the prior lower levels over several days and for the most part respected those levels which also coincided with 200 day moving averages. This is important because these levels are widely followed by technical analysts and holding these levels was a big “win” for markets.
While it would be nice to make significant portfolio changes through correction by trimming positions before the drop and adding them back at lower prices, most appreciate that this is harder to do than it sounds without the benefit of a crystal ball. Sometimes just having the conviction to “ride it out” is the right approach. Market timing is never easy, even when you are fairly convinced that the fundamentals will carry the day.
Regarding fundamentals, earnings growth in the S&P500 is expected to be close to 20% this first quarter compared to last year at this time. Much of this is from the corporate tax cuts but it still results in higher earnings left in corporate bank accounts. And as discussed in my last letter, companies are in the process of repatriating huge cash balances from overseas so this quarterly earnings reports should highlight some initial thoughts on what companies plan to do with these extra balances. Stock buybacks and dividend increases should be very supportive for markets through the balance of this year.
On the negative side of the ledger, markets are going to have to contend with higher interest rates although I don’t think it will be that disruptive to stock valuations. While the days of plentiful liquidity are likely in the past for this cycle, signs of credit distress are still not present which is positive. Also in the negative column is the upcoming US mid-term elections this fall with the Democrats building momentum. Should the Republican White House lose its majority in either the House or the Senate (or both!), implementing policy will be harder. And of course there is still the Mueller investigation into the whole Trump and Russia collusion (“fake news”) and this certainly has the potential to put markets on edge very quickly depending on what that investigation reveals.
I still think this will be a reasonably rewarding year for portfolios but it will be much harder than the last 2 years. I don’t see a US recession on the horizon over the next year and until we see one, we have to give stocks the benefit of the doubt. And after a healthy correction in the first quarter (especially in those very crowded sectors that I highlighted in my New Year’s letter), I think things will settle down a bit and we can make up some lost ground during the balance of the year.