Trade war, policy shifts weigh on US stocks
US stocks could be taking a year off as the economic cycle matures, before taking the next step, amid concerns over growth, agreements and policy, writes Charles Schwab's Jeffrey Kleintop.
Stocks seem to be taking a gap year. While 2017’s big effort generated a 22 per cent gain, stocks, both locally and globally, have moved little from where they started in 2018, as measured by the MSCI World Index. Are stocks taking a year off as the economic cycle matures before taking the next step? The causes of this gap year include concerns over growth, agreements, and policy.
Growth is on the slide
Global growth momentum may have peaked in January. The widely watched global composite Purchasing Managers Index (PMI) of business activity has been sliding since January. Economic growth measured by GDP slowed during the first quarter in many countries. And, crucially for investors, analysts’ earnings per share estimates for the next 12 months flattened out after the sharp rise in January as US corporate tax cuts were enacted, as you can see in the chart below.
Earnings growth has moderated
Source: Charles Schwab, Factset data as of 5/24/2018.
Changes to trade agreements weigh on equities
Trade agreements have been a major topic in global media this year as demonstrated with a leap in the use of the phrase “trade war” in news articles, as you can see in the chart below. Concerns over material changes to trade agreements, or abandoning them in favour of new tariffs, is likely to have contributed to the pause in stocks this year. Although this year’s trade disagreements have fallen well short of a trade war, with more than half of the sales of global companies in the MSCI World Index tied to international trade even a small risk of an actual trade war must be monitored.
“Trade war” became a hot topic this year
Source: Charles Schwab, Bloomberg data as of 5/24/2018.
End to policy stimulus curbs momentum
Stocks may have also paused in response to the ending of US monetary policy stimulus. While the Federal Reserve has been tightening for some time, only this year has the policy rate moved above inflation, ending monetary policy stimulus and turning the focus to tightening as the real fed funds rate crosses zero. This can be seen in the chart below of the real federal funds rate, which is the federal funds rate less the pace of inflation tracked by the Fed’s favourite measure, the core personal consumption expenditures (PCE) deflator. Currently the pace of core PCE is 1.88 per cent. In June, we saw the Fed raise the fed funds rate to 2 per cent.
Fed finally ends monetary stimulus, ECB may follow
Source: Charles Schwab, Bloomberg data as of 5/24/2018.
In Europe, we anticipate that QE will end in the second half of 2018. The European Central Bank (ECB) may continue to follow the path of the Fed on real policy rates (with the typical lag of about 275 days seen over the past 10 years), as you can see in the chart above.
Premature end to the gap year
Will all of 2018 end up as a gap year or will stocks resume their progress? We believe the “gap” may be narrower than a whole year. Here’s why:
• Global growth measured by GDP is expected to reaccelerate in the second quarter for many major countries by the consensus of economists tracked by Bloomberg, as you can see in the chart below. This may help to sustain the rise in earnings per share for global companies.
GDP is expected to rebound in the second quarter for major countries
*Bloomberg-tracked economist consensus forecast
Source: Charles Schwab, Bloomberg data as of 5/18/2018.
•The risk to trade agreements is balanced by the reality that world trade growth has sustained the fastest pace in years, as you can see in the chart below.
World trade volume growth has sustained a rapid pace in 2018
Source: Charles Schwab, Bloomberg data as of 5/24/2018.
• Monetary policy is beginning to tighten in the US, but fiscal policy stimulus (tax cuts) is helping offset the economic impact. More broadly, global financial conditions remain favourable to growth, as you can see in the chart below.
Financial conditions remain favourable to growth
Other concerns have emerged to keep stock markets volatile such as Italy’s many attempts to form government, an issue which took three months of negotiations to resolve. But if the major concerns that caused this gap continue to fade as they have since this year’s low in March, stocks may not end up taking a year off from gains after all.
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Jeffrey Kleintop is senior vice president and chief global investment strategist with Charles Schwab.
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