Cooler Heads Will Prevail
Investors were buffeted last week by market-roiling news from several directions, and many of them headed for the exits. They shouldn’t have. Yes, the S&P 500 dropped nearly six percent, mostly on Thursday and Friday, and, yes, the week’s close marked a 12% decline from peak to trough thus far this year. These corrections are more common than most people realize, and a closer look at the news behind last week’s news reveals that investors can avoid the worst pitfalls and position themselves to benefit from earnings-driven stock appreciation.
Let’s step back to gain a bit of perspective before we tackle the news. Over the last 40 or so years, the S&P 500 has experienced peak-to-trough declines exceeding 10% in more years than not. Surprisingly, perhaps, in more than half of those years with such large peak-to-trough declines, the S&P 500 finished the year in positive territory. And even when the market did end up down for the year, the following year saw double digit returns in almost every case. So the messages here are: first, markets are volatile, and, second, the market usually moves higher. And the reasons for the persistent (if not entirely consistent) increase in stock prices tells us how we should be parsing the news.
A company’s stock rises when the company is expected to produce more stuff and make more profits, both in the near term and far into the future. What happened last week to alter those expectations? Facebook troubles, anticipation of widespread tariffs, concerns over global instability, and fears of higher interest rates.
Facebook news kicked off the week, and, as our CIO Chuck Lieberman noted in Barron’s over the weekend, the company has a fundamental conflict in its business model and investors now know this. Facebook may be able to resolve this conflict and continue to earn advertising revenues from its user base, but the coming adjustments may very well constrain profit growth. Its value dropped sharply, as it should have.
Tariffs, as I’ve written previously, are usually a bad idea since they increase the cost of inputs for U.S. firms and increase the cost of groceries and other consumer products for households. This dispute with China, though, is a bit different. And not because of the trade deficit (see my example concerning you and your favorite grocery store in a previous commentary). The Trump administration is trying to address a long-standing practice by the Chinese government whereby it has been, in effect, charging foreign firms to gain access to its vast and growing consumer base. As China’s economy developed over the past few decades, the buying power of its consumers expanded and firms around the world wanted in. Because it can control its borders, China’s government has the power to put up a toll, in a manner of speaking, and extract some of the profits that foreign firms would get by selling to this newly flush group of households. Foreign firms still come out ahead by selling in China, but this government policy leaves China with a bigger share of the global pie than it would get under purely competitive markets. It looks like the U.S. government has decided our firms should no longer be paying the toll.
The tariffs likely to be proposed by the administration would be purely punitive, as opposed to tariffs designed to offset some unfair subsidy or otherwise level the playing field in a particular industry. This $60 billion in tariffs is meant to counter the toll China is in effect charging U.S. firms. China’s “toll” comes in the form of demands for technological knowledge – U.S. firms’ intellectual property (IP). China has insisted in many cases that a firm wishing to do business in China must partner with a Chinese firm and form a joint venture. Intel has done this as has General Motors. China has had its chance to develop economically, and its practice of extracting IP from the rest of the world needs to stop. Whether this tariff package can do the job is yet to be seen. China is readying retaliatory tariffs and that further worries investors. But tariffs are focused—they affect some companies and not others, and so investors can alter portfolios to reduce adverse impacts. If this turns into a full-blown trade war, affecting many more industries and severely raising producer and consumer prices, aggregate economic activity may be slowed, however, and that could then affect the market as a whole. For now, though, we’re likely to see a more limited engagement since China has far more to lose as it strives to support its economic growth by pushing its products more broadly into international markets. We are starting to see further evidence of that this morning as news points to backroom negotiations between U.S. and China trade representatives, reportedly making progress towards an alternative solution to reduce the barriers U.S. firms face in gaining access to China’s consumers.
The final news items impacting markets last week emanated from domestic developments – the Fed meeting, new faces at the White House, and the budget deal. That interest rates will continue to rise is no surprise, but investors are now realizing that the forces moving them higher are likely to accelerate—both from ongoing economic expansion (and rising wages and inflation) and from a growing federal deficit. The replacement of H.R. McMaster by John Bolton introduces a more hawkish tone to foreign policy. The ramifications of the latter for stocks remain unclear, but investors appear to be acknowledging the likelihood of greater global political uncertainty. We have already taken steps to be positioned for both of these scenarios.
Market volatility, after a couple years of relative calm, looks like it’s here to stay for a while, but history tells us to expect sell offs such as the one we saw last week. The corporate tax cut, an expansionary global economy, and rising consumer spending all point to strong earnings growth, at least for this year and next, and that supports continued increases in stock prices.
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