Q4 and Beyond: Putting Market Uncertainties in their Place

Oct 15, 2018

More than a few market riddles face investors in the fourth quarter, the biggest of which may be identifying where we are in this cycle. Somewhat unbelievably, September 15 marked a full 10 years since Lehman Brothers collapsed and the beginnings of the extraordinary era of central bank-fueled easy money. So now it’s reasonable to ask— what’s normal as the Federal Reserve (Fed) raises rates and brings that era to an end?

Time will answer that question. For now, we know that “new normals” continue to evolve, sometimes at odds with their market counterparts. That makes it tough to put all the pieces of the puzzle together, so here we focus on some of the more sizable corner pieces that shape today’s investment landscape: policy, China, and disruption.

Geopolitics, Fed policy could determine bull run’s fate

Whether one of the longest running U.S. equity bull market in history is on its last legs or still mid-cycle is up for debate. Wherever it is, geopolitics, especially with the approaching midterm elections, and the Fed will likely have a say.

Should the Republicans fend off the Democrats in the House, investors can expect the administration to continue to curate this new era of U.S. protectionism, which has contributed to polarization across global markets. In short, the U.S. is up in 2018 and the rest of the world is down, retreating from its 2017 surge amid dollar strengthening.

Something to watch is that business done abroad represents more than 40% of sales for constituents of the S&P 500 Index®.1 If geopolitical events tamp down the global economy, there is a risk that the current positive cycle in the U.S. economy ends earlier than expected.

As for the Fed, the U.S. yield curve has been flattening, with the spread between the 10-year and 2-year Treasury yield ending Q3 just 24 basis points (bps) from inversion yet they recently pulled back from the inversion edge. While this could suggest a Fed policy misstep and/or a meaningful macro slowdown is possible for 2019 or 2020. Again, this is new territory, but history says curve inversion preceded the past seven recessions by 4-5 quarters. But another thought is that the tightening yield spread could reflect the U.S. being viewed as one of the few “safe havens”. For example, any concerns about the euro will likely drive flows into the USD and put downward pressure on long-term Treasury yields.

U.S. banks may give the good word about a forthcoming recession, as they have risen in lock-step with U.S. interest rates. When rates rise and bank stocks fall, that will likely signal that monetary policy is set to put downward pressure on GDP and EPS (earnings per share) estimates.2

For the record, the Fed seems to say “this time is different” and that a flat or inverted curve won’t derail its hiking strategy, which includes plans for three more in 2019. However, an increasingly hawkish Fed appears to be a likely catalyst for fresh losses across markets.

China remains a long-term secular story, tariffs or no tariffs

Initially the trade spat seemed more about politics than economics. But it may have evolved into something more economically meaty with another $200 billion of Chinese imports targeted for tariffs. Tariffs will hit global supply chains, and could derail global growth prospects. They will also hit earnings, and possibly affect the tones of company conference calls.

Signs of a slowdown in China materialized in recent months too, perhaps giving investors another reason to question exposure. But the Organization for Economic Co-operation and Development’s (OECD) leading indicators suggest China is poised to accelerate; right now, that’s an anomaly compared to much of the world.3

Several structural positives continue to support China’s investment case as well. For one, its economy is much less export-dependent than in the past, meaning tariffs have a limited effect. Case in point: $50 billion worth of goods affect only 2% of all Chinese exports. Now, another $200 billion would bring that number to 10%—more significant at just over half of last year’s China’s exports to the U.S., but not a death spiral.4

Headlines don’t necessarily tell the whole story about tariffs either. The under-the-radar Miscellaneous Tariff Bill of 20185 signed into law actually slices tariffs on nearly 1,700 products that the U.S. imports via exemptions through 2020, possibly including more than 1,000 products from China targeted for tariffs.6

In addition, Beijing appears more open to establishing relationships abroad. U.S. protectionism magnifies China’s newfound interest in establishing trade ties and development initiatives elsewhere.

Chinese domestic consumption is rising as well, with technology helping consumers access entertainment, education, healthcare, and travel services. In the first half, consumption accounted for 78.5% of GDP growth, versus just 45.2% the same period in 2013.4

And not to be overlooked is that China’s monetary policy seems increasingly prescient. The central bank has accelerated its easing; among other tactics, it lowered reserve-requirement ratios to increase commercial bank lending and support economic growth.

Disruption themes to persist

A favorite pastime for investors since the financial crisis involves seeking technology-driven disruption. If easy central bank money provided fuel for the bull run, technology revved up the octane. Today, technology allows new players to encroach on traditional stalwarts at faster rates, forcing reinvention and innovation across sectors, not to mention new considerations when measuring economic performance.

The result has been better productivity and changing consumer habits. The everyday effect of this evolution is not a far-off concern. It’s here, with artificial intelligence, big data, and robots becoming increasingly smarter and more ubiquitous. For example, industrial robots could total more than 3 million by 2020, double the number in 2014.7 And that affects people. Currently in the U.S., manufacturing jobs total roughly 13 million, 4 million less than in 2000.8

Also, technology-driven services disruption is well under way. Consumers and the close relationship many have with their devices is evidence. In 2017, connected devices, including computers, smartphones, and tablets, totaled 27 billion. In 2030, estimates put that number at a robust 125 billion.9

Consumers are predicted to access myriad services via those devices for longer too. People aged 65 and over are expected to number 2.1 billion by 2050, up from 600 million today. The economics of that bear watching, given the upward pressure the aged will put on savings.2

Our final thoughts for the near future

There’s polarization across, and within, global markets. Protectionism has the U.S. up and the rest of the world down. The U.S. equity bull market continues to run even as the Fed restocks its toolkit and with the yield curve not that far from typically recession-predictive inversion. Then again, the extraordinarily low interest rates of the last decade isn’t typical either. And the U.S. and China continue to spar on trade, the tenor of which could be affected by the November elections in the U.S, as well as China’s compelling macro trends.

It’s difficult to keep track of how all the pieces fit. But one thing investors can count on is technology-driven disruption. It is an established new normal that affects how people, markets, and economies behave. As for us, we’ll continue to look for those sector disruptors in Q4 and beyond.

Category: Commentary

Topics: Macroeconomic

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