Stocks were unable to sustain the strong gains achieved during the start of the year, with the S&P closing out the first quarter with a 1.2% decline. While strong corporate earnings buoyed investor spirits, they were not enough to offset concerns regarding potential trade frictions and weakness in technology stocks. Recent volatility notwithstanding, we maintain our constructive view on the market and continue to believe that a healthy economy and robust corporate sector should bode well for stocks moving forward.
Concerns about potential trade wars have been a key focus for investors since President Trump announced his intention to implement tariffs on steel and aluminum imports. While markets initially reacted negatively to Trump’s announcement, investors were assuaged in the ensuing days as it became clear that many international economies would be exempted from these tariffs. However, Trump recently detailed plans to levy tariffs on certain imported goods from China, prompting fears of a trade war between the world’s two largest economies and putting capital markets on edge.
While we agree that a trade war with China would likely disrupt economic activity and result in lower stock prices, we believe that the most likely outcome of this friction is a successful negotiation between the US, China, and other trading partners to address current imbalances. In our estimation, both sides realize that there are no benefits to be had from a trade war, and we therefore view the proposals at this time to be mostly posturing and starting points for negotiation. While the prospect of a trade war with China remains a key potential risk factor, we are cautiously optimistic that it can be avoided.
A separate but related issue pertaining to economic relations with China is the transfer of intellectual property (“IP”). We believe that for some time now, many US corporations have been forced to effectively give away their IP in order to gain access to Chinese markets. In our view, these companies stand to benefit in the long run should the current trade negotiations result in these companies having the ability to start monetizing their intellectual property.
Another headwind facing investors in recent weeks has been weakness in the technology sector. Social media has been particularly vulnerable following recent allegations that political data firm Cambridge Analytica improperly obtained data on millions of Facebook users in an effort to build voter profiles. This has led to calls for greater restrictions and regulations on social media companies, which in turn has investors concerned about the potential impact on future earnings power.
Indeed, damning headlines and the potential for more stringent regulations may negatively impact certain technology companies. However, we also view these companies as having dominant positions in online advertising which at this stage, we believe are unlikely to be materially impacted by regulation. Therefore, while these events have dampened sentiment on the technology sector, we believe that the secular trends that are driving the fortunes of our portfolio remain intact.
Turning to the economy, we remain encouraged by the preponderance of the recent data points. On the consumer front, the University of Michigan’s sentiment index for March reached its best level since 2004, and real consumer spending remains near all-time highs. The ISM’s widely followed survey of the manufacturing space remains near the 14-year best (60.8%) achieved in February. Moreover, during March, the IHS Markit manufacturing PMI accelerated at its fastest pace in 3 years. In our view, these data points provide strong evidence that our economy remains stronger than it has been in quite some time, and we believe that the broadly favorable impact of the Tax Cuts and Jobs Act is still largely ahead of us.
We continue to view stocks constructively, due in large part to the strength in corporate profits. Many analysts are calling for 17% growth in aggregate S&P 500 EPS for the first quarter, and estimates for the full year have increased by a healthy 7% (to $157.77 from $147.24) since the beginning of January. This upward revision in full year estimates is the largest seen during the first quarter of any year since FactSet began tracking the data in 1996. Moreover, the combination of higher profit estimates and lower stock prices has taken the market’s forward P/E ratio (based on 2019 estimates) down to just over 15x as of this writing, a reasonable level very much in line with historical averages.
In our view, key risks to the market include the potential for escalating trade-related tensions, particularly with China. While we are optimistic that cooler heads will prevail, we acknowledge that the potential for a disruptive trade war is higher today than it has been in recent memory. We also continue to keep a close watch on inflation. Investors were rattled earlier in the year when the initial release of the January jobs report showed wages were running ahead of expectations, igniting fears that higher inflation would force the Fed to accelerate their interest rate hikes. These fears have calmed of late though, as both the January and February PCE (personal consumption expenditures) price indices came in below the Fed’s 2% target, and wage growth has moderated from January’s peak of 2.8%. We will continue to monitor these and other market risk factors, and stand ready to shift to a more defensive posture should we deem it prudent to do so.
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