Published on Jul. 19, 2018
Second Quarter 2018 Equity Commentary
Stocks advanced during the second quarter, with the S&P 500 gaining 3.4%. In our view, this was mainly due to a healthy domestic economy and strong corporate profits, which offset rising concerns over international trade. However, markets may see a pickup in volatility until trade disputes are resolved and uncertainties abated. Therefore, our near-term view is more guarded, but we remain hopeful that trade wars can be averted and maintain our constructive longer-term outlook.
Trade issues have dominated financial headlines in recent months as the US has enacted fresh tariffs on many key global economies, most of which have responded in kind. Fortunately, the tariffs implemented thus far have been relatively minor and in our view are not likely to cause significant economic damage. However, President Trump has threatened additional tariffs on up to $400 billion of Chinese imported goods, but many economists believe this threat is not credible given the collateral damage it could do to US companies that manufacture goods in China. While we agree with this assessment, we think that investors should still consider the possibility that additional layers of tariffs may be implemented. How many and to what extent are key unknowns that will likely play a large role in determining the market’s performance in the months to come.
Certain companies are already seeing an impact from newly enacted tariffs. Harley Davidson announced plans to move some of its manufacturing outside of the US in order to avoid European tariffs on US based exports. In the interim, the company will face higher supply-chain costs but at this point it has been an outlier as few other companies have noted these types of headwinds. We would however expect markets to react negatively should more companies come out with tariff-induced profit warnings.
The tailwinds of growth in the US economy have not been broad-based and instead have concentrated in growth and small capitalization stocks, which may be more immune to the market risks that have captured investors’ attention. Our inclination is that smaller companies may continue their outperformance, particularly if trade concerns persist, and could act as a natural hedge and outperform should the broader market decline because of investor fears about trade conflict or slowing growth outside the US.
We currently hold a nuanced view on the market. Our foundational outlook continues to be that cooler heads will prevail and that the bulk of the tariffs that have been threatened will not be implemented. We expect that investor attention will ultimately shift back to economic fundamentals which have been strong in the US, enabling stocks to move higher over the medium- to longer-term. Consumer confidence, while off of its highs, remains at healthy levels, and surveys of the manufacturing and service sectors have strengthened. Many economists are projecting GDP growth of over 4% for the second quarter, which would be quite impressive in our view. Meanwhile, corporate earnings have been robust and we expect this trend will continue during the upcoming second quarter earnings season.
For the near-term, we are more cautious. It is possible that trade issues will persist and we believe that the associated uncertainty has been weighing on capital markets. While domestic stocks are up on a year-to-date basis, we think that the gains have been quite modest given the stellar pace of corporate profit growth. Moreover, the yield curve has continued to flatten with the spread between the 2-year and 10-year Treasury yields now hovering near a decade low. In our view, absent trade related uncertainties, stock markets would be trading higher and the yield curve would likely be steeper.
Trade uncertainties could also exacerbate certain geopolitical risks. South Korea has intimated that if the Trump administration were to apply tariffs on automotive imports, it would step back from its role in the US-North Korea denuclearization talks. While capital markets were not impacted earlier in the year when the relationship between President Trump and Kim Jong-un was openly hostile, they could still be at risk if the situation were to deteriorate. With trade tensions potentially impacting geopolitics during a period in which nationalism has been on the rise globally, we think that the near-term risks for multinational corporations are elevated. As such, we remain optimistic that these tensions will ultimately cool but as always, we are prepared to take further risk management actions should conditions change.