On the Horizon: 8 Focus Areas | Third Quarter 2018
In a nutshell: U.S. politics and the actions of the current administration remain a focus of the investing community. While trade relations have progressed on several fronts, it has not improved with respect to China, the world’s second largest economy. Midterm elections also loom and are likely to give investors pause. Outside of the geopolitical realm, however, there is plenty to keep the attention of investors. The actions of the Federal Reserve will be even more closely scrutinized as they approach a point where their actions create more debate and the yield curve flattens.
For insights on each of these 8 focus areas, read below.
While unanticipated events always occur, there are typically some themes, data points and anticipated events that can be reasonably expected to impact markets; it is those that we address below. In our comments, we also attempt to gauge what the market may be anticipating, given that markets typically place their bets ahead of actual announcements or resolutions based on what it believes the likely outcome is. Therefore, market reaction is often more a result of how different the result was from the prediction.
- US and China Trade Relations. While the Trump administration has taken issue with and action against many of our global trade partners over the course of the last two years, the relationship with China gives investors the most angst. This is certainly understandable given that the U.S. and China are the two largest economies in the world. Relations with a number of our trade partners have begun to take a more positive turn but the relationship with China has unfortunately deteriorated. As recently as mid-September further tariffs were announced by both sides in what increasingly looks like a high stakes game of chicken. On a more positive note for investors, markets do appear to have discounted some of the impact as the most recent announcements were viewed by some as smaller than feared and markets traded up the day after the announcements. Given the scope and scale of a true U.S./China trade war, this remains the biggest risk to markets and is impossible to “handicap”.
- Midterm Elections. We cited this event for its market-moving ability last quarter, but it was much further down the list due to elections being several months out at the time. November 6th is fast approaching and the media and market will be increasingly focused on the races that could swing the balance of power in Washington. Market nervousness is always a bit elevated around elections and this cycle promises to have more than its fair share of drama and mudslinging. If nothing else, the lead-up to the elections increases the rhetoric and reduces the focus on more important issues.
- The Fed and Inflation. As the Fed continues on its path to “normalizing” rates the concern over the level of rates and inflation are likely to come into greater focus and lead to more anxiety among investors. The current federal funds rate is still relatively low, but each rate hike (most recent in September) brings us closer to what the market would consider the equilibrium rate (i.e. the federal funds rate that neither stimulates nor restrains economic growth). Nobody knows exactly what that rate is or should be, but with each hike comes more discussion about the Fed “overshooting” (raising rates too high). With inflation ticking higher and labor markets increasingly tighter, the discussion may even turn to whether they are raising rates fast enough. A faster pace of hikes or an adjustment higher in the equilibrium rate would likely be negatively received by the market. The initial cycle of Fed rate hikes met with little resistance, but with each successive hike the debate about what the right course of action is will only grow.
- The Return of BREXIT Fears. We are more than two years removed from the June 2016 Brexit referendum that sent a temporary shock through markets. After the initial selloff and shock, Brexit concerns have generally been viewed as something to worry about in the future. Well, the future is almost here. While the formal Brexit or U.K. exit date is not until March 2019, there will be several key events during the 4th quarter that will shape the actual terms of the U.K.’s exit from the European Union. Fortunately, Brexit likely doesn’t pose a large systematic risk to global markets, as the most damaging effects would be confined to the U.K. itself.
- Roll Forward of Estimates into 2019. Every year during the 4th quarter, Wall Street starts to turn its attention to the upcoming calendar year and rolls forward its estimates for economic and earnings growth. These outlooks are typically fairly optimistic and while we’d expect to see optimism again, there are a few more headwinds leading into 2019. Wall Street closely watches year-over-year comparisons (revenue, earnings, etc.) and with 2018 earnings growth being exceptionally strong in the U.S., it simply sets a very high bar. The tax reforms passed in late 2017 were the driver of a significant portion of this growth, but there are elements of the growth that were one-time in nature or even borrowed from forward growth. As an example, lower corporate tax rates in 2018 provided a sizeable boost to companies’ bottom lines that will not be repeated. Companies will still benefit from the lower tax rate going forward, but it won’t result in an increase in earnings by itself (like it did in 2018).
- Emerging Markets Contagion or Isolated Issues? After strong returns in 2017, emerging markets have retraced some of those gains during 2018. Country-specific issues in Argentina, Brazil and Turkey have resulted in investors trying to anticipate what countries may experience issues next. The issues in each of those three countries appear to be country-specific and relatively contained. Nevertheless, it has resulted in a broader selloff in emerging market currencies and assets. This may be somewhat par for the course with emerging market countries (and often why they are considered emerging in the first place!), but it can and has at times caused weakness in broader markets. While we believe emerging market valuations already discount much of the concern, it bears watching given the knock-on effects further weakness could have.
- The Yield Curve. The shape of the yield curve is a closely watched market dynamic due to its historical ability to signal future economic recessions. Typically, the longer the time until maturity for a bond the greater the yield. This creates a yield curve that is normally upward sloping as shown in the accompanying graph. That upward curve, however, has at times “inverted” or switched to being downward sloping. The yield curve is currently still upward sloping, but with each Fed rate hike the curve has “flattened” and moved closer to “inversion”. There is certainly no guarantee that an inversion will occur or that it signals an imminent recession, but with market signals of this nature, it can also become a self-fulfilling prophecy if believed broadly enough by investors.
- Russia Investigation. The Mueller investigation continues and occasionally produces worrisome headlines for investors. It’s unclear exactly where the investigation is headed or when it will conclude, but it has the potential to meaningfully disrupt markets. Whether that potential is ever realized is anyone’s guess. Investors have also become somewhat conditioned to the headlines and Twitter battles, so until there is an official conclusion or a true bombshell revelation, market impact is likely limited. It is clearly a market-moving event, but with no certainty of direction. An exoneration of the administration clears the air and removes the overhang. Anything less is likely to involve a long, drawn-out process creating additional uncertainty that markets dislike.
If it feels like the above list is full of more potential negatives than positives, that is likely an outgrowth of 1) the lengthy bull market we’ve enjoyed and 2) a focus on geopolitical risks which tend to have an overly pessimistic tone. Fears of low probability events that might come to pass, however, should not act as a deterrent to long term-investors, including SHWM. Geopolitical risks will always exist and are typically less impactful than investors fear. Comparatively speaking we have experienced relative peace and strong economic growth across the globe and have much to be thankful for and excited about. To learn more about our 8 focus areas contact Brad Swinsburg 404-874-6244.
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Unless stated otherwise, any estimates or projections (including performance and risk) given in this presentation are intended to be forward-looking statements. Such estimates are subject to actual known and unknown risks, uncertainties, and other factors that could cause actual results to differ materially from those projected. The securities described within this presentation do not represent all of the securities purchased, sold or recommended for client accounts. The reader should not assume that an investment in such securities was or will be profitable. Past performance does not indicate future results.