by Liz Ann Sonders, Brad Sorensen, Jeffrey Kleintop, Charles Schwab and Company
Key Points
- Market action has been short-term focused, leading to some volatile daily moves. Don’t ignore what happens on any given day, but keep it in context of the bigger picture.
- The economy shows few signs of slowing down materially, but markets remain skittish about a possible trade war. The Fed looks to continue its gradual path of normalization and doesn’t seem overly concerned with the recent stock volatility.
- The global wall of worry has a few more bricks in it, but positive news should help markets continue to climb that wall, although trade protectionism remains a threat to global growth.
March “Madness”
“If you can keep your head when all about you are losing theirs…yours is the earth and everything that’s in it.”—Rudyard Kipling
Over the past few weeks we’ve seen some fairly dramatic and speculation-driven stock market moves. We’ve seen kneejerk reactions to Chairman Powell’s testimony, which was judged to be more hawkish; only to reverse two days later when he was seen as having a more dovish tilt. More recently, we’ve seen harsh reactions to the announcement of steel and aluminum tariffs by President Trump, the resignation of National Economics Council head Gary Cohn, and the abrupt firing of Secretary of State Rex Tillerson. However, they were followed by relatively quick rebounds.
Stocks are still positive over the past month
Past performance is no guarantee of future results.
Recent market action has helped ease elevated investor sentiment according to the Ned Davis Research Crowd Sentiment Poll, allowing for a partial rebuilding of the “wall of worry” stocks like to climb.
The opening gambit of tariffs
We remain ardent supporters of free trade and believe that history has shown that the freer the trade, the better economies and markets tend to do. But damaging distortions can develop when governments try to place a heavy hand on the scale to their country’s benefit. Few economists would argue that China has not been doing just that with their steel and aluminum industries, with even the country itself recently touting its plans to cut overcapacity over the next couple of years (Ministry of Industry and Information Technology, Chinese Government, as reported in eurasiareview—February 27, 2018). How to potentially force them into further corrections in steel production can be debated, and we would certainly join the chorus decrying indiscriminate, across the board tariffs. But we have learned that the opening gambit from the President isn’t necessarily the final story and investors should refrain from overreacting to any single announcement…or tweet. Case in point would be the softer implementation that excludes Mexico and Canada and provides flexibility for other nations to be excluded. If, in the end, his throwing down of the gauntlet ultimately leads to the advancement of NAFTA negotiations and some more trade dialog with other nations—while avoiding a global trade war—then we could see a less-dire ending to this story. Were a full-blown trade war to develop, with China at the center (more on that below), the damage to the U.S. and global economies and markets would likely be more severe.
Bigger picture still looking good
With the recent myopic focus on tariffs and trade over the past several weeks, investors might have forgotten that the underlying foundation of the U.S. economy remains solid, although the softer retail sales report caused the Atlanta Fed GDPNow model to dip under 2% for the first quarter, which now has only a couple of weeks left. In spite of these weaker first quarter growth projections, business sentiment remains very optimistic. The NFIB small business optimism index is at its highest level since 1983, with a record-high reading for its “good time to expand” component. In addition, the Institute of Supply Management (ISM) Non-Manufacturing Index (covering about 88% of the U.S. economy) dipped only slightly to 59.5, while the forward-looking new order component rose to a quite robust 64.8. The accompanying ISM Manufacturing Index (covering the other 12% of the U.S. economy) rose to a robust 60.8, while orders remained strong. And actions are increasingly backing up these positive surveys, with The Wall Street Journal reporting that according to FTR Transportation Intelligence, heavy truck orders were up 76% in February relative to the year ago period.
Sentiment remains strong
Additionally, the labor market remains strong, with forward-looking jobless claims recently hitting their lowest level since 1969 and the latest monthly jobs report showing a surprisingly strong 313,000 jobs were added in February. The unemployment rate remained at a low 4.1%; with its flat reading reflecting a jump in the labor force participation rate from 62.7% to 63.0%. Perhaps most calming to the markets was that average hourly earnings were up only 2.6% year-over-year; down from the downwardly revised 2.8% in January, and calming some fears about more aggressive Federal Reserve policy after the prior month’s hotter wage reading.
Claims are historically low
As is unemployment
Fed focus
With the tighter labor market and signs that inflation is beginning to inflect higher, the markets have turned a keen eye on the Federal Open Market Committee (FOMC) in advance of its meeting next week. This will be the first FOMC meeting, accompanied by a press conference, for new Fed Chair Jerome Powell; and much focus will likely be on the so-called “dots plot”—representing the FOMC’s collective forecast for the trajectory of short-term interest rates. Economic and inflation tailwinds have been noted, especially from the fiscal side as a result of the tax cuts. But for now, the Fed’s preferred measure of inflation—the core personal consumption expenditures (PCE) price index—rose by a benign 1.5% year-over-year in the latest reading (for January), still below the Fed’s implied 2.0% target rate. We believe inflation pressures are building, but there remain enough deflationary forces coming from intense competition driving down costs, that the threat of runaway inflation remains low. Four rate hikes are a possibility this year, but it’s not the Fed’s desire to slam the brakes on this economic expansion. That said, late-cycle economic tendencies—including tighter monetary policy—have been volatility-drivers historically; and this year is shaping up to fit that historic bill.
Wall of worry
As noted above, markets are said to climb a “wall of worry” as solid economic and profit growth overcome new developments that pose risks to growth. While we can always count on new risks developing, a strong growth backdrop can help markets shrug off concerns after an initial negative reaction. Fortunately, market participants have had plenty of reminders about how strong the global economic backdrop has been in the past week.
- On March 13, the Organization for Economic Cooperation and Development (OECD) raised its 2018 and 2019 global growth forecasts for the majority of the G20 countries, as you can see in the table below.
- The upgrade brings the OECD’s world gross domestic product (GDP) growth forecast to 3.9% for both years—the fastest growth rate since 2000 (4.0%).
Nearly every country got a GDP upgrade in the latest round of forecasts from the OECD
Source: OECD as of March 13, 2018. http://www.oecd.org/eco/outlook/Getting-stronger-but-tensions-are-rising-presentation-oecd-interim-economic-outlook-march-2018.pdf
China’s economy, the world’s second largest, is off to a strong start in 2018. The economic surprise index—which rises when economic data exceeds economists’ estimates—rose to its highest level since 2009; and well above the average level of recent years as data on January and February were reported this week (see the chart below).
China’s economic data has been surprisingly strong
Source: Charles Schwab, Bloomberg data as of 3/14/2018.
- In Europe, Mario Draghi, the head of the European Central Bank (ECB), made it clear that ECB is satisfied with its base-case inflation outlook, has become more confident in that outlook, and is on track to retire quantitative easing (QE) this year as anticipated. With growth improving, the tapering of QE bond buying that began this year will continue. This has proven to be a favorable combination for European stocks in the past. As the ECB tapered and then trimmed QE from 2012 through 2014, European stocks posted strong gains, as you can see in the chart below.
No Taper Tantrum: Europe’s stocks favor better growth over more QE
Source: Charles Schwab, Bloomberg data as of 3/14/2018.
Past performance is no guarantee of future results.
While the global growth backdrop looks resilient, a potential risk has also become more potent: trade spats. With more than half of sales for the average global company coming from international trade, measured by the MSCI AC World Index, it is easy to see why developments that may impact the flow of the world’s goods and services across borders can have a big impact on the earnings of global companies.
The next trade spat may be with China. The metals tariffs alone hold little impact for China. The United States ranks 26th on the list of countries to which China exports steel. But, with the pending outcome of the Trump administration’s review of China’s alleged “theft” of U.S. intellectual property rights, a far more significant series of tariffs, quotas, and investment restrictions on China could be proposed, and China could respond in kind (our commentary on the threat of a global trade war can be found here: https://www.schwab.comhttps://www.schwab.com/resource-center/insights/content/trade-war-and-peace-which-markets-are-most-risk).
As noted above, with the initial tariff implementation, the Trump administration has pursued much softer actions than the rhetoric on trade; the actions taken are similar to those enacted under prior administrations, and has committed to working within World Trade Organization and to renegotiate NAFTA. Nevertheless, President Trump might take a protectionist turn at some point, and the risk that it may be with China has risen; making it a tougher wall for the market to climb without slipping.
So what?
Stock market behavior and volatility can be maddening at times, but focusing on the longer term, remaining disciplined, and refraining from kneejerk reactions tends to dampen that madness. The U.S. economy still looks healthy, inflation pressures remain modest, and earnings growth has been strong; all of which should allow the bull market to continue, albeit with increased volatility.
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