Co-founder and CIO
09 March 2018
The stock market experienced a speedy recovery between 9th and 27th February, recouping nearly 75% of its previous losses from the late-January correction. However, the recovery was interrupted by the Fed’s relatively hawkish tone, and the political circus around international trade spats. What happens next is difficult to predict, because it looks like the correction may not be over yet.
By our estimate, an additional 0.25% increase in long-term interest rates could generate roughly -4.25% impact to the S&P 500. This has been largely priced into the market, and we do not expect further weakness in the stock market as a result of the latest Fed’s stance.
Past economic cycles have shown us that rate hikes have rarely been a problem for the stock market, as they reflect improving fundamentals. On the contrary, the last two bear market episodes have seen prior reversals in market expectations from rate hikes to rate cuts.
Trump announced his intention to impose a 25% tariff on steel and 10% on aluminium imports, in addition to the previously announced tariffs on washing machines and solar panels. This falls under US politics, but it would have effects on markets globally. While reactions in China have been relatively muted, traditional allies of the US, including Japan, Australia, and the Euro-zone, were infuriated when they heard that the tariffs would be uniformly applied to all trading partners. Republicans don’t like trade disputes either, because they don’t want their new tax reform progress reversed.
The bigger concern for financial markets is whether these trade spats would invite retaliations from other nations and risk spiraling into a global trade war. In this risk scenario, tariffs and counter-tariffs would raise prices of raw materials and resources, which in turn contribute to higher inflation.
Investors should let dollar-cost averaging work in their favour, and buy growth-oriented assets on weakness while economic fundamentals are still healthy.Our asset allocation model also favours adding undervalued protective assets, such as gold and US inflation-linked bonds, to growth-oriented portfolios. These assets strengthen portfolios’ defenses against unforeseen adverse events, such as an escalation in trade disputes.
Timing the market and trying to assess when the correction is actually over is an impossible task. Investors may get it right once and feel smart, just to be wrong the next time around. For the long-term investor, dollar-cost averaging is, and remains, the right strategy before, during and after a correction. Using famous investor Peter Lynch’s words, “Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.”
February 2018 was certainly a rocky month for global markets. From peak to bottom, the stock market correction that began on 29th January saw the S&P 500 decline by as much as 11.84%. But it’s wise to keep in mind that corrections tend to be short-lived when growth is still solid. From 9th February, the stock market experienced a speedy recovery, and recouped nearly 75% of its previous losses by 27th February.
Whether the correction is over is unclear at this point. Given that economic fundamentals are strong, it’s fair to expect that a recovery is on the horizon, even if we will probably experience a little more volatility along the way.
On 27th February, newly minted Fed Chief Jerome Powell testified at the House Financial Services panel, at which time he affirmed his view that the economic outlook remains strong. And then, on 1st March, William Dudley, the outgoing but influential President of the New York Fed, expressed his view that four rate hikes in 2018 would be considered “gradual”. In essence, these two key comments mean that the Fed is targeting four interest rate hikes (25bps each) for 2018. This means the Fed is emphasising one more rate hike than market expectations, and the S&P 500 reacted by declining 4% from its peak (prior to Powell’s testimony) to the close of business on 1st March.
Why would an additional 0.25% increase in interest rates matter for stocks? Let’s consider the stock market as a synthetic bond with cash flows linked to future earnings. At any point in time, the stock market has an expectation about what the average of these future earnings would be. Each dollar of future earnings then has to be discounted to present value, because a dollar in the future is worth less in today’s term (time value of money). This is where interest rates come in. When interest rates rise, discounts are greater, and the present value of future earnings declines, and vice versa.
An increase of 0.25% in long-term interest rates could generate roughly -4.25% impact on the present value of future stock earnings. This scenario assumes that earnings expectations stay the same, which is not unrealistic given that the stock market has been pricing-in any potential upside. This estimate is in line with the 4% decline in the S&P 500 (using levels prior to Powell’s testimony on 27th February versus closing price on 1st March). The bottom line is that any negative impact from the Fed’s relatively hawkish tone has already been priced into the stock market.
History has taught us that rate hikes were never a problem for the stock market. When the Fed hiked rates, it was mostly trying to react to improving economic fundamentals. As opposed to steering the economy, the Fed’s mandate has always been focused on smoothing the path for growth and to keep inflation under control.
On the contrary, the last two bear markets for US and Global equities developed after interest rate expectations reversed from rate hikes to rate cuts. These reversals in interest rate policy are depicted in the bottom panel of Figure 2, where the blue line (“FF6”) cuts the orange line from above. The bear markets that ensued can be observed in the circled areas in the top panel of Figure 2. Note that the mid-1995 rate cut expectation failed to lead to a bear market as rate cuts back then were considered to be a remedy to prior policy mistakes (over-tightening by the Fed), and was greeted positively by the S&P 500.
Just when the market was starting to cope with the Fed’s new monetary policy stance, Trump stirred things up in international trade. Adding to his declaration on protectionist measures on washing machines and solar panels, Trump announced his intentions to impose a 25% tariff on steel and a 10% tariff on aluminium imports to keep these industries going in the US. Trump is also using tariffs as a bargaining chip to seal a quick deal on a new version of the NAFTA (North American Free Trade Agreement).
Allies of the US, including the Euro-zone, Australia, Canada, Japan, and Mexico, have been more vocal with their reactions than China has when they learned that the tariffs are planned to be uniformly applied to all trading partners. The European response has been the most aggressive. President of the European Commission Jean-Claude Juncker has threatened to counter US tariffs by targeting iconic US brands and industries, such as Harley-Davidson Inc. motorbikes, Levi Strauss & Co. Jeans, and bourbon whiskey.
The irony is that the Republicans don’t even like trade disputes. On 6th March, House Republican Speaker Paul Ryan urged Trump not to proceed with the tariff plans, and stated that the US economy could suffer from it. According to a Bloomberg article, the statement from Ryan’s office was, “we are extremely worried about the consequences of a trade war and are urging the White House to not advance with this plan.”
The bigger concern for financial markets is whether these trade spats would invite retaliations from other nations, and spiral into a global trade war. In this risk scenario, tariffs and counter-tariffs would increase prices of raw materials and resources, in turn contributing to higher inflation.
Yes, there are plenty of emotional triggers, such as rising interest rates and trade spats, that are making growth assets nervous. This “noise” is emotionally charged and disconnected from the fundamentals where leading economic indicators are still strong and improving. Investors should let dollar-cost averaging work in their favour, and keep buying growth-oriented assets, as fundamentals are still healthy.
Our asset allocation model continues to favour adding undervalued protective assets, such as gold and US inflation-linked bonds, for growth-oriented portfolios. These assets strengthen portfolios’ defenses against unforeseen adverse events, such as an escalation in trade disputes.
As timing the market is an impossible game, our recommendation is always to invest steadily, perhaps with monthly standing instructions, to take “automatic advantage” of fluctuations in the market; ideally those investments should go into a diversified portfolio of growth-oriented and protective asset classes. As iterated several times by world-famous investor Warren Buffet, for long term investors, a drop in the market is good news because it gives opportunities to buy on sale.