Well, look at that…the market does go both ways.
2018 started by continuing the calm, steady, upward market climb we have experienced for the last two years. By the end of January, the S&P had gained 6%. Then the seemingly unthinkable happened…the market had a bad day and just days later was in a correction (defined as 10% below the most recent market peak), the first correction since December 2015 – February 2016.
Why the sudden and violent whiplash? Hyman Minsky, a 20th century American economist, is remembered for his work on the relationship between stability and instability. He argued that stable environments create unstable environments, we just can’t observe the inherent instability until it is fully born. When an environment is calm, people are comfortable and assume things will continue as they are. In market activity, this leads people to ignore risk. That is essentially what happened in January.
As we noted in our 2017 Q2 commentary, the volatility index (VIX – the fear gauge, which measures investor’s expectations of future volatility) had been trending lower over the last few years and had reached its lowest point on record. Hedge fund traders (and Target store managers – Google “Target manager VIX trader”) were taking advantage of this trend by heavily shorting the VIX (betting it would continue to go down). As the calm continued, more and more funds piled into the trade with many using leverage to increase their returns. This provided the appearance of stability – returns were increasing, the pool of investors was widening, and the sun continued to shine.
The thing about market parties is they only last so long and they never wind down slowly. Instead of an organized and calm departure, it’s more like the police showing up at a college frat party…everyone rushes for the exit at once. When this happens in the markets it results in what traders call a liquidity spiral. There are more sellers than buyers and as people try to unwind their now losing position they take huge losses. This is exactly what happened…liquidity dried up across markets, volatility went through the roof, and the stock market went down quickly.
A liquidity spiral in a market the size of the VIX isn’t going to cause a lot of collateral damage. It’s like dropping a small stone in a lake…the ripples in the water caused by the stone dissipate quickly (in contrast to what happened with sub-prime housing in 2007…that was dropping a nuclear submarine into a lake). By the time of this writing, markets have calmed but volatility remains elevated from where it was at the beginning of the year. We expect this to continue. With the instability from the VIX shorting trade worked out, markets are now noticing structural issues with both businesses and the economy while also trying to wrap their minds around the introduction of tariffs. We will briefly look at each of these concerns below.
In our last commentary we talked about how we are likely nearing the top of the market and business cycles. Evidence of that change is starting to appear. Over the last few years, the factors that drove corporate profit margins to highs – low interest rates, low inflation rates, low wage growth – are starting to deteriorate: interest rates are going up, which raises borrowing costs; inflation in materials is increasing making it more costly for corporations to build projects; and, low unemployment is creating tighter labor markets, which is slowly driving up wages.
Tight labor markets and increasing interest rates are signs of a healthy economy but once they start impacting corporate profits it points to a peaking/turning cycle. Corporations will do what they can to pass the inflationary cost on to their customers. Housing provides an instructive example. Inflation in materials – particularly timber – and labor have driven up the cost of building new homes. Up to now, consumers have been willing to pay more to cover the increase. But that can only last so long before consumer habits change. Once that starts, corporations will be forced to cut profit margins to maintain sales and compete with other players in the market.
The harder part for corporations to deal with will be rising interest rates. Corporations have used the low interest rates of the last several years to go on a debt binge. According to Standard & Poor’s, 37% of global companies are highly indebted as of 2017. That’s 5% points higher than in 2007, just before the financial crisis (keep in mind though…in 2007 the debt was concentrated in banks, which is what caused the financial crisis. Bank balance sheet are, generally, in a better position now). Most of the debt added by publicly traded corporations appears to have been used to re-purchase their own shares. While share re-purchases are good for current shareholders, it does nothing to increase revenues. If interest rates do increase, and companies must refinance at higher rates, their profit margins will be further reduced. For the first time in years, corporate profits are at a serious risk of declining.
Market volatility has been furthered as President Trump has announced tariffs on several industries. The actual economic impact of the tariffs announced so far is limited. The planned tariffs against China (as of the end of 2018 Q1…this can change fast) have an estimated impact of a .1% reduction on Chinese economic growth (as measured by Gross Domestic Product). The industries targeted are ones included in China’s, “Made in China 2025” plan. China’s announced retaliation tariffs appear to be more politically driven than economic. Industries impacted by the tariffs are prevalent in congressional districts polling as toss-ups in the coming mid-term election. Targeted groups include farming – particularly soybeans – and the pork industry. Also targeted were industries prevalent in Wisconsin (cranberries) and Kentucky (bourbon), the states of Speaker of the House, Paul Ryan, and the Senate Majority Leader, Mitch McConnell. None of these industries are vital to US economy and the tariffs against those industries do not pose a national threat to economic growth. So why the market brouhaha? The market is concerned that this could be the beginning of a broader trade war.
The World Trade Organization attempts to fairly regulate world trade. Virtually every country in the world, except North Korea, Turkmenistan, Eritrea and Greenland, are either members or observers. As members or observers, they agree to follow rules that limit their ability to squeeze foreign rivals with trade restrictions and they agree to adhere to processes designed to reduce dodgy trade practices. The President’s first round of tariffs – solar panels and dish washers – utilized WTO measures. The second round of tariffs – on steel and aluminum – did not. To enact tariffs on steel and aluminum, the President utilized a section of US law (Section 232 of the Trade Expansion Act of 1962) that allows the President to protect industry in the interest of national defense. In the eyes of the world community, the President is no longer playing by the rules. Once he – and subsequently China – acted outside of the WTO the possibility of an escalating trade war increased.
Since WWII and the signing of the General Agreement on Tariffs and Trade in 1947 by 23 countries the world has moved closer and closer towards global free trade. During this time, the world’s economic growth has been extraordinary. It is hard to determine how much of that growth has been attributable to free trade. The benefits of free trade are theoretical (e.g., the theory of comparative advantage…David Ricardo, a 19th century Englishman) but the logic behind the theory is sound and it is hard to argue with the results. If the world were to regress to a system of protectionism and widespread trade wars, global economic growth may stagnate.
Will there be a trade war? In our opinion, it seems unlikely. Thus far, the Trump administration’s actions regarding almost any policy have been more measured relative to the Presidents rhetoric. This trend appears to be continuing with foreign trade. Within days of the announcement of steel and aluminum tariffs the Trump administration said it may allow exceptions for close allies of the US, i.e. Canada, Mexico and the EU. Also, the announced tariffs specifically aimed at China have yet to be implemented and a meeting between Chinese and American officials has been scheduled to discuss trade. It is likely that these maneuvers are designed to create leverage for negotiating a better deal. This tends to be the President’s negotiation style – create leverage by being unpredictable. For decades the US has negotiated these deals with carrots. In the President’s public view, that strategy has resulted in bad deals. Now he’s getting out a stick. His goal – as it always is with this President – is to make a deal. That is ultimately what we think will happen.
Past performance is not a guarantee of future earnings. Asset allocation does not assure a profit or protect against loss in a declining market. Blake A. Stanley, CFP® is an Investment Advisor Representative of Legacy Advisory Group, LLC a Registered Investment Advisory Firm.