Tax Cuts and Trade War or is it Trade MORE!
The prognosis for the economy and the stock market appeared healthy as we headed into 2018, and the outlook has improved since, thanks much to stronger-than-expected economic momentum from the passage of the Republicans’ long awaited tax cuts.
The United States is projected to grow 2.7% in 2018, according to the International Monetary Fund (IMF), which raised its forecast after Republicans passed the largest overhaul of the U.S. tax code in more than 30 years. According to the IMF, the sweeping reduction in the corporate tax rate from 35% to 21% should stimulate business investment and growth. If that growth comes to pass, it would be the largest since 2015, when the U.S. economy grew at 2.9%.
Consumer confidence plays a large role in current conditions. Everyone likes tax cuts (well, mostly everyone; there are always naysayers), and U.S. consumer confidence hit an 18-year high in February, primarily due to outlook on business conditions. It fell a bit in March, breaking a two-month streak of gains, but the decline is minimal: Index levels remain historically high, suggesting further strong growth in the months ahead.
Why are consumers so happy? Employment is one reason. The U.S. economy added 103,000 jobs in March, marking 90 straight months of employment gains, with the unemployment rate holding steady at 4.1%. Now, if you read my columns regularly you’ll know I’m skeptical of the level of government data, but the lack of change is interesting. The data itself might not tell is much, but the fact that it’s not changing does. The housing market has also been steadily recovering since late 2011, with the S&P/Case Shiller U.S. National Home Price Index up more than 6% year-over-year in March; it’s averaged more than 6% annually over the last six years as well.
Is there any bad news? Sure. Despite the economy adding jobs, average hourly pay grew just 2.7% from March 2017 to March 2018. And, there could be trouble brewing in the housing market, with commercial real estate prices, which often serve as a proxy for the overall economy, falling for the first time in years.
I could go on, but more importantly, how did stocks perform with this backdrop? Well, that’s interesting. They peaked within days of President Trump’s State of the Union address: As of January 26, the three main U.S. stock-market indices had risen between 7.5% and 8.7% in less than a month. Then market volatility returned in with a vengeance: A January to February selloff took most major indices down in the double-digit range. The S&P 500 Index ended the first quarter down almost 1%.
There are multiple explanations for the correction, including concerns about interest-rate hikes, inflation, and a trade war.
At its March meeting, the U.S. Federal Reserve (Fed) raised the target range for the federal funds rate for the first time this year—by 0.25%, to a range between 1.5% and 1.75&. And it expects to raise interest rates by 0.25% two three additional times this year. This was the sixth increase since December 2015, when the Fed started tightening monetary policy after the financial crisis, but rates are still extremely low by historical standards.
As for inflation, earlier in the year, a surprising 2.9% jump in U.S. wages tweaked concerns about inflation and the likelihood of more aggressive tightening by the Fed. Inflation (as represented by the Consumer Price Index) edged down 0.1% in March, thanks to a big drop in gasoline prices, but it was up 2.4% year over year, the largest 12-month increase since the period ending March 2017 and higher than the 1.6% average annual rate over the past 10 years. But, as you now know, I don’t put a lot of faith in government numbers, so take that with a grain of salt.
As for a trade war, earlier this year, the Trump administration announced tariffs on solar panels, washing machines, and steel, and Trump’s top economic adviser, Gary Cohn, resigned in disagreement. To some, this signaled an impending full-blown trade conflict. But to put things in perspective, these four products account for 4% of total U.S. imports, or 0.5% of U.S. gross domestic product (GDP). As long as we don’t see major retaliatory measures from our trade partners, the impact of these tariffs will likely be limited. That certainly seems to be the case. For example, when the Trump administration later announced tariffs on $60 billion of Chinese imports, China responded by targeting $3 billion of U.S. exports to China—not very significant. This “trade war” is likely a lot of posturing as a negotiation tactic. We’ve all seen Trump reverse a strong task. He calls it “the art of the deal.”
I could go on and on about the potential for interest-rate hikes, inflation, and a trade war, making arguments that they will or will not happen and how they will affect the economy and markets. But the main point to keep in mind is that the first-quarter correction shouldn’t have been surprising: Over the past 30 years, the S&P 500 Index has seen a market correction (defined as a decrease in value of more than 10% but less than 20% from a 52-week high) occur about once per year. With such strong equity growth over 2017, a correction in 2018 should have been expected.
Currently, the markets are in a wait-and-see period. Investors are trying to decide if the nine-year bull market we’re currently in is ending, and we’re entering a bear market, which is a stock-price decrease of 20% or more from a 52-week high. In this way, things look a lot like they did last year. But as we move through market cycles, it’s important to understand what each stage brings so we can find opportunities. We might lower the duration of bold holdings are interest rates rise, for example, or increase exposure to international equities to ensure diversification across markets.
Thank you for the trust you have placed in GPS. We will continue to work hard every day to maintain that trust and guide you through this, and all, market cycles.
Mark Anthony Grimaldi
Portfolio Manager, Author