Monthly Markets Memo - April 2018
by Dan Zalipski, CFA & Scott Rosenquist, CFA
With twitter tirades, tariff threats, and trouble in tech, it sure is noisy out there. The U.S. markets, as measured by the S&P 500, re-tested February lows as the quarter came to an end. The volatility was fed by escalating trade disputes as the Trump administration raised the prospect of additional tariffs on Chinese products, with the Chinese responding in-kind with their own tariffs on U.S. imports. The tech sector wrestled with its own problems which added to the pain; Tesla is struggling to meet production goals, Facebook is working damage control for a scandal involving the improper sharing of user’s data, and Amazon finds itself in President Trump’s crosshairs over taxes and its business with the post office.
Developed and emerging markets outside of the U.S. have mostly tracked the S&P 500 through the first quarter. Not to be outdone by equities, the fixed income market reminded us it can also be volatile. Investment grade fixed income remains negative on the year as prices decline in the face of rising interest rates. With the deficit set to increase and inflation potentially heating up, investors are concerned that the Fed may be forced to raise rates faster than expected; a move that would likely see a negative reaction from both equities and fixed income.
With all this noise, investors are turning their attention towards something with more substance, earnings. Over the next several weeks, U.S. companies will report first quarter earnings, which are the first of which to include the full impact of the recent tax reform bill. This introduces the challenge of separating the expected short-term effects related to the tax cuts against the longer-term underlying fundamental market trends. Earnings growth for the first quarter is expected to come in at an impressive 20%. Credit Suisse estimates the tax cuts are responsible for 7% of that growth. Backing out the impact from the tax cuts results in earnings growth at a level that is closer to historical averages, representing the longer-term market trend. This dynamic has investors looking to determine just how long the impact from the tax cuts will last.
Moving from earnings growth to GDP, the Congressional Budget Office (CBO) has estimated that 2018 GDP will grow at 3.3%, and 2.4% in 2019. Unfortunately, that is where the good news may end. As the effects from the tax cuts fade, GDP growth for the 2020 decade is expected to average a below-average 1.7%. The CBO cites swelling budget deficits and the overall level of government debt as a drag on growth. These factors also have the potential to limit the tools available to the government which are needed to address future challenges. These estimates are partly based on the status quo and could change should Congress move to address these issues. However, potential solutions are likely to be unpopular such as raising taxes or reducing spending on popular social programs. Tough decisions for any elected official to make.
The labor market will present its own challenges as we move forward. Many companies are reporting difficulties in finding qualified applicants for open positions. As unemployment continues to trend down, companies will need to raise wages to attract workers. An increase in wages will pressure their margins, resulting in lower earnings, eventually leading to a deceleration in earnings growth. Rising wages can also contribute towards inflation, which could lead to the more aggressive Fed action mentioned in the opening paragraph. These are all important inflection points to monitor in a late cycle bull market.
"The hardest thing to understand in the world is income tax." - Albert Einstein
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