Looking back, the first half of 2018 ended with markets up modestly and on-track for an “average” return year in the mid-to-high single digit range.
While this might not sound noteworthy, consider that the last five years have seen equity markets gain nearly 16 percent on average, well above that level. That is another example of the process of normalization underway in the financial markets. Volatility also reemerged in the first half as new fears over inflation and tariffs entered the fray and marked a shift from last year. Whether we look at the policies coming out of the White House, the monetary policy set by the Federal Reserve (the Fed) or the global investing landscape, these shifts are part of the process to unwind the extraordinary measures put in place following the financial crisis in an effort to boost economic growth.
The key is still the corporate profit cycle which has seen better-than-expected growth this year. Ultimately, investors shifting back to a focus on fundamentals is a welcome change here at Westwood. We believe the future is well suited for our fundamental stock picking investment approach, focused on Quality Value companies.
Fading political noise down from deafening levels, especially after the midterm elections, should further enable investors to refocus on the nominal GDP growth in excess of 5 percent. Having been largely absent for many years, this nominal growth could be a key driver in the markets. Growth at this rate has historically been supportive of earnings growth in the range of 8 percent to 12 percent.
2018 Second Quarter and One-Year Trailing Returns Across Asset Classes
Fiscal tailwinds from easing regulatory burdens and lower corporate taxes should be positive catalysts for profits. However, inflationary concerns are rising given the strong economic indicators, including increasing demand for raw materials and rising wages. Whether companies are fearful of the “Amazon effect” or simply more confident in the future, this should lead to increased investments in automation and other productivity drivers.
Tariff disputes remain a potential headwind, though separating the headlines from reality is important as the impact has been minimal so far. As these issues subside, the focus will reset back on global economic improvement and the efforts by the European Central Bank (ECB) and Bank of Japan (BoJ) to reduce and normalize their own monetary policies respectively. They would be joining the Fed, who remains focused on reducing their balance sheet at a faster pace as rate hikes have moved the federal funds rate toward a neutral level — with little or no acceleration or braking on interest rates. While this remains our operative, and most likely, scenario, this could prove to be conservative or optimistic depending on several factors.
More gas in the tank?
Having started in the U.S., there could be a “lot more gas in the tank” if the synchronized growth across the world accelerates as a result of underlying strength.
Trade fears could resolve into “win-win” deals to support notable acceleration in Europe and Japan. As monetary policy shifts to be less accommodative, the recent negative yield experiment could fade further in the rearview mirror as both short- and long-term bond
Deflation concerns could ease on strong personal consumption and an improved housing market from higher wage growth.
Corporations, repatriating and bringing home their previously stranded foreign profits, could generate a surge in acquisition activity, share repurchases and internal investments concurrently. Despite likely increased expense pressures on margins, corporate profits could move sharply higher on the back of even stronger nominal growth and fiscal tailwinds.
Conversely, if fears of a trade war materialize, it could create headwinds to economic activity as disruptions to trade patterns tend to limit demand and push corporate profits lower.
Midterm elections could drive uncertainty higher and weigh on investor sentiment, increasing the risk that the Fed remains on autopilot. Continued reductions in monetary stimulus could produce a series of unintended consequences. Businesses would face higher capital costs as rising yields tend to push financing costs higher and squeeze operating margins, given higher costs and lower sales. This would likely extend globally, exacerbated by currency fluctuations, and contribute to a rise in populism and protectionism. If the global growth narrative were to end, emerging markets could see sharp selling as investors attempt to preserve capital.
While those more extreme scenarios are certainly possible, it’s important to remember that equity markets in the U.S. remain attractive as valuations are not demanding and earnings are growing. Fundamentals remain largely strong globally, though we must remain vigilant given the broad return of volatility across asset classes.