Three Key Thoughts:
1. Tech and Trade Tantrums
2. Bonds Riskier than Stocks?
3. Bumpy Road Ahead
Facebook went public in 2012 with revenue around $5 billion. By 2017, just five years later, its revenue had increased eight fold, to more than $40 billion, generating profits of nearly $16 billion. Yet somehow it escaped the public consciousness that Facebook was selling users’ personal data to generate this enormous profit, sometimes to people who did things we wouldn’t approve of. To paraphrase Meredith Wilson: Trouble, oh we got trouble/Right here in River City!/With a capital T/That rhymes with “FB”/And that stands for Facebook.
Since peaking on February 1, the value of Facebook stock has dropped more than 20%. Surveys show trust in the company has plummeted as well. The stock of Alphabet, parent of Google and YouTube, also peaked around the same time, amid concerns about new taxes from European regulators. And lately, Amazon has become President Trump’s favorite Twitter target. Bottom line, these big cap tech stocks, which had led the market up throughout 2017, have now led it down, about 10% off the peak. That we had a significant correction coming was no surprise to any serious investor – we had recently set records for low volatility and length of time without a correction. But questioning the future prospects of these tech titans was real news.
Unfortunately, tech woes weren’t the only things upsetting the markets. Interest rates on Treasury bonds jumped in the January causing investors to wonder whether stock prices should be ratcheted down because higher rates mean future earnings are worth less.
And, finally, we come to trade. Like many a Trump position, it is difficult to separate real policy from posturing for negotiating purposes. At this writing, the markets are rightfully concerned about the prospect of a growing trade rift with China. China appears to be taking a measured response to Trump’s planned tariffs but where this will lead is anyone’s guess. At the same time, the US is attempting to re-negotiate NAFTA with Canada and Mexico.
Our concern is that the administration is apparently basing its positions on a false premise, i.e., that trade deficits with any country are inherently bad for the US and must be the result of poor trade terms. Trade deficits are a function of our consuming more than we produce at home. It’s that simple. Shifting the terms of trade through tariffs is likely to drive up prices for imports, costing US consumers more and slowing the economy. Not only is this counterproductive but it takes away some of the benefits of the lower corporate tax rates that were just put into place.
Meanwhile, the trade issues also add to concerns about inflation, as tariffs on imports drive up prices. With the unemployment rate already at a very low rate (4.1%) and likely headed lower as job growth remains strong, it is just a matter of time before wages begin to rise more strongly. And with them will come higher inflation expectations and higher interest rates.
Gradually rising interest rates are generally okay for investors. For stock investors, this usually means the economy is doing well and earnings will likely rise, buoying stock prices. If rates rise too quickly, stock prices typically get marked down as investors are willing to pay less for future earnings as their present value is reduced. For bond investors, gradually reinvesting their interest payments at higher rates produces higher future income. The problem arises when rates rise suddenly or unexpectedly. It’s important to remember that the absolute level of interest rates is still quite low (30 year US Treasury bonds yield about 3%) so bond prices are extraordinarily sensitive to changes in interest rates. For example, a 1% rise in 30 year Treasury rates from their current level would cause their value to fall about 17%. We aren’t saying that bonds are necessarily riskier than stocks but, if we were to wake up to markedly higher inflation reports and interest rates, both bonds and stocks could be in for substantial declines.
One final point about US stocks. The combination of (1) the recent market correction and (2) the substantial mark-up in earnings estimates due to lower future tax rates makes it look like stocks are trading at close to an average multiple of future earnings. Indeed, we have been able to find some individual stocks trading at quite reasonable prices that we have added to client portfolios. However, we hasten to point out that those upcoming earnings are benefitting from lower taxes, a weaker dollar, higher energy prices and stable wages. It is certainly possible that a year from now, none of these factors will be tailwinds.
On a longer term basis, we are concerned that the recent tax cuts and spending bills enacted by Congress will add very significantly to the budget deficit. At a time when the economy is growing pretty strongly, we should be looking to reduce the deficit, not add to it. But in Washington, no one wants to make the hard choices. And no one gets re-elected by saying we need to make them, either. The deficit numbers are just too big for us to grow out of them and, ultimately, they make it more difficult for the government to respond to downturns in the economy.
In 2017, sentiment turned in favor of many international stock markets, particularly those of emerging markets. The better growth, better earnings and reasonable valuations of these markets had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for several years, perhaps making up much of their poor performance relative to the US since 2011. That said, we have some concern that investors will get too excited and push prices to unreasonable levels too quickly.
While 2017 was a cautionary tale about not letting politics color one’s investing approach, we could be entering a period where government policies have more impact on the investment landscape than they have in the recent past. Markets usually move on the basis of the expected marginal change in the environment and, so far, that judgment has been that the environment for investors has gotten better. Lower taxes and less regulation are generally good for companies’ bottom lines. Uncertainties created by shifting trade, immigration and foreign policies are much less business friendly, and may be less market friendly.
In client portfolios, we remain underweight in fixed income as we believe the risks far outweigh the small potential rewards. We have maintained our substantial weight in international stocks and have held onto US stock positions while carefully minding valuations.
April 6, 2018 © Essential Investment Partners, LLC All Rights Reserved