Preparing to Pivot

Asset Management, Investment Themes, The Economy October 10, 2018

Preparing to Pivot

The current economic expansion is now the second longest on record, causing us to pose the question: When will the party end?

Last quarter, we outlined three possible reasons the current bull market might come to an end: valuation, trade wars, and the Federal Reserve overtightening. Since then, both the S&P 500 and the Dow Jones Industrial Average have crept higher, with the S&P 500 hitting a fresh high of 2,913 on September 21. Nevertheless, the forward price-to earnings valuation multiple has stayed reasonable, primarily because corporate earnings, aided by the 2017 tax cut, have grown significantly. As a result, we have greater confidence that valuation will not be the culprit that ends this market cycle.

Foreign trade, on the other hand, has become increasingly concerning. Earlier this year, tariffs were confined to a few high-profile examples— steel and aluminum—which together make up roughly $50 billion worth of imports. While nothing to sneeze at, a 25% tariff on $50 billion equated to only 0.4% of total U.S. imports, which were about $2.9 trillion in 2017. We believed at the time that fresh rounds of tariff proposals by the administration were likely bluster for more leverage ahead of trade negotiations. However, months have gone by with no significant trade agreements, the U.S.- Mexico trade deal notwithstanding, and instead of scaling back, the administration has increased tariff proposals substantially.

The Trump administration has now threatened or imposed tariffs on nearly $900 billion worth of imports. This includes virtually all $500 billion worth of Chinese imports. Assuming a 25% tariff rate, this would equate to about 7.5% of the value of all imports, about a third the 20% level reached following the enactment of the Smoot-Hawley Tariff Act in the 1930s. Both the administration and its trading partners have inched closer to an actual trade war. While we hope that subsequent trade talks result in some kind of resolution, at this point we must consider the possible economic collateral damage of a trade war.

Emerging markets have already felt the negative effects in the near term. We currently have very low exposure in our portfolios to international stocks, and particularly to emerging markets. We are watching valuations for a turning point that may offer an opportunity to invest.

From a domestic perspective, tariffs are fundamentally inflationary. They are effectively a tax on the consumer. Nearly every American company has projected price increases to offset rising costs of imported goods and materials. We also see inflationary pressures in the tight labor market, with unemployment at historic lows and accelerating wage growth. The most recent batch of data from the labor market indicated that wages rose 2.9% from a year ago, the highest level of growth since the end of the financial crisis.

The Federal Reserve is tasked with managing this inflationary pressure. The Fed has telegraphed one more increase in its target rate between now and the end of the year, which would bring the Fed Funds Target Rate to 2.50%. We continue to believe that the Fed overtightening is ultimately what will likely bring this bull market to an end. The current inflationary pressures in the market give the Fed room to push forward with its scheduled rate hikes, as it chases inflation higher with no change in real rates.

The political drama in Washington will continue to hog headlines, but we do not believe it will have an impact on the markets. If the November midterm elections produce a Democratic majority in the House or Senate, this should lead to political gridlock, which is often a good thing for economic activity. If Republicans maintain their majorities, it is possible that we may see nother piece of legislation down the road, perhaps in infrastructure or another attempt at repealing and replacing the Affordable Care Act.

We continue to monitor two particular economic data points very closely. The spread between the 2-year and 10-year U.S. Treasury yields is now at 0.23%. Recall that this spread has turned negative as the yield curve has inverted 6 to 18 months ahead of every recession since WWII. We also track the year-over-year change in nonfarm jobs. When this number dips below 1% alongside an inverted yield curve, we will reduce risk across our client portfolios. If current trends persist, the 2-10 spread will turn negative in early 2019 while the change in nonfarm payrolls likely will stay above 1% until late 2019 or early 2020. For now, we are staying fully invested, adjusting target allocations on a client-by-client basis. Meanwhile, the markets grind higher, climbing the proverbial wall of worry.


Individual investment positions detailed in this post should not be construed as a recommendation to purchase or sell the security. Past performance is not necessarily a guide to future performance. There are risks involved in investing, including possible loss of principal. This information is provided for informational purposes only and does not constitute a recommendation for any investment strategy, security or product described herein. Employees and/or owners of Nelson Roberts Investment Advisors, LLC may have a position securities mentioned in this post. Please contact us for a complete list of portfolio holdings. For additional information please contact us at 650-322-4000.

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