The second half of 2018 is looking a lot like the first half of the year for equities, with policy speculation and geopolitical risks dominating the headlines. Distinguishing between news and noise is critically important for investors. For example, concerns about a potential exit of Italy from the euro area is more likely to be noise, creating trading opportunities. In contrast, developments on trade policy or in technology sector growth may be more newsworthy, providing insight into the prospects for equities.
3 Issues That May Be More Noise Than News
1. President Donald Trump’s tweets and statements criticizing the Federal Reserve: For perhaps the first time in his presidency, Trump may be on the same page as Sen. Rand Paul, son of Ron “End the Fed” Paul. Trump’s criticism of the Fed’s interest rate hikes disturbed many Fed-watchers, but does not jeopardize the independence of the Fed. Although recent presidents have refrained from criticizing the Fed, Trump is not the first president to be critical of Fed policy.
Trump’s appointees to the Fed have signaled their independence, providing consistent reminders of the Fed’s dual mandate to “promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.” Lessons from the past, including mistakes made by Fed leaders under pressure from Presidents Johnson and Nixon, haven’t been forgotten by the current leaders and staffers at the Fed.
2. Italy exiting the euro area: Italy has serious long-term issues, but the near-term risk of “Italexit” is slim. Italian credit spreads recently widened after reports that the leaders of Italy’s coalition government were pressuring Finance Minister Giovanni Tria to resign. Investors think of Tria as the “voice of reason” in a government led by “magical thinkers” wanting to dramatically increase Italy’s fiscal deficit.
Italy’s financial challenges are considerable. Stagnant incomes, high government debt, low worker productivity and high youth unemployment have created an environment in which populist solutions appeal to Italian voters. Despite mutual frustration, Italian and euro area leaders both face constraints that make worst-case outcomes less likely. Italian populists are constrained by a weak banking system and high retail ownership of bank debt.
Legal barriers are also an issue for those who favor an “Italexit.” The Italian Constitution prohibits a referendum on treaties, so a Brexit-like referendum isn’t in the cards. Europe, particularly Germany, is constrained by the magnitude of Italian debt and liabilities held by foreign investors. Given these constraints, Italy’s problems are likely to be “kicked down the road” for an extended period of time.
3. Inversion of the yield curve: The yield curve, as measured by the spreads between 10-year and 2-year Treasury yields, has been flattening since early 2011, when the spread peaked at nearly 2.9%. The spread recently broke below the 30 basis-point level. An inverted yield curve, which is when the 2-year yield is higher than the 10-year yield, is considered one of the most reliable indicators of an upcoming recession.
The flattening yield curve is viewed as an alarming indicator by many investors, but there is a significant difference between flat and inverted yield curves. There can be a long lag between yield curve flattening and inversion. During previous cycles, the yield curve often has stayed “flat” for more than a year before inverting. Stock market returns are often strong when the yield curve is flat, providing a late-stage market rally. Although the Fed has signaled plans to increase short-term rates twice more in 2018 and multiple times in 2019, rate hikes on the short-end of the curve aren’t a guaranty of inversion. It is possible that flattening pressure from rising short-term rates would be offset by long-term rates moving up in response to a re-anchoring of long-term inflation expectations. Consequently, investors should be monitoring for yield curve inversion, but not assume that inversion is imminent.
2 Potential Developments That Could Spark a Market Correction in 2018:
1. Technology growth momentum stalls. Technology stocks have been market leaders for several years, and technology disruption isn’t going away. However, the high growth and margins enjoyed by technology companies may not last forever. A slowdown in growth, compression in margins, or threats from regulators could change the sentiment toward today’s technology leaders.
The slowdown in Netflix subscriber growth could prove to be more than a one-quarter phenomenon or content providers such as Disney could chip away at the Netflix business model. Facebook has already tumbled as a result of privacy-related changes to its model, and could be vulnerable to additional slowdowns in user growth or engagement. Perhaps investors will decide that profit margins do matter for Amazon, or that Amazon’s future growth is worth less in a rising interest rate environment. Tesla stock has already fallen from favor, as investors try to digest the company’s production challenges and periodic erratic behavior of founder Elon Musk. Although technology companies may be vulnerable to a market correction, the technology sector in 2018 is vastly different than the technology sector of 1999, so investors hoping for a dot-com type meltdown are likely to be disappointed.
2. Trade tensions turn into a trade war: Trump’s trade threats frustrate many Investors, and his stated beliefs about trade are contrary to conventional economic wisdom and historical experience. Trump’s trade approach may be more influenced by politics than by economics, as trade protectionism is a political winner among his voter base. Consumer price increases and supply chain disruption are potential consequences of a trade war, and protectionism could conceivably create more new jobs for robots than people. The indirect impact on business and consumer sentiment from tariffs could be far more harmful than the direct impact on economic growth.
The consensus earlier this year was that tariff threats were part of Trump’s “Art of the Deal” approach to governing, and that he would ultimately agree to a set of compromises on trade. The market is less convinced about that consensus today. In one analyst’s words, “voters are a constraint against a quick deal.” Absent a rise in unemployment or an economic slowdown that changes voter support for trade actions, Trump is likely to keep trade policy in the headlines. The risks associated with trade conflict garner more attention, but the less likely (but possible) scenario in which tariffs and market barriers are reduced would be a favorable development.
Agile investors may be able to take advantage of short-term dislocations caused by lower probability risks such as “Italexit.” Developments that are more noise than news may create trading opportunities. In contrast, newsworthy developments in the technology sector and trade policy may provide important signals for the future path of equities.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA Charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.