Assessing the road ahead after a turbulent first quarter
The first quarter of the year has ended with major developed market indices down slightly and major emerging market indices up slightly. But those numbers belie a very turbulent period in which stocks were whipsawed. Bonds also experienced gyrations, with the yield on the 10-year US Treasury moving from 2.41% at the start of the quarter to a peak of 2.94% and ending at 2.74%1. As we begin the second quarter, there are five critical things to watch.
1. Global growth
In my recent travels, one question that keeps coming up is whether recent global stock market weakness is foreshadowing a global economic downturn. My base case scenario is that, while risks are growing, I believe growth accelerates from here. This view is supported by recent economic data for most major economies, as well as the Organisation for Economic Cooperation and Development’s upward revision to its global growth estimate for 2018. However, we will need to follow economic data closely given the rising risks, which I will discuss below.
2. The dot plot thickens
The March US jobs report will be released April 6 and is expected to show the creation of significant nonfarm payrolls — and it could even show a further reduction in the unemployment rate. But most importantly, I believe it will show an increase in average hourly earnings. That may be a catalyst — especially if supported by subsequent data showing higher wage growth — for the Federal Reserve (Fed) to raise rates more than three times this year. Recall that the Fed released a revised dot plot in March that showed no change to the Federal Open Market Committee’s (FOMC) policy prescription for 2018 — but significant changes for 2019. However, I believe that if economic data is strong enough at some point this year, which seems likely, the FOMC will revise that dot plot up to four rate hikes this year. We need to be prepared for markets to react negatively to the adjustment — especially if the yield on the 10-year Treasury remains near recent levels.
3. Debt affordability
As borrowing costs rise, debt is becoming a bigger concern for consumers, businesses and the government. In its most recent Global Financial Stability Report, the International Monetary Fund has warned about the growing debt overhang occurring in different economies2. The US ran a budget deficit of 3.5% of gross domestic product (GDP) last year, which was the highest of any industrialized nation other than Japan, and that deficit is expected to increase this year3. This only adds to the US’ overall government debt, which was at 78% of GDP in net terms as of Dec. 31, 20173. It currently takes a significant 8% of US government revenues to service the US’ outstanding debt, but with debt growing and, more importantly, rates rising, Moody’s estimates that this will increase to a whopping 20.4% by 20274. Contributing to the problem is that the average term to maturity on US debt is under six years5 (well below other developed countries such as the UK), meaning that most of the US’ lower-yielding bonds must be exchanged for more expensive debt in the next five to 10 years, further raising future interest costs. This problem is not isolated to the US and may have negative effects on debtholders in any economy raising rates. For example, Canadian homeowners may come under pressure given that they have either adjustable rate mortgages or short-term fixed rate mortgages that must be refinanced in the next decade.
4. Protectionism persists
This past weekend, China announced that retaliatory tariffs on 128 goods constituting about $3 billion in US imports would be implemented starting April 2; many agricultural products will be affected by these tariffs. Also over the weekend, US President Donald Trump once again threatened that the US will walk away from the North American Free Trade Agreement, tying the issue to the building of a wall between the US and Mexico. Some economists have downplayed the importance of the tariffs announced thus far; however, I would caution against dismissing them. Protectionist actions could easily multiply quickly as rhetoric amps up. In the meantime, we should follow closely the Economic Policy Uncertainty Index. Interestingly, despite significant deregulation in the past year, economic policy uncertainty has actually increased recently — and I suspect the current protectionist fervor has played a role. Historically we have seen an inverse correlation between economic policy uncertainty and business spending, so we will want to follow this metric — and corporate spending plans — closely.
5. Tech trauma
The technology sector posted poor performance in the last two weeks of March, which helped drag down the overall stock market. This is quite a reversal of fortune, as the tech sector has been a key driver of strong stock market returns in recent years. While I believe tech sector underperformance is likely to continue in the shorter term, I remain positive on the sector as fundamentals remain strong. According to FactSet Research Systems, the technology sector is expected to report the third-highest (year-over-year) earnings growth of all 11 sectors at 22.0% for the first quarter. At the industry level, all seven of the industries in the tech sector are expected to report positive earnings growth, with growth for five of these seven predicted to be in the double digits. And for calendar year 2018, the technology sector is projected to have the second-highest revenue growth of all sectors6. Admittedly, it is difficult to anticipate what regulations will ultimately look like and therefore how much they will impact revenues. However, I believe that regulations are unlikely to ruin business models and that tech companies are a critical part of the future of the global economy.
In summary, the Ides of March may be over, but I expect more volatility ahead. We will need to keep our eyes on the key risks to my positive base case scenario for global growth in 2018. In this environment, opportunities to add exposure to risk assets at more attractive values will likely present themselves. At the same time, I believe it’s important to ensure broad diversification, including adequate exposure to alternative strategies with low historical correlations to equities and fixed income.
1 Source: Bloomberg, L.P.
2 Source: IMF Global Financial Stability Report, October 2017.
3 Source: Congressional Budget Office.
4 Source: Moody’s Investors Service, “Preeminent Financial, Economic Position Offsets Weakening Government Finances,” February 2018.
5 Source: OECD Sovereign Borrowing Outlook 2018.
6 Source: FactSet Research Systems, March 30, 2018.
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