What is driving volatility in the equity markets? A case of the two-footed driver
Remember drivers’ education? We were taught that, when driving an automatic transmission vehicle, you only use one foot. Your right foot operates the accelerator and the brake. Your left foot just goes along for the ride. Have you ever seen a driver, after leaving a stop at an intersection, accelerate with the brake lights on? That is a two-foot driver.
Two-foot driving explains the situation driving the economy and the recent stock market action. We have several forces attempting to accelerate economic growth and corporate earnings and, at the same time, we have many forces tapping the brakes.
President Donald Trump has his foot on the accelerator. He is an advocate of economic growth by providing stimulus, spurring job growth and corporate earnings.
Recent fiscal stimulus and lower corporate tax rates punched the accelerator
Stimulus boosted real gross domestic product (GDP) to more than 4 percent in the second quarter and we expect more than 3 percent growth in the third quarter. This is positive for corporate profits and has driven up stock prices. We expect the U.S. economy to grow approximately 3 percent in 2018, then slow to 2.5 percent in 2019.
Lower corporate tax rates pumped up earnings. S&P 500 earnings are expected to be up 25 percent in 2018, propping up stock prices. The concern over 2019 earnings growth, which may only be in the 5 to 10 percent range, is causing the market to pause.
These are highly correlated to capital expenditures and share buybacks. Capital expenditures and share buybacks are up 20 percent and 80 percent, respectively, this year. Both have historically been shown to be drivers of future earnings. At the end of the day, earnings drive stock prices.
Around the world, low interest rates have led to synchronized global growth. As global economic growth expanded, large multi-national companies made money, supporting increases in stock prices. The synchronized global growth theme is now waning, bringing equity valuation into question and causing volatility.
President Trump and the Federal Reserve (Fed) are tapping the brakes. While the President has his right foot on the accelerator, he also has his left foot on the brake.
The President’s trade policy and tariffs
These are creating uncertainty, increasing costs and potentially creating inflation. He may be attempting to correct unfair trading practices, but his actions are akin to having his foot on the brake.
A trade war with China could trim 0.5-1.0 percent off U.S. GDP and negatively impact corporate earnings 3-5 percent.
Potential inflation increase
Unemployment is at 3.7 percent and expected to move lower. Slack in the labor market is dissipating. Historically, every time the unemployment rate moves below 4 percent, there has been a meaningful change in inflation. Average hourly earnings are up only 2.7 percent, however, and the core personal consumption expenditures (PCE) index (the Fed’s favorite inflation barometer) has been stuck at approximately 2 percent for the last six months.
Earnings are expected to slow in 2019
Corporate earnings growth has gone from the accelerator to the brake pedal. Earnings growth in 2018 will be close to 25 percent. The market, being a discounting mechanism, now looks to earnings growth in 2019. With fiscal stimulus less impactful, earnings growth in 2019 is now in question, pumping the brakes on stock prices and valuations.
The Parking Brake
Perhaps the Fed gets a bad rap. They are always blamed for ending an economic expansion by hiking interest rates. There is an adage on Wall Street that says, “Bull markets don’t die of old age, they are killed by the Fed.”
The Fed and inflation
The Fed has the brake lights on. Historically, the Fed has been data dependent. It appears that the new Fed chairman, Jerome Powell, is managing short-term interest rates on the idea that inflation and economic hyper-growth is imminent, even though the readily available data may not support that thinking. The Fed has communicated its plan of hiking rates, one more increase this year and three more next year, taking the Fed Funds rate to 3.25 percent by the end of 2019.
If the Fed continues to hike rates with no supporting economic data, there will be downward pressure on stocks. If the economy heats up, corporate revenues and earnings should continue at a robust pace, supporting stock prices. If the Fed hikes rates too fast and too far, they put the economic expansion in park. All this creates volatility in equity markets.
The Road Ahead
When driving a car, if you have one foot on the accelerator and one foot on the brake, it results in a lot of wear and tear on the vehicle. In the economy, if you have one foot on the accelerator and one foot on the brake, it results in volatility in the financial markets.
This two-footed driving situation is one we expect to see for the remainder of 2018 and into the beginning of 2019. We remain cautiously optimistic on risk-based assets. We think the economic expansion and corporate earnings will continue to support higher stock prices.
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