In the second quarter, US equity markets followed a now familiar trajectory. The S&P 500 Index closed at a new high on 30 April, buoyed by a de-escalation in trade tensions and rising expectations that central banks will ease policy to support slowing growth globally. In May, a flurry of action on trade, including a breakdown in US-China negotiations and threatened tariffs on imports from Mexico, led the price of the S&P 500 Index to decline by 7%. Finally, the price of the Index gained 4.3% for the quarter (17.3% for the year-to-date), as the immediate trade threat receded and the Federal Reserve signaled a dovish pivot.
In the near term, our view is that trade and monetary policy will continue to dominate the market narrative, while escalating tensions with Iran will be another flashpoint to watch. News on trade has become more positive again—potential tariffs on Mexico were suspended; Vice President Pence’s second hawkish “China speech” was delayed; and Presidents Trump and Xi are talking rather than ratcheting up trade barriers and confrontational rhetoric. However, further escalation still remains likely, and we continue to believe that markets underestimate both the breadth of the administration’s actions and its willingness to follow through on threats.
Similarly, expectations for easier monetary policy are high, with fed funds futures pricing nearly three Fed rate cuts by year end on the back of dovish “Fedspeak” and new projections showing that seven of 17 Federal Open Market Committee (FOMC) meeting participants expect two rate cuts in 2019. As a result, the yield curve has inverted more deeply and bond and equity markets are sending different messages about the economy, with sovereign yields falling as stock prices rise (see chart).
We continue to believe that the case for rate cuts is weaker than markets imply, but that the threat from protectionism is more serious. US and global growth have slowed, but this was widely anticipated, in part due to fading US fiscal stimulus and efforts to rebalance the Chinese economy. Despite this deceleration, our outlook for the US household sector remains solid, which should support real GDP growth as it returns to levels more in line with potential. Some of the more pessimistic market views likely reflect a pronounced slowdown in the industrial economy, which has gone through several cycles since the global financial crisis, even as consumption has sustained overall economic growth.
Indeed, upside surprises in first quarter GDP growth in a number of major economies suggested that headline data could stabilize. However, that was before the latest trade threats. Our concern now is that the continued overhang of unpredictable US trade policy is undermining corporate confidence and could slow investment and hiring decisions if it escalates, with larger economic impacts than trade volumes alone would suggest.
The implications of this mixed outlook for US equity investors is that, in our view, they should remain invested, but concentrate their capital in companies with high sustainable returns on capital that trade at attractive valuations. We acknowledge that recent policy volatility and share price moves have made attractive valuations harder to find, but fortunately in a market with thousands of choices, stock pickers can always build a portfolio of stocks with appealing risk/reward characteristics. Bonds appear rich (yields are too low and spreads are too tight). While equities appear expensive relative to history, we continue to view them as cheap relative to fixed income. Given the risky environment, attractively valued companies with the ability to compound earnings are likely better able to defend than are companies with weaker competitive advantages or more expensive valuations.
The preceding is an excerpt from our Outlook on the United States. Read the full paper.
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