Apr 05, 2018
It was the third quarter of 2015 that stocks last turned in negative returns, triggered by recession fears and collapsing oil prices. While this quarter’s market decline of 1% – 2% came amidst stronger economic trends and positive earnings news, the modest loss masks a 10% correction from the January highs.
Following a year where little went wrong for stocks, markets are struggling with a normalization process in U.S. monetary policy and increased sensitivity to political risks. Neither necessarily impairs what should continue to be a positive backdrop for stocks. They do, however, bring increased uncertainty and a change to what investors have grown accustomed to.
Key Storylines for the First Quarter
Stock market volatility returns with a vengeance
The market calm of last year is gone. In its place is a market that on occasion seems unhinged, subject to wide swings both lower and higher. No single catalyst appears to be behind these moves. Explanations have centered on rising interest rates, tariffs, fading tech sector leadership, historically high valuations for risk assets, and quant-driven trading.
Some of these triggers are new, some aren’t. Behind these factors, though, is something larger that has led to a less stable environment – the transition to a more normalized economic growth outlook.
Out is the so-called “Goldilocks” economy, where years of sluggish growth, low interest rates and Central Bank accommodation created an environment conducive for cash around the world to flow into stocks. What’s in is a more normal mid-to late-cycle environment with a healthier economy, accompanied by the likelihood of rising interest rates, firming inflation, and the gradual unwinding of the Fed’s easy money policies.
This changes the Fed’s role from that of a suppressor of volatility and safety net for stock prices to a watchdog responsible for protecting the economy from overheating. Markets see risk that the Fed will overplay their hand and hasten the end of the growth phase of this business cycle. Increased volatility reflects this uncertainty and the reality of a broader range of outcomes.
Trade policies in play
The Administration’s approach to negotiating new trade policies has created uncertainty in the markets, even though this has been a key part of the Administration’s policy platform. In reality, neither the U.S. nor China wants to end up in a full blown trade war. For now, we expect markets will continue to react to the headlines as this process plays out, which could certainly take a while. Increased risk notwithstanding, we do not preclude the possibility that our trade deals actually end up in a better place as a result.
While not a function of trade, we wanted to make a brief comment about fiscal policy. Not that we are surprised, but we note the lack of visible angst over our current deficit spending and longer-term debt accumulation. Passage of the recent Omnibus budget bill was a relative non-event from the market’s view, but the longer-term implications of this spending behavior cannot end well. We understand why politicians do not want to talk about this since the reckoning will be on someone else’s watch, but we expect at some point the markets will make this a current issue.
Technology sector leadership fades
One of the more significant developments over recent weeks has been the rotation out of large cap technology stocks. This sector has been the driving force behind the outperformance of growth strategies and recently made up the largest sector of the S&P 500 with a 25% weighting.
We made reference to the FAANG stocks (Facebook, Amazon, Apple, Netflix, and Google) in our Investment Update last quarter, noting their popularity and disproportionate contribution to investment returns. We also acknowledged that the relevance of this acronym will hold up as long as the stocks continue to act in unison.
That appears now to be breaking down. The data privacy controversy around Facebook has made it the poster child for all that is wrong about social media. Spillover sentiment has infected other tech-related names, including Amazon contending with direct attacks from the Administration. The key question for investors is whether data abuse issues lead to new regulatory restrictions, antitrust sentiment, and enough pushback from loyal users to impair their respective, very profitable business models.
These are highly complex issues that will take time to sort out once the headlines move on to something else. Two observations to take away:
- A correction in these names and other Tech leaders, for whatever reason, seems overdue. That said, investors will be hard pressed to find alternative investments with stronger balance sheets and similar revenue growth, cash generation, and earnings growth potential. As FAANG breaks down, each company needs to be evaluated relative to its own exposure to the broader concerns referenced above and its own value proposition at a given price.
- This setback underscores what can, and often does, happen to the most loved investment ideas. Before the fact, it is difficult to foresee where a problem could take root. In the case of big tech, there have been signs of a building backlash in and outside the U.S. toward the size and power of these corporate behemoths. All that was needed was a story of substance to galvanize this sentiment. Whether Facebook’s mistakes are one of naive mismanagement or blatant betrayal of their users’ trust may, in the end, matter less than the realization that something like this could actually happen.
A correction and the return of highly volatile markets were not necessary to appreciate the investment environment of the last couple years, but we should neither be fearful of the environment ahead. Markets are moving back toward normalcy. No assurance of what that exactly looks like today, but we expect it will include increased volatility, a period of lower prospective returns, and a likely a shift to more value-style driven performance.
Higher volatility notwithstanding, we do not believe the bull market is over, though the same may be said for the correction. We believe the positive prospects for the economy and corporate profitability will be an important backdrop as markets deal with trade issues, tech sector rotation, Fed policy, and fiscal policy. Nine years of an economic recovery does not make the end of the business cycle or bull market imminent, though it does make you think that you should be able to see it from here.