CAPTRUST Chief Investment Officer
“George Washington is the only president who didn’t blame the previous administration for his troubles” (Anonymous)
So far, 2018 has proven to be a year of extremes. We followed up last year’s global stock surge with a continuation of the rally in January as U.S. stocks added another 7.5 percent. We then experienced a significant market pullback that ushered in a period of volatility that has persisted since. Several potential catalysts for this volatility exist—North Korean nukes, trade tensions with China, and turmoil in Washington among them. One—or all—of them, plus a few others, could be the culprit.
Nonetheless, it is important to recognize that the period of relative calm we experienced over the past two years is unusual. Stock market investors should expect a 10 percent pullback at some point during most calendar years—even if the markets post gains for the year. As we look forward to the rest of 2018, we believe that the key to investment success will be maintaining perspective about two key drivers. We foresee first, a strengthening economy; second, higher volatility triggered by headlines from Washington, D.C., and increasing interest rates.
Midterm Election Blues
2018 is a midterm election year. Historically, the performance of the U.S. stock market in midterm election years is characterized by a volatile first three quarters and a rewarding fourth quarter, as Figure One demonstrates. It is not unusual for the markets to experience intra-year declines of between 10 to 18 percent from peak levels in the early and middle part of midterm election years.
Figure One: Average S&P 500 Performance Following Midterm Elections (Since 1994)
This year, through March 31, the stock market has already declined about 10 percent from its intra-year high in late January—although given the substantial appreciation we saw early in January, the stock market declined a little less than 1 percent in the first quarter. The good news is that the heightened volatility leading up to elections in the fall is frequently followed by a rally over the next 12 months.
Fewer, but More Passionate Voters
We expect dramatic headlines will continue to emanate from our nation’s capital. Headlines might feel stronger than normal because the political parties are intent on getting out the vote. This can be an important challenge in midterm election years. As Figure Two below shows, recent midterm election voter turnouts have been nearly 35 percent lower than the 2016 presidential election voter turnout.
Figure Two: Voter Turnout in Recent Elections
Experienced politicians understand that they must appeal to their party’s base to incentivize turnout. It is the passionate believers who come out to vote in midterm elections. Therefore, both parties will reduce their desire to appeal to the more moderate middle and increase their messaging to their core voters. For this reason, political and policy headlines will seem more extreme than they would during a presidential election year when the more moderate middle must be won.
More Thunder Than Lightning
Mark Twain once said: “Thunder is impressive, but it is lighting that does the work.”
Although we expect more strident headlines—some of which will roil the market—overall, we are confident about the U.S. stock market in the longer term because it is resting on a solid economic foundation.
Let’s review the misery index. This gauge of economic strength is calculated by adding the unemployment rate and the inflation rate. As Figure Three demonstrates, in the late 1970s, when the inflation rate was over 15 percent and unemployment exceeded 7 percent, consumers had good cause to feel miserable. The late 1970s saw a misery rate of more than 22 percent before the index began declining in the 1980s.
More recently, it spiked to 12.5 percent in late 2009 as a result of the financial crisis. Today it is just over half that number, at 6.3 percent.
Figure Three: U.S. Misery Index (1960-Present)
The headlines have been filled with talk of tariffs lately. Tariffs—or worse, a trade war with China or another major trading partner—could certainly put a damper on the economy since the tariffs raise the prices of imported goods. But we are not overly concerned about tariffs for several reasons.
First, a quick primer on tariffs and why they matter.
A tariff is a tax. Let’s walk through an example. If the U.S. exports an automobile to Germany, Germany adds a tariff equal to 10 percent of the vehicle’s purchase price. This tax increases the sales price of a U.S. car to a German consumer. German car companies benefit because they can price their cars higher than if there were no tariff imposed. Interestingly, when Germany exports an automobile to the U.S., the U.S. imposes only a 2.5 percent tariff. Meanwhile, China imposes a 25 percent tariff on U.S.-made automobiles.
While we take the tariff talk most seriously, we want to highlight that the tariff amounts under discussion are much lower than recent stimulus. The Tax Cut and Jobs Act should increase incomes to consumers by $100 billion this year. It should increase income to businesses by nearly the same amount. On top of this, substantial increases in government spending could add another $100 billion of stimulus to the economy.
Even if the tariffs amount to $100 billion, that amount would be just one-third of the $300 billion in stimulus. In sum, the stimulus should be more than enough to counterbalance proposed tariffs and still propel the economy to stronger levels.
Even so, some political observers believe that President Trump remains interested more in having other countries lower their tariffs than in the U.S. imposing higher tariffs. It may turn out that negotiation tactics are more extreme than the result.
So far, headlines have been large enough to generate the photo opportunities necessary in a midterm election year. But details have been less consequential. For example, the announcement of steel tariffs listed many countries, including the five largest exporters of steel to the U.S. Less than a month later, four of the five countries had been taken off the list.
The administration’s trade policy could become as strong as steel, but the first act does remind some of Swiss cheese—a solid surface but with many holes in it. This is a pattern that we expect to repeat.
Consumers account for two-thirds of all economic activity—with government and businesses contributing the balance. And they feel confident today. Because of lower tax rates, after-tax income has increased—for many—by as much as 3.5 percent. In addition, working consumers saw an average wage increase of 2.5 percent from their employers. This 6 percent increase in income this year is the biggest raise for consumers in the last 15 years.
In addition to higher incomes, consumer confidence has been boosted by home prices, which are up 5.5 percent over the past year. Home equity is the largest asset for most Americans. Consumers are also comforted by the low levels of unemployment and the relative ease of finding a job. Lastly, increased confidence has been boosted by an increase in retirement savings accounts due to stock market appreciation.
The result is a level of consumer confidence not seen since before the financial crisis. Figure Four shows consumer confidence as measured by the University of Michigan Consumer Sentiment Index. This index peaked at just 100 under in 2005, plummeted to 60 in the depths of the recession, and is now above the prior peak.
Figure Four: University of Michigan Consumer Sentiment Index
While some may worry that the stock market has peaked and begin to fixate on the next slowdown, we highlight that the economy remains sound. In addition to consumer strength, high levels of corporate profits, aging equipment, and attractive incentives for corporate reinvestment provided in the recent tax deal, all argue for increased capital spending, which should extend the business cycle. It would prove very abnormal for a recession to begin with increasing corporate profits and high levels of consumer sentiment.
More Midterm Mania?
Just several months ago, most of the market-leading, so-called FAANG stocks—Facebook, Amazon, Apple, Netflix, and Google—enjoyed light government regulations and high levels of consumer trust. These two positives contributed to the high price of earnings valuations ascribed to these firms. This has changed for now.
During the Obama administration, some felt that banks and energy firms were special targets for increased regulation (and, therefore, carried lower price-to-earnings valuations). Meanwhile, the Trump administration appears to be targeting tech and social media firms. The President has tweeted about both Jeff Bezos’ ownership of the Washington Post and Amazon’s package delivery deal with the U.S. Post Office. Recently, other politicians have grown concerned with the use of Facebook user data in recent elections. Both Google and Facebook have decided to hire more non-revenue-producing workers to verify the appropriateness of content and news stories.
A recent Reuters survey indicated that more than one-half of Facebook users do not trust the company with their data. Facebook CEO Mark Zuckerberg testified before Congress and may be called upon to do so again. The FAANG companies have responded to the threat of increased regulation by hiring more lobbying firms. Figure Five shows the increase to 58 from 44 lobbying firms in the last year.
Figure Five: Technology Company Lobbying Spend
Why is this important? The FAANG stocks have been large contributors to overall stock market gains and the outperformance of growth stocks compared to value stocks. Increased political interest in regulating these firms and decreased public trust could well be passing fancies. But we are focused on this situation and its potential impact on market levels and value stock valuations (relative to growth stocks).
In summary, we believe that investors should stay the course despite the bouts of volatility they are likely to experience. It will be important for them to retain perspective this year and remember that the economy is strong and getting stronger. While the headlines can be dramatic in an election year, as always, we believe that a well-diversified portfolio is the best preparation for increased volatility and that investors are rewarded for maintaining a long-term investment horizon.