The Return of Risk: Assessing Recent Volatility, Trade Tensions & The Long Expansion
May 7th, 2018
Following a relatively calm 2017, markets have encountered volatility this year that could even be characterized as above-average.
- Behind this volatility are investors’ concerns about the longevity of the expansion and, most recently, concerns surrounding trade policy and the potential for trade wars.
- The cumulative impact of trade policy changes should be rather small and not enough to derail the ongoing expansion so long as trade tensions do not escalate materially.
- Further, investors’ concerns about the age of the expansion are justified, but an important offset that reduces the risk of recession is the lack of accumulated excesses during the expansion.
- Investors should continue to position portfolios to participate in ongoing economic and profit growth, but should build in some protection given the modest rise in risk.
2017 was a calm year. Domestic equity markets delivered 20% returns that seemed to come in a nearly straight line. International equity markets gained more. So far, 2018 has been a much different experience (Exhibit 1). While most of January seemed to be a continuation of the 2017 rally, since January 26, the U.S. stock market has twice dipped into correction territory, marked by a 10%-or-more decline. Markets have seemed more focused on various risks to the expansion than the ongoing expansion itself.
EXHIBIT 1: Equity Markets Have Been on a Wild Ride This Year
Source: Glenmede, Factset Data through 04/24/2018 Data shown is the historical price of the S&P 500 Index. This represents past performance, which is not indicative of future results.
Volatility Back to (and Above) Normal
Putting recent volatility into context, one could even characterize 2017 as unusually calm and 2018 as exhibiting more normal or even above-normal volatility. The U.S. stock market typically experiences daily moves of 1% or more in either direction, about 60 times per year (Exhibit 2). In 2017, there were only eight such occurrences. Although we are through only a little over a quarter of the trading days this year, we’ve already seen 27 days with the S&P 500 moving more than 1%, and it won’t take much to reach the historical average. In fact, if the current pace were to continue, the total for the year would reach 100 trading days, quite a bit higher than the historical average.
EXHIBIT 2: Volatility Is on Track for an Above-Average Year
Source: Glenmede, Factset Data through 04/24/2018 2018 projected annualizes the results for 2018 year-to-date. Dotted line is the average since 1969. Projections are inherently uncertain and cannot be relied upon.
Tariffs and Trade War Worries
At the heart of this volatility has been a series of investor concerns, each of which is rooted in unease over the possible impact on the ongoing, long economic expansion. The most recent of these concerns surrounds trade policy. First, the administration announced steel and aluminum tariffs, which have since been watered down with exemptions for many of our major trade partners. The focus then turned to tariffs between the U.S. and China, sparking fears of a trade war between two of the world’s largest economies.
China has undoubtedly become an important partner to the U.S. since joining the World Trade Organization in late 2001. However, while many may joke about how consumer goods often have a “Made in China” tag, less than 8% of our total trade in goods and services is with China. That’s not an insignificant amount by any means, and China is our largest trading partner behind the European Union, but the size of the relationship may not be as large as some people believe.
The tariffs announced so far, in total, cover $124 billion of traded goods, a relatively small fraction of total U.S. trade (Exhibit 3). The big bar all the way to the right is the total amount of U.S. imports and exports, in billions of dollars. The little, blue highlighted section on the bottom is how much trade is done with China. The three much smaller bars on the left are the aluminum & steel tariffs, the U.S. tariffs on Chinese goods and China’s retaliatory tariffs. So not only can you see that China is a small portion of trade, but also that the goods subject to the recently announced tariffs are an even smaller sliver of the larger trade basket.
EXHIBIT 3: Tariffs Announced So Far Are a Small Portion of Total Trade
Source: Glenmede Factset, U.S. Census Bureau Data through 04/24/2018 *Includes Chinese response to steel and aluminum tariffs and proposed Section 301 tariffs. Data shown is the total value of imports and exports directly
affected by each tariff in isolation, from 2017 levels. Steel and aluminum tariffs include exemptions for Canada, Mexico, the European Union, South Korea, Australia, Brazil and Argentina.
Another way to look at this is to try to quantify the potential impacts of the tariffs on U.S. economic growth and compare that impact to other significant catalysts affecting the economy (Exhibit 4). The baseline estimates from economists for 2018 nominal GDP growth stood at 2.4% around November of last year. End-of-year tax reform boosted those expectations by approximately 0.5%. This increase, however, is offset slightly by an estimated 0.1% headwind from the Federal Reserve’s ongoing, gradual rate hikes and tightening monetary policy. The first-order effect of the announced tariffs, estimated by calculating the total value of tariffs paid relative to the overall economy, should similarly shave only 0.1% off of GDP growth this year. The perspective this crude comparison provides is that the announced tariffs are unlikely to change the story of economic improvement in 2018.
EXHIBIT 4: The Economic Impact of the Tariffs Appears Modest
Source: Glenmede, Cornerstone Macro, Blue Chip Economics, Estimates as of 04/24/2018
*Includes the impact of Section 232 steel and aluminum tariffs (with exemptions for certain countries), Section 301 tariffs against China and reciprocal tariffs. Assumes full-demand destruction from a tariff-induced price shock to quantify the hit to U.S. real GDP. Projections are inherently uncertain and cannot be relied upon.
Of course, this is not all of the story. The situation could spiral between the U.S. and China, reaching a full-blown trade war between the two largest contributors to global GDP growth. A plausible worst-case scenario could see the U.S. and China enacting 25% tariffs on all goods that flow between the two countries (Exhibit 5). In such a case, U.S. GDP would see a more meaningful headwind of nearly 1.0%, resulting in a slowdown of growth from the prior year.
EXHIBIT 5: The Risk Lies In an Escalation of the Trade War
Source: Glenmede, Cornerstone Macro, Blue Chip Economics, Estimates as of 04/24/2018
*Assumes a trade war escalates to encompass 100% of U.S./China trade at a 25% rate. Analysis assumes full-demand destruction from a tariff-induced price shock to quantify the hit to U.S. real GDP. Projections are inherently uncertain and cannot be relied upon.
There are, of course, far more moving parts than this rather simplistic analysis suggests. The impacts on individual industries and businesses will likely vary greatly, with some feeling the lion’s share while others go relatively unscathed. Even still, companies in either economy could shift their supply lines to other countries in order to evade the tariffs, since these are not unilateral against all trading partners. Such shifting would reduce the impact. On the other hand, a wild card in the outcome could be the reaction by businesses. Expectations have been that businesses will increase capital spending due to the tax law changes and improved economic prospects. However, trade policy uncertainty may prompt them to curtail, reduce or delay such initiatives.
Nonetheless, in aggregate, recent developments are forecasted to have only a modest negative effect on growth, not enough to meaningfully slow the expansion, assuming the situation does not escalate significantly from this base case.
The Long Expansion
Recent volatility seems to suggest that investors are nervous the economic expansion in place since 2009 could be nearing an end. Yet, it is important to evaluate the expansion and its sustainability on more than just its age. While long in years, the expansion has been relatively moderate, with cumulative growth over eight years matching levels reached after only four years of an average historical expansion (Exhibit 6).
EXHIBIT 6: Eight Years of Expansion Feels More Like Four
Source: Glenmede, FactSet Data through 04/23/2018
*Historical average reflects the average expansion since 1947, excluding the ‘80s double-dip recession. Series are indexed to 100 at the pre-recession base, the fourth quarter of 2007.
As a result of this modest growth rate, we have not seen the typical accumulation of excesses in the economic system. Excesses are economic activity that run meaningfully above more “normal” economic levels, such as over-spending by consumers, over-building by companies or the accumulation of too much debt. The theory is that recessions develop from accumulated excesses that revert as economic momentum deteriorates and even turns. The excesses provide the economy room to fall, resulting in the more noticeable recessions that inflict damage on businesses and investors. The lack of excesses has led the Glenmede Recession Model to foresee a low likelihood of recession.
Strategy: Invest to Participate and Protect
Overall, our base case is that the economic expansion will continue, with very little of the typical excesses that signal the end of an expansion, a still-ongoing relative boost from recent fiscal policy changes and only a marginal impact from trade policy. So, it makes sense for investors to keep a full weight in equities.
EXHIBIT 7: U.S. Equities Are Expensive, But Can Remain Expensive
Source: Glenmede, MSCI Data through 04/24/2018
Long-term fair value is based on normalized earnings, cash flows and book value using MSCI’s USA Index. Past performance is not indicative of future results. This is an unmanaged, total return index with dividends reinvested. One cannot invest directly in an index.
At the same time, valuations, particularly in the U.S., are a bit stretched (Exhibit 7) and inflation is accelerating marginally, putting pressure on the Fed to raise rates. There is also the possibility that the trade situation will deteriorate further. As a result of all of these factors, and perhaps in recognition that, as investors, we can’t perfectly forecast all of these risks, it makes sense to build in some downside protection. One of our preferred ways to do this is with defensive strategies within equities by investing in portfolios of stocks or companies that are inherently more stable than the overall equity market
What Should Investors Do?
On the margin, we are employing investment strategies within equities that favor smaller, more regional businesses, as we believe such investments are likely more insulated from trade disruption than their peers. Further, we still see pockets of relative value, particularly in international markets where valuations are a bit more attractive. We’ve been highlighting Japan in particular due to its ongoing efforts with corporate reform combined with attractive valuations.
Lastly, alternatives, such as absolute return or hedge funds, may be an effective way to control portfolio risk given they are less-correlated investments. At the same time, investors shouldn’t ignore bonds, which serve an important role in balancing out the risk in a portfolio.
By combining all of these items, our goal is to position client portfolios to exhibit some protection on the downside, but also to participate in the further upside that comes from an ongoing expansion.
EXHIBIT 8: The Near-Term Likelihood of Recession Is Still Low
Source: Glenmede Data through 03/31/2018
*The Glenmede Recession Model is a tool developed by Glenmede to help estimate the probability of a recession. The model is a well-balanced mix of long-term excess indicators covering manufacturing, employment, debt balances and near-term leading indicators covering monetary policy, credit markets, business sentiment, and other economic trends. Though created in good faith, there can be no guarantee that these indicators will be accurate.
The Glenmede Recession Model (Exhibit 8) is a balanced mix of various measures of economic excesses and a few forward-looking economic indicators, such as our own leading economic indicator (LEI). As shown, the model’s computed probability of recession within the next 18 months remains relatively low, a reflection in part of the lack of excesses in the economy, despite the length of the expansion. While this model might not be the perfect predictor for every cycle, it provides an objective measure and framework for thinking about the risk of recession. As a result, we will be monitoring it closely, while also keeping our eyes and ears open for excesses that are not yet considered in its framework.
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