EQUITIES COMMENT - "Tug-of-War" - Trade Noise and Inflation Fears Battle Strong Fundamenta
An eventful first quarter saw global equity markets tested by the struggle between strong fundamentals and fears of higher inflation and protectionism.
January Stocks reached record highs on the back of very strong earnings growth.
February A surprisingly high U.S. inflation reading shattered investor euphoria and stocks plummeted. Investors were no sooner reassured by lower inflation statistics and stocks were recovering when…
March … the U.S. implemented tariffs on steel and aluminum. As countries were exempted, stocks rose. Then, a series of tariffs announced by the U.S. and China pushed markets back down.
TSX Composite—three months ended April 9, 2018—Source: TMX Money
Trade Noise--How Serious Is It?
Tariffs are like an extra tax on imported goods. They increase inflation although changes in exchange rates can mute the effect. If we think of Walmart that sources many of the goods it sells from China, the cost of those goods increases. The result is shoppers buy less which hurts the economy. Walmart might not pass all the costs on so their profitability declines—negative for Walmart stock.
Economics 101 says protectionism has a negative impact on economic growth because it reroutes demand to less efficient producers and causes disruptions in supply chains. If Walmart decides to no longer buy certain goods from China because of the higher tariffs, it must find another supplier (who may charge a higher price) and set up production and shipping. This takes time and money that costs consumers and Walmart.
Let’s not forget many countries other than the U.S. are signing new trade deals such as the Trans Pacific Partnership.
The trade noise could have a good outcome if U.S. pressure forces China to open their markets to foreign companies with fewer strings attached (such as technology transfer).
We believe there is a low probability of a full blown trade war due to the economic damage it would cause and corresponding political suicide.
In February, U.S. economic statistics indicated inflation was increasing more than expected for wages and consumer prices causing bond yields to jump. Higher inflation is not too surprising with the U.S. unemployment rate at 4.1% (signalling a strong economy) and oil prices increasing to over $60 per barrel.
There is a risk of more negative inflation surprises due to higher U.S. government spending when unemployment is so low.
Trade tariffs would also be inflationary if enacted.
The U.S. Federal Reserve might have to raise rates more than expected to keep the economy from growing too quickly and sparking higher inflation. This could cause bond yields to rise to the point where bonds become more attractive than stocks.
Inflation pressures outside of the U.S. are subdued or contained.
Fundamentals for Stocks—Strong Enough?
The world economy is expanding at a solid pace with many countries experiencing stronger growth than in recent years.
Global corporate profits are slated to grow substantially this year and next.
Modest, albeit rising global inflation is reflecting the quicker expansion. Excess capacity in many countries should keep inflation contained.
Some governments are increasing spending; this will bolster economies especially in regions where growth is still depressed.
Monetary authorities are reducing stimulus; interest rates and bond yields are rising but remain at low levels.
Valuations have improved with stocks falling and earnings increasing.
The underlying fundamentals for stocks should be strong enough to support a continuation of the bull market as long as higher inflation is accompanied by robust economic growth.
If extensive protectionist trade policies are enacted (low probability), an economic slowdown accompanied by higher inflation would be a possible outcome. In such an environment, global equity markets would be less likely to forge ahead.
Outlook for the TSX—another Tug-of-War?
Our twelve month target for the TSX is 17,000 supported by powerful earnings growth and assuming higher bond yields—two important factors in determining fair value.
A “Made in Canada” discount is holding back the TSX. International and domestic investors are investing less in Canadian stocks due to:
Uncertainty surrounding NAFTA negotiations
Shortage of pipeline capacity and failure by governments to adequately address this
High level of consumer indebtedness
We believe the TSX could rally when NAFTA uncertainty is removed and if there is some progress on pipeline approvals (potentially in the second quarter). Although consumer debt levels are high, the carrying costs of that debt are very manageable given still low levels of interest rates. A tightly regulated domestic financial services industry, particularly in the mortgage space, also reduces the risk of severe negative economic fallout. Continued stellar earnings growth from the banks should help to put these fears at rest.
For patient investors, Canadian stocks offer good value and potential for higher returns if these “made in Canada” issues are resolved favourably.