What surprised us most about the stock market strength in 2017 was the way investors completely ignored the daily deluge of potentially disruptive moves out of the Trump administration that normally might have been expected to make investors more nervous.  From fights with supposed partners such as the EU and Canada to geo-political risks on the Korean peninsula to allegations about the involvement with Russians and their online influence on election results to constant turnover in the West Wing to sexual bribery allegations to potential government shutdowns over budget fights and a debt which exceeded US$20 trillion, investors just went on their merry way, taking no notice of all this noise and focusing instead on the potential benefits from deregulation and the tax cuts that finally got passed late in the year.  But this has all changed in 2018 as the news out of Washington is having an economic impact.  What really weighed on the stock market was the escalation of the trade wars, notably with President Donald Trump calling for tariffs of $200 billion of imports from China, on top of the levies on $50 billion already announced.  Trump also threatened 20% tariffs on European autos.  This is a completely different story than the press scandals of 2017 because it undercuts one of the key tenets of the stock market strength, that being the strength of the U.S. economy and the consequent strength in corporate profits.  The bottom line is that when the Washington headlines begin focusing on economic and profit issues, then investors begin paying attention!

While stocks started the year strongly, the sharp sell-off in early February was the first 10% correction seen in stocks since the 2016 Presidential election.  The trigger for the initial sell-off was some wage pressures seen in the monthly U.S. employment numbers.  This heightened fears about more aggressive interest rate increases by new Federal Reserve Chairman, Jerome Powell.  Since that initial decline, we have seen stocks rally towards the old highs numerous times only to fall back each time to those February lows, but not break below them.  We saw another such failed rally in June which erased most of the 2018 gains once again.  So stocks have clearly defined a trading range over the past five months, with the market unable to break through to new highs but also with the lows holding on three separate occasions.

Our view is still that stocks will break below those February lows at some point this year as investors become disappointed with economic and earnings growth.  Our cautious outlook is based on a few trends we continue to see.  We don’t think the ‘synchronous global economic recovery’ story that seems to be the accepted consensus of investors is quite as solid as it was in 2017.  The rising U.S. dollar is putting pressure on emerging market currencies in much the same way as we saw during the Asian currency crisis in 1997.  This has lead to capital outflows and rising interest rates in key emerging economies in Europe, Asia and South America.  The Chinese stock market entered official bear market territory in June as the Shanghai Composite Index dropped more than 20% from its January highs and has fallen over 12% since May, just when the ‘tariff talk’ with the U.S. began to heat up.

Outside of emerging markets, we have also seen weaker economic data in the developed world with Europe and Japan seeing slowing growth.  While nothing close to recessionary levels, we believe we have seen the ‘high water mark’ for economic growth in those economies for this cycle.  We are also wary of the steps that had to be taken to get economic growth moving higher again and move stocks to record levels.  Debt is at record levels and monetary stimulus has been exhausted so the central bankers of the world have basically ‘run out of ammunition’ to further stimulate economic growth without lighting up inflationary fears.

More importantly for stocks though, the liquidity that has been the greatest source of financial market strength over the past five years is being slowly withdrawn.  The U.S. is the only one taking interest rates higher for now but we also expect the EU to start reducing their quantitative easing programs later this year.  Rising oil prices, rising labour costs and a higher U.S. dollar are also starting to raise input costs and reduce overseas sales for most of the large multinational companies that make up the S&P500 Index.  This will begin to impact profit growth just as the benefits of the tax cuts are starting to wear off.  We expect profit growth to slow down to under 5% by year end.  Higher inflation will also keep upward pressure on interest rates, which should also reduce the earnings multiple for the stock market as a whole.  This could be a particular problem for the higher growth/higher valuation stocks such as Amazon and Netflix since their future earnings will have to be discounted at a higher rate, which leads to a lower valuation.  It is basically the unwinding of what has buoyed stocks higher in a slow growth environment.

Trade and other tensions not going unnoticed by Canadians.  Every week, Nanos Research asks 250 Canadians for their views on personal finances, job security, the outlook for the economy and where real estate prices are headed.  The overall index plunged to 55.3 in the week ended June 22, which is the lowest weekly level since 2016.  The 1.8 point drop is the largest since Nanos began weekly polling in 2013.  While all four questions have recorded a deterioration in sentiment over the past two weeks, the biggest drop has been in the outlook for the economy.  The share of Canadians who say they expect the economy to get stronger over the next six months dropped to 14.7%, the lowest since 2015 when Canada suffered a technical recession.  The share of Canadians who see the economy weakening jumped to 38.2%, the highest since 2016.  The drop reflects the deterioration in U.S.-Canada relations, which have rarely been more strained.  Prime Minister Trudeau’s closing press conference at the G7 summit June 9 sparked outrage within the Trump administration after the PM said the U.S. decision to impose tariffs on Canadian steel and aluminum on national security grounds was “insulting.”  Consumer confidence measure such as the Nano Indicator can be a good barometer of an economy’s overall health and the spat with Trump is fuelling concern when households are already uneasy about their prospects.

Canadians are not the only ‘former friend’ of the U.S. facing conflicts with the new administration as key EU leaders, among others, continue to face criticism from President TrumpBut the U.S. might have to be careful about who they pick these fights with as all indications are that they will need the goodwill of foreign entities in some matters.  With U.S. debt now exceeding US$21 trillion and rising at an escalating rate, America is becoming more and more dependent on foreign investors to fund this shortfall.  However, Trump’s trade tactics and the resultant conflicts with their major trading partners could be putting some of that ongoing support at risk.  Foreign governments pulled back their purchases of longer-term U.S. debt as trade tensions escalated around the world.  One of the most glaring declines has come from Russia, which sliced its holdings of U.S. debt nearly in half from March to April, falling from $96.1 billion to $48.7 billion.  In all, foreigners held $6.17 trillion of the total $14.84 trillion of Treasury debt outstanding through April.  Russia isn’t the only country cutting back in its U.S. holdings.  China, the largest owner of U.S. debt, reduced its level by $5.8 billion in April to $1.18 trillion, while Japan, the second largest, cut its holdings by $12.3 billion to $1.03 trillion.  Ireland, the U.K. and Switzerland also pulled back.  With the budget deficit expected to rise in coming years — passing $1 trillion in 2020, according to CBO estimates — the government has been issuing debt heavily.  The total for 2018 has been $443.7 billion, a 139% jump from 2016.  The U.S. may have to start ‘making nice’ again if they want to fund these deficits.  Otherwise interest rates will likely also have to rise further to attract this capital.

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