Fears over Trump’s trade wars add to turbulence

US markets reached record highs in 2017, buoyed by a growing economy and the Trump administration’s promises of tax reform and deregulation. But 2018 has seen a more bumpy ride so far, volatility returning with a jolt in February, while president Donald Trump’s recent talk of trade tariffs and protectionist tendencies have unnerved markets, as have his threats of increased regulation for tech firms. 

With the US in the latter stages of the economic cycle, is now the time for investors to favour other markets, or does all this uncertainty provide a buying opportunity? 

There are reasons for “cautious optimism” going forward, believes Scott Malatesta, senior product strategist for the BlackRock North American Income Trust. He points to rising consumer incomes in the US, along with household balance sheets which are in a better place than they have been for a long time, along with the stimulus from tax reform and the rebuilding from last year’s natural disasters. 

“As terrible as events such as the California fires and the hurricanes were, you also then have the rebuilding process which has to take place and creates a stimulus effect,” explains Mr Malatesta. 

Nevertheless, he is cautioning investors to temper their performance expectations this year. “We think the equity market may have 6 to 8 per cent going forward, so not as strong as it has been, but good when you compare it with other asset classes.”

Treading carefully

Despite an equity bull market that delivered a “perfect year” for the S&P 500 in 2017, equity investors have remained cautious, believes Alexandra Coupe, associate director at California-based institutional investment firm PAAMCO. “We haven’t seen the psychological exuberance that has characterised prior bull markets,” she says. “Part of the reason investors haven’t gone gangbusters is that there is a lingering concern about a successful handoff from monetary stimulus to fiscal stimulus.” 

President Trump’s tax cuts helped to alleviate that concern, adds Ms Coupe, but ongoing uncertainty about global growth, inflation, geopolitical tensions and the potential for a trade war are likely to keep investors treading carefully.

Although there were pockets of extreme losses as a result of recent market fluctuations, an uptick in volatility is really more of a return to a normal market environment, she believes. “The quiet of the past couple of years was more abnormal than the recent market activity.”

Although there have been some “pretty strong” growth forecasts for the year ahead, much of that has already been priced into the market, claims Eugene Philalithis, portfolio manager of the Fidelity Multi Asset Income fund. He has been underweight US equities, recently, predominatly because of valuations.

“On a number of measures you could argue the market is looking fully valued, though not outrageously expensive. And we see better value in other markets. We like Europe and Japan.” 

When you take the US equity market as a whole, and then factor in company fundamentals, a picture emerges of a stockmarket that is well positioned, but not without risks, believes Grant Bowers, vice president and portfolio manager at Franklin Templeton. 

Innovation is really driving this market, he explains. “This is about the proliferation of technology into non-traditional areas such as retail, energy, industrials, everything from factory automation to healthcare and drug development.” 

These changes and developments are leading to increased efficiency and profitability, says Mr Bowers. “That is a big part of why we are so positive as to what is coming down the road in 2018 and even into next year.” 

Technology is the largest sector in Mr Bowers’ portfolio, as his team seeks to identify businesses with multi-year growth prospects because of dislocations and changes being played out. Cloud computing, artificial intelligence, big data, robotics and factory automation are all trends which Franklin Templeton is looking to profit from. Valuations in these sectors can be high, but looking at the longer-term picture and their growth potential, “that gets us excited”, says Mr Bowers.

The influence of technology is a reason for optimism as regards company earnings growth, says Kera Van Valen, fund manager at New York-headquartered EPOCH Investment Partners. “Tech can help companies become more efficient and more profitable,” she explains. “You need to invest less hard cash up front and it can help generate cash flow.”

The shift from quantitative easing to tighter monetary policies will mean markets are less driven by central bank actions, says Ms Van Valen, rather fundamentals will be of increased importance. “This can mean increased volatility and that means you need to be more selective. It is not the time to just play the whole market.”

Trade disputes

Donald Trump was elected off the back of a promise to put “America First”, and a central tenet of this has always been to address what he perceives to be the “unfair” balance of trade. On the campaign trail he repeatedly promised to renegotiate trade deals and impose tariffs, and while the first year of his presidency saw little movement in this area, 2018 has been a different story so far, and the markets do not like it.

On March 8, the president signed an order calling for a levy of 25 per cent on steel imports and 10 per cent on aluminium. This has been followed by a worsening tit-for-tat dispute with China, with both countries threatening to impose tariffs on the other’s products. Just what does all this mean for the US, and indeed the global economy?

“Under Trump’s presidency, trade was always going to be a wild card given the president’s ability to act somewhat independently, unlike other areas which require legislation,” says Cormac Weldon, fund manager of three US-focused funds at Artemis. “Unequivocally, a significant, long-term trade war would be negative for all economies, although perhaps less so for the US given its size.” 

Mr Trump’s long-promised renegotiation of the North American Free Trade Agreement (NAFTA) in favour of the US would be highly disruptive to some US industries, including automotive, says Mr Weldon. But political realities, such as the agricultural Republican states which benefit from NAFTA and Mr Trump’s lack of a well-thought-out position, mean there will not be an extended or vigorous trade war, but rather sabre-rattling and in the end relatively little action, believes Mr Weldon.

When the two biggest economies in the world go head-to-head on trade, no one should be surprised financial markets do not like it, says Joseph Amato, CIO equities at Neuberger Berman. What we are seeing now could just be a noisier, more public version of the give-and-take that has always characterised US-China economic relations, he explains, but warns that trade tensions are unlikely to ease in the near term. 

“The rising tide of economic nationalism is likely to be a motivating theme in markets for the foreseeable future,” says Mr Amato. “There is scope for behind-the-scenes pragmatism while sabres get rattled in public, and that is probably the most likely outcome. But the fact is when sabres get rattled, blood sometimes gets spilled.”

Inflation risks

Increased levels of volatility in financial markets have meant worries over inflation have slipped to the back of investors’ minds in recent weeks, yet the surprise strength in US wage growth in February was one of the factors which led to this turbulence.

“If we see wages rise faster than expected, and corresponding inflation, we would have to believe that interest rates would move at a faster pace,” says Mr Bowers at Franklin Templeton. In February, investors who had been anticipating two, or maybe three, rate increases this year, started to predict three or probably four. “It sounds small but the reality is, that when interest rates rise, your valuation models and your discount rates, which you use to value equities, all have to adjust.”

The wage growth figures for March were more moderate than in the previous month, but if we see any further signs of inflation then markets may experience increased volatility amid expectations of further rate hikes, says Krishna Memani, chief investment officer at OppenheimerFunds. 

“It is imperative to watch the inflation data,” he warns. “Rate hikes are a blunt policy tool and anything that brings forward Fed tightening could curtail the cycle.” Mr Memani recommends avoiding the more interest rate-sensitive sectors, including utilities, and strategies that focus on higher dividend-paying companies, and favours international equities over the US.

Portfolio construction

For most of the past five years, Citi Private Bank has been overweight US equities, reports global chief investment strategist Steven Wieting, but this has now been dialled back to neutral. 

The US has led the recovery in global equity markets since 2009, and Mr Wieting still expects to see strong earnings per share growth this year, although there could be some contraction from previous levels. “US equities are stable compared with others, it is a higher-quality market, recessions are infrequent, inflation is nominal. So there are a lot of reasons to hold onto US equities.”

Yet valuations are high he says, and while the US is at a late stage in its economic cycle, in the rest of the world the recovery is less established. 

He points to the eurozone as an area where share prices are lagging economic fundamentals, and highlights opportunities in emerging markets. 

“Between those two, and a bit of Japan, it is very easy to construct a stronger portfolio. And by diversifying significantly we are reducing portfolio risk. Truly global recessions are rare. Most of the time they are very regional.”

The multi-manager team at BMO Global Asset Management is currently neutral in equities, and effectively underweight US equities, according to investment manager Scott Spencer. 

“In a nutshell, our underweight in US equities is down to valuations compared with the opportunities in other asset classes, be that emerging markets or Japan,” he says, adding that he does see opportunities in the US for bottom-up managers. BMO uses both active and passive funds, but has been activating the more active area of its portfolios in the last 12 months because it believes this is an environment for stockpickers.

“The underweight US is not necessarily an underweight on the US economy, it is more that we think there are better opportunities elsewhere,” says Mr Spencer. “But we are well aware that we are at the end of the party rather than at the beginning.”

But others believe now is the time to add exposure to the US. “The US equity market remains well positioned to outperform, in our opinion,” says Julien Lafargue, vice president European Strategies at JP Morgan Private Bank. 

Wage pressures are not building up as much as some feared, he explains, while the fundamental backdrop remains supportive with positive earnings revisions, gradually rising but still benign interest rates, a weaker US dollar and more reasonable valuations following recent corrections. 

“As such, we believe clients should continue to use the volatility to add exposure to the US equity market,” says Mr Lafargue, highlighting the financial, technology, industrials and healthcare sectors along with the M&A, Capex and buyback themes.   

VIEW FROM MORNINGSTAR: Tech stocks lose momentum as market falters

US equities have posted negative results thus far in 2018, with the S&P 500 index falling by 0.9  per cent in US dollar terms, making it the first negative quarter since 2015. This is a small loss when compared to other major equity regions, and it comes after an exceptional 2017 during which all major US indices recorded double digit gains. 

Concerns about a rapid rise in interest and inflation rates triggered a sharp sell-off at the start of February erasing gains achieved since the start of the year. Losses were extended into March driven by fears around Donald Trump’s tariff plans and increased need for more regulation for high-flying technology companies, exacerbated further by recent users’ data leaks at Facebook. 

Technology stocks, particularly Facebook, Amazon, Apple, Microsoft and Alphabet (the FAAMG group) which were star performers in 2017, have lost momentum. Given their dominant position in the index, returns from these stocks have explained much of the overall return from US equities over recent years. 

Declines in technology companies’ share prices have boosted short selling and overall market weakness has resulted in significant outflows from US equity funds. It is also worth noting that while US equities remain expensive, valuations have trended slightly lower lately, with the S&P 500 trading at a multiple of 20.8 times earnings. This stems primarily from the pullback in technology names.

The Silver rated Robeco BP US Large Cap Equities fund is managed by two investors, Mark Donovan and David Pyle, who have worked together since 2000. The duo is supported by a strong, broad bench of quant and fundamental analysts. They use a bottom-up approach combining quantitative and qualitative analyses to identify stocks with catalysts that can unlock value in the next year or two. 

The fund tends to trade lightly in the income-oriented telecom and utilities sectors, while favouring consumer discretionary, healthcare, and especially technology. The approach has resulted in strong outperformance over the long term.  

The Franklin US Opportunities fund has been managed by Grant Bowers since March 2007. The emphasis is on companies with high barriers to entry, competitive advantages, quality management and attractive valuations. Portfolio positioning has favoured consumer discretionary, healthcare and technology segments in recent years. 

Technology exposure was at its peak in October 2017, at 49 per cent of assets, providing a significant tailwind to returns in 2017.

Fatima Khizou, Analyst, Manager Research, Morningstar