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  • Stocks suffer worst week in two years.  Tariffs, rate hike, Facebook scandal.
  • The market decline in perspective.
  • Powell press conference: we like his style so far.
  • Optimistic earnings estimates threatened by tariff retaliation?
  • Defense spending boosted in budget compromise.
  • Trade worries likely to dominate the holiday-shortened week.

Stocks suffer worst week in two years.  Tariffs, rate hike, Facebook scandal.

Few things went right for the markets in the latest week.  First, tech stocks were hurt by the Facebook privacy scandal, opening the door to increased regulation of social media firms, as well as EU proposals for a 3% digital tax on U.S. tech giants (Apple, Google, Facebook, Amazon and Twitter).  More broadly, the Federal Open Market Committee (FOMC) raised short term interest rates, boosting headwinds to stocks and bonds.  In addition, China announced initial retaliatory measures in response to the Trump tariffs, which introduced uncertainty about optimistic sales and earnings forecasts.  Finally, early economic reports in the EU dipped from recent highs.

The S&P 500 lost -5.93%, pushing the first quarter performance into negative territory (-2.76%).  Technology stocks took the biggest hit losing -7.87% followed by financials (-7.21%), but all eleven sectors fell.  Small-caps, international and emerging market stocks also declined but by a lesser degree.  Analysts noted that trading volume was relatively light, and most of the market weakness tended to come in the final hour of trading, suggesting a lack of buyers more than a surge of sellers.

The market decline in perspective.

The S&P 500 closed the week at 2588.26, slightly above the 2581.00 low on February 8 but down -9.91% from the January 26 closing high.  A “retest” of the February low was expected by many market technicians, including Via Nova, and so was not completely unexpected.  Importantly, the S&P 500 closed nearly on top of its 200-day moving average, which has been widely viewed as the bottom channel in the current bull market.  So, while market confidence is being tested, technical support levels are holding… for now.

While one might expect a rush to bonds in an uncertain environment, the yield on the 10-year Treasury note barely budged for the week, slipping to 2.83% from 2.85%.  Treasuries and Treasury Inflation Protected Securities (TIPS) gained a bit, but corporate credit spreads widened, causing modest losses in corporate and high yield bonds.  The Bloomberg/Barclays U.S. Aggregate Bond Index was down -2.08% year-to-date.  We would note that, despite the turmoil of the week, the yield on the 10-year Treasury remained in the 2.80%-2.90% range since the beginning of the year.  In other markets, oil and gold prices rose, but real estate and the value of the dollar fell.

Powell press conference: we like his style so far.

Jay Powell is different.  Listening to Chairman Powell on Wednesday afternoon, we were reminded of the famous Alan Greenspan quote from 1987, when he said, “If I seem unduly clear to you, you must have misunderstood what I said.”  Jerome Powell, an attorney by training, delivered what we considered a relatively direct, unpretentious and efficient press conference with no glaring stumbles; no “rookie mistakes.”  He did not try to hide behind theory or jargon and avoided the false sense of precision often ascribed to economic theory.  Key points from the FOMC meeting:

1.      The FOMC raised the target federal funds rate a quarter percent to 1½%-1¾%, as expected.  The vote was unanimous.  “We made one decision in the meeting,” said Powell, focusing on the day’s decision to raise interest rates.  He defused persistent questions about the evolution of the individual forecasts, commonly referred to as the “dot-plots.”

2.      The economic and interest rate projections from the various members edged higher, in aggregate, while the projected unemployment rate fell, with surprisingly little change in the inflation forecast.  Seven of 15 participants now expect four rate hikes in 2018 compared with four of 16 at the December meeting.  Futures markets are now pricing a 40% chance of four increases this year.  Bond yields finished the session largely unchanged, however, despite the more optimistic projections.

3.      Powell said the effects of the fiscal stimulus would likely increase income and confidence and, hopefully, boost capital investment which typically leads to higher productivity, but he offered no definitive expectation or model on how that might play out or how long it might take.

4.      The Chairman dismissed questions asking him to speculate on the impact of a possible trade war, instead emphasizing the FOMC’s dual charge of maximizing growth and employment while keeping inflation stable.

5.      Powell understands the economic theory and the literature, but he also looks at the hard data.  He expressed some surprise that the large job gains and significant drop in the unemployment rate in the current expansion have yet to significantly boost wage growth, in reference to the Phillips Curve tradeoff.  “You've only seen very gradual upward pressures on inflation and wages despite that very large increase [in employment].  And, that suggests that the relationship between changes in slack and inflation is not so tight.”

Optimistic earnings estimates threatened by tariff retaliation?

Thomson Reuters estimates that S&P 500 operating earnings in the first quarter will increase 18.4% from a year ago (up from 18.2% the previous week), and surge 19.7% for all of 2018.  After the stock market drop over the past couple of weeks, the price/estimated earnings ratio (forward P/E) fell to 16.7 from over 18.  While earnings forecasts remain quite healthy, the unknown effects of any global trade tariffs appear to be weighing on market confidence in these rosy estimates.

Defense spending boosted in budget compromise.

After considerable wrangling, the Congress passed, and President Trump signed, a $1.3 trillion spending bill, but not without some last-minute tension, threats and politicking.  As is often the case in election years, the compromise involved spending on many diverse items.  The spending bill boosts defense spending by $80B and domestic spending by $63B above limits set in 2011, as well as $1.6B for a border wall with Mexico and $100M for autonomous car research and testing.  The bill averted another government shutdown and keeps federal agencies funded until Sept. 30.

The increase to the federal deficit is a growing concern to financial markets, but on the positive side, government agencies will now be able to return to a more normal procurement process compared with the series of continuing resolutions.  The increase in defense spending will be a positive for many industrial firms, including those that build ships, planes and tanks.

Coming Week: Trade worries likely to dominate the holiday-shortened week.

We will see data on personal income and spending in the final week of the first quarter, but the focus will be on tariff retaliation.  Continued high market volatility is likely.  Will technical support levels hold?