Halfway through a troubling year
U.S. stocks are up, even as much of the world suffers, but there are reasons to be wary
Almost everything on the list of investor concerns at the start of the year has come true — yet U.S. stocks are up, even as many of the world’s markets suffer. Investors shouldn’t expect this American exceptionalism to continue.
The main worries in January were rising Treasury yields, a too-good-to-be-true world economy, Donald Trump’s policies, the return of volatility and European politics. All have taken a turn for the worse, hammering assets in each area, but leaving the U.S. equity markets miraculously unharmed.
The first-half gain of 1.67% in 2018 was truly unusual: The S&P 500 has swung up or down by less only five times in the first half of a year since 1963. Those smaller moves weren’t propitious for investors, led by the calm of the six months to June 2015, just before China’s devaluation sparked widespread concerns about its economy and a10% correction in the S&P.
The other calm periods look like a roster of times to sell: June 2000, shortly before the dot-com crash spread into the wider markets; June 1990, the last month before a recession; June1978, two months after the inflation that would ravage real portfolio valuations began to accelerate; and June 1965, which was followed by a brief boom before the1966 bear market (a decade later the S&P was still at the same level as in June 1965).
There is nothing in a sixmonth change that would matter to statisticians, so this may well be nothing more than luck. But there are reasons to be concerned, and they are mainly the same reasons that held at the start of the year.
The first is the Federal Reserve. Investors think it has become more hawkish, with the probability priced into federalfunds futures of a total of four rate rises this year up from 9% in January to 41% on Monday, according to CME Group. Treasury yields have risen too, and even worse is that the link between stocks and bonds seems to be breaking down.
In the past two decades higher yields have typically been strongly tied to rises in stocks, as a stronger economy pushes up both. This year so far the six-month correlation of daily changes in the S&P and the 10year Treasury yield, a formal measure of the link, is just 27%, half the level of a year ago. If it breaks down further, higher bond yields could be bad for stocks, as happened briefly in February.
The second is the global economy. At the start of the year, hopes for global growth were high, and investors became overconfident. Hope ran far ahead of reality, and European, Japanese, Chinese and other emerging-market data came in well below expectations while economists upgraded their forecasts for U.S. growth. The rise in the dollar should help narrow the economic divergence, by hurting U.S. exports and foreign profits of U.S. multinationals, and there has been some disappointment in the U.S. data already, if minor so far.
The third risk is from Mr. Trump’s trade war. At the start of the year the political focus was on the beneficial effects for investors of Mr. Trump’s corporate-tax cuts, but his trade policies are detested by markets. New tariffs contributed to China’s bear market, and U.S. companies are just beginning to warn of profit hits from retaliatory tariffs and supply-chain problems.
“As investors we have been long global trade for three decades,” says Pascal Blanqué, chief investment officer at France’s Amundi Asset Management. “We are moving into an era of dominance of politics over economics.”
The fourth risk is the return of market volatility. Last year was extraordinarily calm for equities, bonds and currencies, with the Cboe Volatility Index, or VIX, reaching new lows. But volatility has risen, and the Cboe’s VVIX index, a measure of swings in the VIX itself, had its highest average over six months in more than a decade. If the VVIX moves indicate a broader rise in volatility ahead, that will hurt stocks.
Finally there is European politics. Italy’s general election always threatened to deliver a win for populists, but the eventual coalition between populists on the left and right spooked markets. European stress over immigration is spreading, with the leader of Germany’s junior coalition partner offering to resign this weekend and political opportunists taking advantage. Investors in the U.S. are reasonably insulated from day-to-day politics in Europe, but 2012 demonstrated that if troubles become serious in Europe, Wall Street will suffer, too.
Why are U.S. markets taking it so well?
Part of the answer is that investors aren’t pricing in much of a drag from the rest of the world, wrongly in my view. But another part is the enthusiasm for big technology stocks, almost all of which are listed in the U.S. The big gains in Amazon, Apple, Microsoft, Netflix, Facebook, Nvidia and Alphabet in the first half accounted for the entire gain in the S&P 500, according to S&P senior index analyst Howard Silverblatt. Their momentum may keep them going for a while yet. But if Big Tech stumbles, the U.S. stock market may not prove so exceptional after all.