Weighing Trade Concern Against a Backdrop of Fiscal Stimulus
S&P 500 earnings growth has been booming thus far in 2018. In Q1, earnings gained 14.8% year-over-year and are forecast to grow by 20.3% in Q2, as opposed to Q2 2017. Much of the boom in earnings is coming from the December tax cuts, however, the economy continues to expand, even accelerate. Based on their latest data, the Atlanta Fed reports a real-time estimate for Q2 GDP. They call it GDPNow. On June 6th, it projected 4.5% real GDP growth after stripping out inflation, which they are currently tracking at 2.3%. Strong economic growth tends to manifest itself in higher top line sales growth, and that’s precisely was has happened. Sales growth has accelerated 3.3 percentage points in the past year, an indication that the strong earnings environment is about more than tax cuts alone.
Despite the robust earnings environment, the Business Roundtable CEO Economic Outlook fell for Q2, representing its first decline in seven quarters. Uncertainty around trade, particularly the implementation of tariffs, has caused some anxiety among CEOs, but for now, we would categorize tariffs as “noise” rather than “news”. The actual news is the injection of fiscal stimulus, which is picking up the slack for the removal of the Fed’s monetary stimulus. Tax cuts, government spending and repatriation of overseas cash are all working to provide economic support.
The chart below from Strategas Research Partners quantifies the drag from tariffs and contrasts it to the injection from fiscal policy. Thus far, tariffs are estimated to subtract $120 billion from an estimated $800 billion in fiscal stimulus. That means that tariffs are likely manageable for now, especially given the positive momentum in the U.S. economy.
The verdict from the market itself has been mixed. Companies with heavy revenue exposure to Mexico have underperformed this year; however, companies with higher exposure to China have done relatively well. The risk of a breakdown of NAFTA negotiations is being priced with the expectation for long-lasting damage in trade with China. North American countries have a complex supply chain, particularly in the automotive and electronics industries. Should NAFTA break up, it’s likely that those supply chains will be disrupted, resulting in higher prices.
It’s entirely possible that the “noise” will turn into “news” in the future. But for now, the economy remains on solid footing, potentially accelerating. While the Fed continues to remove stimulus, the fiscal environment is becoming more accommodative. The earnings environment is quite positive. Equities have not made much headway despite the fundamental improvement. The effect has been to alleviate lofty valuation pressures. For now, trade tensions are simply adding a brick to the “wall of worry.” We continue to expect a positive year for risk assets, albeit with higher volatility.
What Is News or Noise?
Like most of you, we are inundated with information on our phones, in our email inboxes and on the Internet. Clearly, the world doesn’t need another investing blog to reprocess stale information or reformat the day’s useless headlines. Thus, in our investment blog, News or Noise, we’ve taken up the challenge of sorting through the infinite bits of background noise and seeking the few truly newsworthy nuggets of information. What are the stories today that are likely to be meaningful for investors in the future? A very small number of headlines are important, and of those, many are immediately processed by investors. Only a tiny fraction of all the new data is truly relevant and underappreciated.