As of 9/12/2018
- The U.S. stock market posted its best summer performance (May through August) since 2009
- Investors largely ignored trade tensions and instead focused on solid economic data
- Consumer confidence levels and labor conditions are in the best position in decades
- When U.S. stocks trend high this late in the year, they tend to sustain their momentum through year-end
- Tariffs, uncertainty around mid-term elections and rising U.S. interest rates could increase market volatility
- The U.S. stock market will likely continue to outperform the rest of the world through 2018
Data Source: FactSet
The consequence of American strength
Unquestionably, the U.S. is outperforming the rest of the world this year. Earnings are stronger, labor conditions are better, consumer confidence is higher, and the U.S. is experiencing tailwinds from fiscal stimulus and a Federal Reserve confident enough to slowly increase interest rates. While it is reasonable to expect some U.S. stock market volatility as we move through the rest of the year, the economy should continue with its momentum, in our view.
Historically, when U.S. stocks are up this much this late in the year and are notably outperforming international markets, these trends continue through year-end.
In our view, the largest causality of this current round of “American exceptionalism” can be found in emerging markets. What started as a stock market sell-off in Turkey and Argentina, has spread into larger developing economies such as Indonesia, South Africa, Russia, Poland and Mexico. Taken in total with equity declines across China this year, investors are looking for less risk by reducing exposure to emerging markets as growth concerns and currency issues have led to less positive sentiment.
Conversely, U.S. stocks continue to trace all-time highs. This is, in part, because global investors typically view the U.S. as a safer port in the storm during times of economic stress.
Global volatility due in part to a stronger U.S. dollar
Around the world, several countries are struggling to boost their economies. South Africa is in a recession and Turkey, Argentina and Indonesia are on the cusp of one because of surging inflation and severe economic conditions. Higher dollar-denominated debt levels across emerging markets are becoming a larger concern as the U.S. dollar continues to strengthen.
According to the Bank of International Settlements, the amount of dollar-denominated debt (debt issued in U.S. dollars by other nations) across emerging markets has more than doubled over the past decade to $3.7 trillion.
The U.S. Dollar Index is up more than 3.0% this year and has risen almost 7.0% since its February low.1 If the dollar continues to rise versus other currencies, emerging market debt in U.S. dollar terms will become more expensive and exert increasing stress on highly indebted nations and corporations.
Unless the Federal Reserve chooses to scale back its current money-tightening policy (perhaps due to the impact of trade issues) we expect interest rates to rise in the U.S. through the rest of the year. This could contribute to tighter U.S. financial conditions, continued strength in the dollar and increased pressure on emerging markets.
Investors shouldn’t ignore the risks
Despite significant concerns, new tariffs implemented by the White House have not knocked the U.S. stock market off its stride. The next round(s) of tariffs imposed on China will likely be harder for investors to discount. When U.S. stocks were at lower levels, it was easier for investors to brush aside trade issues because their corporate/economic impact was muted. Will the next round of tariffs be as benign?
The potential tariffs targeted against $200 billion in Chinese imports are four times larger than what is in place today and will affect far more consumer products. The next round of tariffs could also force a larger swath of companies to reevaluate supply chains and prices, particularly if the tariffs are more lasting. Considering the current high level of U.S. stock prices, we can’t rule out a modest pull-back if trade tensions heat up.
In our view, another round of tariffs could more negatively impact investor sentiment.
If the White House decides to further press tariffs on an additional $267 billion of Chinese goods, essentially all imports from China to the U.S. will be taxed with a tariff. This would escalate tensions and potentially slow growth to a degree that is not yet fully reflected in stock prices.
Secondary market concerns for U.S. stocks include the potential negative impact of a strong dollar on multi-national corporate earnings, the mid-term elections and interest rate/inflation movements.
U.S. markets remain well positioned for now
Importantly, positive fundamental developments in the U.S. this year, combined with more protectionist policies from the White House, give America a perceived edge in the eyes of investors. At the same time, these factors introduce more economic uncertainty in almost every other part of the world.
Potential volatility in U.S. equities aside, we believe this dynamic will continue over the near-term. It is likely that even with the potential for some market volatility, U.S. stocks could continue to outperform those of the rest of the world in the near term. Given the market’s continued run-up in 2018, it may be a good time to have a discussion with your financial advisor about how your portfolio is positioned.
As of September 12, 2018
Data source: Morningstar Direct
1 Market Watch, “U.S. Dollar Index,” https://www.marketwatch.com/investing/index/dxy