2/26: Powell Hawksih testinomy

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1 What a roller coaster ride the market has been in the first quarter (Figure 1)! After the S&P500 reached all time high at 2873 on 1/26/2018, it promptly dropped more than 10% on 2/8/2018 due to inflation fear. Then after Federal Reserve increased Fed Fund interest rate by a quarter point at the FOMC meeting on 3/21/2018 and President Trump announced $60 billion China tariffs the next day, the market responded with a 5% drop in two days fearing tightening financial conditions and a potential trade war with China. On 3/26/2018, Dow staged a 670-points rally, the third biggest point advance in history, only to see tech stocks sell off more than 3% the next day due to regulation fears following the Facebook privacy scandal. The S&P500 finished the quarter with -1.21% return ,873 1/26: Inflation Fear Fear of Missing Out 2,581 2/26: Powell Hawksih testinomy 3/21: Interest Rate Increase 3/22: Tariffs 3/28: Tech selloff 3/26: China and US are negotiating Figure 1: SP500 Performance in 2018Q1 Sources: S&P Dow Jones Indices In the meantime, volatility came back with a vengeance as we predicted in our 2017 Q4 report, VIX doubled for the first time in its history on 2/5/2018 and finished the first quarter at a longterm average of 20, in contrast to sub-10 readings in During the beginning of February, the velocity of volatility selling funds such as billion dollar LJM funds (lost 80% of its value in two days) and rapid machine trading caused a panic for the market. As scary as it was while it was happening, this market volatility is not anything out of ordinary as shown here in Figure 2. The daily average of S&P 500 up and down moves for 2018 is 0.88%, almost three times of 2017 which was 0.30%, second lowest in history. To put it in perspective, the daily average of S&P500 of last 58 years is about 0.67%, 25% lower than this year s number. If anything, the

2 volatility is just a reminder that the calm investors experienced in 2017 was not a norm, rather it was the exception. Market drawdowns or panic-selling are part of equity market. 2.0% 1.74% 60% 1.5% 1.0% 0.5% 0.0% -0.5% -1.0% -1.5% -2.0% 0.26% Average Daily Movement (Left Axis) 40% 0.88% 20% 0.30% 0% -20% -40% -60% Max Drawdown (Right Axis) Figure 2: Daily average of S&P 500 up and down moves and Intraday year max drawdown Sources: S&P Dow Jones Indices The 10% market drawdown is not anything new either as seen in Figure 2. Since 1996, the S&P500 on average experiences a 7%+ intra-year drawdown every year except for The average yearly max intra-year drawdowns are about 13% for the last 60 years. Midterm election years are always volatile as well as shown later. From 3/12/2018 to 3/25/2018, the S&P 500 finished below the midpoint of its intraday range for a 10th straight session, an unprecedented streak of weakness which signaled a shift in the prevailing mentality among investors: for years, every dip in the S&P 500 was met with torrid buying that pushed the index back to fresh highs in no time. As we turn our attention to second quarter of 2018, is this an indication of death for the nine-year bull market? Let s look beyond headlines and exam the main drivers of the stock market: the economy, a potential acceleration in rate hikes and political uncertainties including escalating trade tensions. Economy: Earnings are still strong, as the 2017 S&P500 per share Q4 earning was $34 per share which is a new high. Projected 2018 Q1 earning is $35.81 as of March 8, a 6% increase from estimate of $33.64 at end of 2017 due to analysts incorporation of tax cuts benefit. The projection for all of 2018 is $156, a 25% increase from 2017, an 8% increase from year end estimate. (Figure 3)

3 03/31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /31/ /30/ /31/ /31/ /31/ /31/ /31/2016 3/31/2017 3/31/2018 3/31/ 标普 500 每股的盈利 2017 Q4 Figure 3: SP500 Quarterly earnings from (Actual in Blue, Estimate in Brown) Sources: S&P Dow Jones Indices Markets are a function of reality meeting expectations. It is tough to know how much all these strong earnings have already been priced into the stock market. If corporations fail to deliver on the high expectations, the market price would have to adjust. Historically, analysts tend to lower their earnings estimate getting closer to the actual dates. That being said, 2018 is a very notable exception and is the biggest upward EPS revision on record (Figure 4). Even with the revised higher EPS, market valuation is high with forward PE at 16.7, which is higher than the 5, 10 and 15-year historical averages. While high valuation has no predictability of short term market returns, a stretched valuation does make the market vulnerable to extern shocks as we witnessed in the past two months. It is also remained to be seen how the Facebook data scandal will impact the high-flying technology sector earnings and regulations going forward. Technology is about 27% of the S&P500, and its performance would have an outsized impact on market returns.

4 Figure 4: Consensus Estimates for S&P 500 Operating Earnings per Share by Calendar Year Sources: Standard and Poor s, Ned Davis Research In the meantime, even though the fundamentals of the U.S. economy are still strong, it is sending mixed messages. Job creation has been robust, but surprisingly weak retail sales and housing reports have prompted economists to downgrade forecasts for first-quarter GDP growth. When Mr. Powell gave his optimistic outlook to Congress, the Atlanta Fed s nowcast of first-quarter GDP was running above 3% annualized. It is now just 2.4%, having briefly been above 5% in January. The synchronized global growth that made everyone so positive earlier this year is showing signs of strain. Economic data has been coming in well below forecasts in the Eurozone, with industrial production and inflation disappointing, and the soft survey data also worse than expected. It is no catastrophe, but forecasters were too optimistic about the pace of improvement. A similar message is coming from the commodity markets. Industrial metals prices have fallen this year after a big run-up last year, supporting the idea that investors were overoptimistic about economic growth and global demand. While all of these are not indication of recession, it could bring further softness to the stock market. Financial Conditions: New Federal Reserve Chairman Jerome Powell was welcomed to the new job with a 4% market drop, which is not too surprising given the past stock performance under new Fed chairpersons as we mentioned in our 2018 outlook. Financial conditions are still very accommodating, and in fact the conditions are even looser than December 2015 according to NFCI (Figure 5) when the Fed started the rate increase. The financial conditions tightened at the end of January due to the fear of high inflation. On

5 3/21/2018, Fed officials said they would increase their benchmark federal-funds rate to a range between 1.5% and 1.75% and penciled in a total of three rate increases for this year. Comparing with December, more officials think they will need to raise interest rates at least four times this year if the economy performs in line with their expectations. Some seven of 15 participants now expect at least four rate increases this year, an increase from four of 16 participants at the December meeting. Chairman Powell sounded hawkish by pointing out that a tight jobs market, strong economic data, expansion around the world and President Donald Trump s tax cuts all supported the idea that headwinds have shifted to tailwinds for the US economy. The Federal Reserve signaled it could lift the interest rate at a slightly more aggressive pace in coming years to keep the strengthening economy on an even keel. Unemployment is at 4.1% which is about 0.6% below the non-accelerating inflation rate of unemployment (NAIRU) estimated by U.S. Congressional Budget Office. According to the standard macroeconomic theory, inflation will tend to rise when the unemployment rate falls below the natural rate. If the inflation picks up later this year, Fed will have to raise interest rates faster than the stated three times. This would cause investors to express concern if the Fed is behind the curve and whether inflation will be a runaway problem. Figure 5: NFCI Source: Federal Reserve One of the stress signs is the London interbank offered rate (LIBOR), one of the most globally significant numbers in finance. Banks, financial institutions, and credit agencies all over the world look to LIBOR to set their own interest rates. There are currently outstanding contracts worth trillions of dollars spread across different maturities from overnight to 30 years that all reference the benchmark LIBOR. It rose to 2.31% on 3/29, the highest since 2008 (Figure 6). In addition to the fact that that the Federal Reserve is tightening policy, the surge could be mostly due to technical explanations: the deluge of Treasury-bill issuance since the U.S. debt ceiling was raised in February and the U.S. tax overhaul with spurring expectations that companies will shift funds from longer-dated commercial paper and other securities as they prepare to repatriate cash. If the Libor blowout has more room to run, investors will have to contemplate if this is a flashing warning signal like it was during the credit crunch or the European sovereign debt crisis.

6 Potential Stress?. Figure 6: 3 month LIBOR Source: Bloomberg Another potential trouble sign is the flattening yield curve, the difference between the 10-year yield and 2-year yield is 50 bps now. Recent recessions were all preceded with inverted yield curve, even though it could be months even years away. Political uncertainties: Mid-term election years have been the weakest of the four-year presidential cycle for the stock market, on average even though recent mid-term years have not been as weak. Mid-term years have tended to endure elongated corrections in Q2 and Q3 before a Q4 rally (Figure 7). The correction that began on January 26 was earlier than normal, but not as severe as the median mid-term decline. The implication is that there could be more weakness later in the year before a year-end rally. Regardless of which party, or whether the president s party is new to the White House, the general pattern during midterm years has been the same: a choppy beginning to the year, an elongated mid-year pullback, and a year-end rally even though the magnitude has differed.

7 Biggest Corrections In Mid-Term Election Years (Dow Jones Industrial Average) Year President Party New Party? Correction Start Date Correction End Date % Change 1902 T. Rooseve R No 4/24/ /15/ T. Rooseve R No 1/19/1906 7/13/ Taft R No 12/31/1909 7/26/ Wilson D No 10/10/ /25/ Harding R Yes 10/14/ /27/ Coolidge R No 2/11/1926 3/30/ Hoover R No 4/17/ /16/ F Roosevel D Yes 2/5/1934 7/26/ F Roosevel D No 1/11/1938 3/31/ F Roosevel D No 1/5/1942 4/28/ Truman D No 5/29/ /9/ Truman D No 6/12/1950 7/13/ Eisenhowe R Yes 8/20/1954 8/31/ Eisenhowe R No 2/4/1958 2/25/ Kennedy D Yes 12/19/1961 6/16/ Johnson D No 2/9/ /7/ Nixon R Yes 1/5/1970 5/26/ Nixon/FordR No 3/13/ /6/ Carter D Yes 9/8/ /14/ Reagan R Yes 1/4/1982 8/12/ Reagan R No 9/4/1986 9/29/ G.H. Bush R No 7/16/ /11/ Clinton D Yes 1/13/1994 4/4/ Clinton D No 7/17/1998 8/31/ G.W. Bush R Yes 3/19/ /9/ G.W. Bush R No 5/10/2006 6/13/ Obama D Yes 4/26/2010 7/2/ Obama D No 12/31/2013 2/3/ YTD Trump R Yes 1/26/18?? 2/8/2018?? Median: All Mid-Term Years Apr-02 Aug Republican Apr-17 Aug Democrat Feb-09 Jul New Party Feb-26 Aug Figure 7: Biggest corrections in Midterm election years Source: S&P 500 Dow Jones Indices Potential trade war: On 3/22/2018, President Donald Trump announced a threat of tariffs on $60 billion of imports and tighter restrictions on acquisitions and technology transfers. The move followed previously announced tariffs on global imports of steel and aluminum, although the administration is negotiating exemptions on those duties for many of its closest allies. As of now, it seems U.S. is using tariffs as a negotiating tool, while the U.S. and China are actively talking to reach an agreement. While the direct effects of the new tariffs on the U.S. economy are likely to be small, tariffs create winners and losers and if retaliation escalates, it could have broader implications for U.S. growth and key trade relationships. A full-blown trade war looks very unlikely at this point, but that does not mean the rhetoric coming out White House will not cause further turbulence in the stock market.

8 With strong economic fundamentals, contained inflation and recession probably low, the current volatility in markets is not a warning of a bear market, it's just volatility. As shown in Figure 8, without recession and an aggressive Fed, it is unlikely we will have a bear market, but with all the uncertainties, volatility is likely here to stay. There were two very important things happened in March in the 21st century, March 2000 was the beginning of end for tech bubble that brought down the longest bull market that had run for 10 years. March 2009 was the beginning of the current bull market. What will this past March bring to us? We will wait and see Market Peak Figure 8: Past 10 bear markets and cause Sources: S&P Dow Jones Index Bear Market Macro Environment Bull Markets Duration (Months) Commodity Spike Aggressive Fed Extreme Valuations Bull Begin Date Bull Return Duration (Months) Market Corrections Bear Return Recession 1. Crash of Excessive leverage, irrational Exuberance Sep-29-86% 32 Y Y Jul % Fed Tighting - Premature Policy Tightening Mar-37-60% 61 Y Y Mar % Post WWII Crash - Post-war Demoblization, Recession Fears May-46-30% 36 Y Y Apr % Flash carsh of Flash Crash, Cuban Missile Crisis Dec-61-28% 6 Y Oct-60 39% Tech Crash of Economic Overheating, civic unrest Nov-68-36% 17 Y Y Y Oct % Stagflation - OPEC oil Embargo Jan-73-48% 20 Y Y May-70 74% Volcker Tigherting - Whip Inflation Now Nov-80-27% 20 Y Y Y Mar-78 62% Crash - Program Trading, Overheating markets Aug-87-34% 3 Y Aug % Tech Bubble - Extreme Valuations,.com boom/bust Mar-00-49% 30 Y Y Oct % Global Financial Crisis - Leverage/Housing, Lehman Collapse Oct-07-57% 17 Y Y Y Oct % 60 Current Cycle Mar % 108 Average -45% % 54 Authored by Weiqing Dong - Head of Research Buckingham Global Advisors wdong@buckinghamga.com