Steel 232 232 Retaliation China 301 301 Retaliation (E) Tax Cuts Spending Repatriated Profits (E) M A R K E T P E R S P E C T I V E Keith Lerner, CFA, CMT Managing Director, Chief Market Strategist SunTrust Advisory Services, Inc. Outlook Intact, Despite Tariff Risk March 26, 2018 Our base case outlook remains unchanged. We came into 2018 anticipating modest equity gains and higher volatility. Geopolitical uncertainty was one of the main reasons we expected a bumpier path for the stock market this year. A full-blown trade war does not appear to be the most likely scenario, though it is a risk. The impact of tariffs announced so far is small at an estimated $36.5 billion relative to fiscal stimulus in the pipeline for 2018. The good news is this corrective period in stocks is helping to reset an overheated market. The S&P 500 s forward P/E has dropped from 18.5x in late January to 16.0x currently. Investor sentiment has also cooled from overly optimistic levels as evidenced by the demand to hedge against market downside reaching a two-year high on Friday. This along with back-to-back 2% down days, such as what we saw on Thursday and Friday, is consistent with what we have seen during other volatile bottoming processes over recent years and typically followed by strong market gains when looking out 12 months. While an escalation in trade tensions could lead to further market downside and will continue to dominate market direction near term, we have found it sensible to invest on a base case rather than a worst case scenario. Uncertainty has been the hallmark of this bull market, and each of the 16 pullbacks seen since 2009 has coincided with uncertainty and bad news. Over the past week, stocks suffered their worst decline in more than two years. Mixed global economic data, technology sector weakness driven by Facebook-related privacy concerns, and Federal Reserve policy uncertainty contributed to the pullback. However, the escalation of trade tensions appeared to be at the forefront of the selling as the Trump administration announced tariffs on China, sparking concerns of a broader trade war. The actual impact of overall tariffs announced so far is relatively small at $36.5 billion (for example, the announced 25% tariffs on $60 billion of Chinese imports equates to $15 billion), especially compared to the fiscal stimulus currently in the pipeline, according to Dan Clifton of Strategas. Indeed, tax cuts combined with the recently signed spending package should be roughly $300 billion. Moreover, there is an estimated $500 billion of profits to be repatriated from overseas. Figure 1: Size of Announced Tariffs is Small Relative to Fiscal Stimulus ($ Billions) Tariffs Estimated = $36.5 Billion 3.5 3 15 15 Fiscal Policy = $800 Billion 200 100 500 Data Source: Strategas, SunTrust IAG Calendar Year 2018; (E = Estimated) Investment and Insurance Products: Are not FDIC or any other Government Agency Insured Are not Bank Guaranteed May Lose Value 1
That said, the market is less concerned with current tariff estimates and more worried about the possibility of a full-blown trade war. This is a risk, but we do not view it as the most likely scenario. The White House has already softened its stance since the initial announcement of steel/aluminum tariffs, as many of the major exporting countries (though not China) were granted exemptions and there appears to be progress on the North American Free Trade Agreement (NAFTA) negotiations. Further, over the weekend, US Treasury Secretary Mnuchin indicated the US and China were having productive conversations and that tariffs are part of the negotiation strategy. Lastly, given it is a US midterm election year, there is incentive for the party in power to avoid policies that could overly disrupt the economy and markets. Market Outlook We are maintaining our base case outlook at this time. We came into the year anticipating modest equity gains and higher volatility. Geopolitical uncertainty, which proved to be overstated in 2017, appeared underappreciated heading into 2018 and was one of the main reasons we have been expecting a bumpier path for the stock market. Following the sharp decline in late January/early February, our thesis has been that the stock market is in a volatile bottoming process that would be measured in weeks and likely months, which has been the norm following other sharp corrections during this bull market (Figure 2). This process is ongoing. Figure 2: Sharp Corrections Within This Bull Market 1300 1500 1200 1400 1100 1300 1200 1000 1100 900 Dec-09 Feb-10 Apr-10 Jun-10 Aug-10 Oct-10 Dec-10 1000 Feb-11 Apr-11 Jun-11 Aug-11 Oct-11 Dec-11 Feb-12 2200 2000 1800 Feb-15 Apr-15 Jun-15 Aug-15 Oct-15 Dec-15 2300 2200 2000 1800 1700 Dec-15 Feb-16 Apr-16 Jun-16 Aug-16 2
The good news is the pullback in stocks is helping to reset an overheated market. The forward Priceto-Earnings Ratio (P/E) has dropped from 18.5x in January to 16.0x currently. We noted earlier in the year, that the market found fundamental support at 16.0x P/E during 2016 around the Brexit shock and US elections. It did so again around the initial pullback in early February of this year. Investor sentiment has also cooled from overly optimistic levels. On Friday, we saw a significant increase in investor demand to hedge against market downside, as measured by the CBOE total put/call ratio, which reached more than a two-year high (Figure 3). This is consistent with what occurred during the bottoming processes in 2010, 2011, 2015, and early in 2016. Similarly, the last time we saw back-to-back 2% down days, like Thursday and Friday, was also during the 2011 and 2015 bottoming processes. Figure 3: Demand for Downside Market Protection Highest Since January 2016 3100 2900 2700 2500 2300 1700 1500 2014 2015 2016 2017 2018 Should trade tensions escalate, we expect the next level of fundamental support to come into play around 14.7x to 15.0x P/E. This is where investors stepped in following the sharp corrections in mid-2015 and early 2016, which were both related to China concerns and global growth. This represents 6% to 8% downside from Friday s close. Nevertheless, we are not advising shifting allocations given the turns following market lows have been swift and difficult to time. Indeed, the 16 pullbacks of more than 5% that we have seen during this bull market have been followed by an average gain of 20% over the next six months (Figure 4). Bottom Line Uncertainty has been the hallmark of this bull market, which is now the second strongest and longest in history. Each of the 16 pullbacks during this bull market has coincided with uncertainty and bad news, including a flash crash, the European debt crisis, the US debt downgrade, recession fears, Ebola, China growth and currency concerns, terrorist attacks, a collapse in oil prices, Russian tensions, and worries about a nuclear war with North Korea. Uncertainty is the admission price to the stock market. We have found it sensible to invest on a base case rather than a worst case scenario. While tariffs are the latest on the carousel of concerns, and are likely to dominate near-term headlines and trading, recession risk still appears low, corporate profits are strong, and stocks remain attractive on a relative basis. 1.8 1.5 1.3 1.0 0.8 CBOE Total Put/Call Ratio* 0.5 2014 2015 2016 2017 2018 *The put/call ratio is often viewed a contrarian gauge of market sentiment. Higher put options buying suggest investors are fearful and hedging a security or market downside risk. 3
Figure 4: Pullbacks during this Bull Market 4
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