Avalon produces a variety of investment commentaries.
Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.
February started with a correction and ended with tariffs. To say the least, it was an adventurous month. The economic data generally came in better than expected outside of housing with manufacturing data continuing to show exceedingly strong growth. Inflation remains tame, and the Federal Reserve under new Chair Jerome Powell appears poised to raise rates an unsurprising three times in 2018. Disappointing economic data could slow the Fed’s plans, and this seems to be somewhat more likely if the trade protectionism persists.
A single data point that showed accelerating wage growth was the impetus for sell-off. The January jobs report showed wage growth rose at a surprisingly quick 2.9% pace. In turn, this led to increased inflation expectations, and therefore, the potential for quicker interest rate increases from the Fed. This inflation spiral gave markets pause, and investors rethought their positioning which led to the market sell-off.
There is some credence to that argument, but somewhat lacking. Most notably, if inflation expectations were the reason for the sell-off, then they should be high. Granted, inflation expectations have moved back to two percent after being much lower during the summer of 2017, but only back to two percent, below where they have been for most of the recovery.
The idea that it was a reaction to higher interest rates is one of the more popular theories as well. Yes, interest rates have increased. However, while interest rates have risen, the U.S. dollar has fallen and financial conditions (measured using the Goldman Sachs Financial Conditions Index) have generally become looser until the early February correction.
The current outlook for the economy is strong. According to Bloomberg, analysts are expecting S&P earnings to be approximately $155 for 2018 — more than a 25% leap from 2017. Much of that is due to tax reform, but some is a result of a faster pace of economic growth.
Of note, the expectation for S&P 500 earnings has not decreased during the sell-off, meaning that valuations have decreased substantially (and quickly). Therefore, markets declined, and so too did multiples.
Steel and aluminum tariffs are not important in the grand scheme of things. But the signal — that the U.S. will impose tariffs at will — has a chilling effect on the positive economic sentiment that has prevailed in 2017 and 2018. The shift in sentiment will have the greatest impact. The direct economic impact will be marginal (assuming the retaliatory measures do not go too far). Critically, the steel and aluminum tariffs will hurt key allies the most.
As can be seen in the charts, China is a minuscule part of the steel trade with the U.S. For aluminum, the figures are even lower. Canada, on the other hand, will feel the tariffs acutely. Given that there is a round of NAFTA negotiations currently underway, the timing of the rhetoric seems suspect. Using the Census Bureau's “For Consumption" figures, China is 2% of steel imports and Canada is 20%. That is a striking difference.
Little detail makes judging the direct impact impossible. But the general direction of less-free trade and increasing protectionism suggests that a weak dollar is likely to persist. Any judgment in other areas should be reserved until the details are known and the follow-through becomes clearer.
In the end, wage growth, as measured by the Atlanta Fed Wage Tracker, appears to have peaked in 2016 and inflation is globally tame. Tariffs are negative for global growth and sentiment, but as long as the retaliations and future U.S. rhetoric do not get out of hand, the global economy should be able to outgrow the worry.
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July 20, 2016
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Why the Fed Needs to Make a Policy Error
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The Fed's Critical Global Mandate
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Quarterly and Monthly Notes
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Third Quarter, 2016
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