Capital spending significantly boosted by tax reform

2018 began well, as the economy benefited from positive momentum off the back of 2017. Nonetheless, the outlook for the second half of the year already depicted concerns, having been - and still being - considerably more opaque, reflecting fiscal stimulus, increased constraints in the labour market and a tighter monetary policy.

Fund Commentary
24 Jul 2018

2018 began well, as the economy benefited from positive momentum off the back of 2017. Nonetheless, the outlook for the second half of the year already depicted concerns, having been – and still being – considerably more opaque, reflecting fiscal stimulus, increased constraints in the labour market and a tighter monetary policy.

Despite the economy having sent mixed signals during the first half of 2018, it remains in good shape. Many expect growth to slow in the second half of the year, however remaining moderately strong. At the same time, the odds of a looming recession have slightly picked up (more details to follow below).

Benchmark revisions of the National Income and Products Accounts will normally be released in July, alongside the advance GDP estimate for Q2 2018. The residual seasonality issue will be further addressed (first quarter GDP growth is normally significantly lower than the average growth over the following three quarters), most probably shifting recent GDP growth figures.

As mentioned in previous reports, consumer spending accounts for a substantial part of GDP (ca. 69%). Interim (quarterly) numbers are often uneven – with a strong quarter being followed by a weaker one. This has been the case in recent quarters, with relatively low first quarter numbers expected to be followed by more robust second quarter figures. In fact, personal spending data in May suggest an inflation-adjusted annual growth rate of 2.5-3% in Q2 2018, depicting strong growth compared to a growth rate of +0.9% in the previous quarter and +4% in Q4 2017- however still missing earlier expectations of a stronger rebound.

As expected, the tax reform led to a significant boost in capital spending, with business fixed investment being robust in Q1 compared to Q4 2017. This said, the attention was on structures (partly due to the on-going recovery in energy exploration) and intellectual property products.

Overall, trade policies remained the most significant risk factor for the stock market in June, with economic data not being significant enough to move the market during the month. The first quarter GDP growth estimate was revised slightly lower, with May data (ex. durable goods orders and inventories) pointing to an uptick in GDP growth for the subsequent quarter. Consumer spending growth was softer than expected in May, suggesting a strong but moderate pace for the 2nd quarter.

Going back to the previously mentioned odds of a looming recession, there are many topics that can be put forward, with this report however sticking to the topic that has garnered the most attention recently- the so-called “cold trade war”.

According to the Investment Adviser, the recent escalation in rhetoric and actual tariffs appears to mark an inflection point, with a “cold war” starting to heat up. A convergence of recent measures triggered this opinion: the elimination of exemptions in relation to steel and aluminium tariffs for Canada and other allies, the already imposed tariffs on $50B worth of Chinese imported goods, and more recently the threat to add an additional $200B worth of Chinese imports. In the Investment Adviser’s opinion, this mix of actual measures coupled with rhetoric leads the US to the aforementioned inflection point.

The team believe that the presidential executive power highlights the plausibility of a potential trade war, with attacks on global trade being substantially more credible than on major firms (e.g. Amazon) due to said power. Oddly, the hurdle to attack Amazon via legislation in congress is considerably higher than imposing tariffs on allies and other nations. Consequently, prior rhetoric against trade partners has carried more weight in financial markets than tweets against companies.

In any case, uncertainty is still king. Not only in terms of the extent of tariffs (import volumes and number of products) and tariff depth (% increase), but also in terms of their sequencing and speed. Thus, in the Investment Adviser’s opinion the only certainty is uncertainty, with things looking like they are heating up.

The question is how this could impact growth over the short and long term? The Investment Adviser believes that growth may well be positive or negative in the short-run. While the impact of a trade war in the long run is clearly negative, in the shortrun the implications could also surprise and actually accelerate growth if the situation is dire enough to persuade firms to build inventories and prepare for a more difficult access to production inputs. An example where short run forecasts were extremely difficult to make and actual results were surpising was during the Brexit vote in June 2016. While most economists discussed the long term consequences of the Brexit, the Bank of England warned prior to the referendum that a “leave vote” could spur a recession. After the vote, growth however remained positive, with the feared changes in consumption and investment proving to be exaggerated.

Thus, in the short-term, economic outcomes are likely to be negative and crowded with more uncertainty, whilst from a longerterm perspective the outcomes tend to be more transparent, as the means of transmission will be more stable.

Some of the benefits from trade are that countries can specialise in products they have a relative advantage in. Further, firms can spread their fixed costs across a bigger customer base when they trade in larger markets and – as they operate globally – can optimise their supply chains. In conclusion, if a trade war increases the cost of trade, the benefits derived from comparative advantages could be quickly tarnished.

Finally, what does all of this entail for the current economic expansion? According to the Investment Adviser, growth in 2018 is healthy thanks to the U.S. consumer and the tax cut acting as a tailwind. A trade war would have to work through financial volatility and a tightening of financial conditions in order to end the expansion in 2018. In terms of the economic cycle, trade issues become serious when rhetoric or actions begin to impair confidence and yield substantial potential for financial tightening, as both act as transmission channels to the real economy. A significant market drop can change perceptions significantly, thereby increasing household savings, reducing consumption and resulting in a so-called “reverse wealth effect”.

As growth remains healthy this year, an extreme shock in financial volatility would be needed to end the current cycle in 2018. Beyond this scenario, which could be triggered by a full on trade war, the Investment Adviser believes that the economy is still strong and the equity market is poised for further upside, with the S&P 500 currently trading at 17.5 times (for the full year 2018) and a YoY earnings growth rate of approx. 20%.

In June the Fund returned +0.40% against +0.64% for the benchmark. In terms of return, Allergan was the largest contributor followed by Becton Dickinson and Sherwin-Williams (0.28%, 0.26% and 0.21% contribution to return respectively). On the other hand, Charles Schwab was the largest monthly detractor, followed by Alibaba and Financial Select Sector (-0.20%, -0.18% and -0.16% contribution to return respectively).

With the next earnings season underway, the following report will include more stock-specific information.

The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 09/07/18 and are based on internal research and modelling.