Submitted by Nicholas Colas of DataTrek Research
Let me offer up a one-word summary of how I see the second half of 2018 for equities: “Recession”.
Don’t worry – this isn’t a doom and gloom prediction. Rather, it is the three-syllable description of the fulcrum issue for stocks. And since correlations tend to rise during periods of volatility all this also applies more or less to global equities as well.
Here’s our thinking:
#1) Corporate managers live at the margin when it comes to planning incremental hiring and capital expenditures. Tax reform is baked into their numbers for 2018 and 2019, making the uncertainty around trade and tariffs their primary planning headache. So even though corporate earnings are +20% in 2018 because of lower tax rates, managers may start to reduce hiring and capex plans if they begin to fear the impact of a trade war on their business. Spook them enough, and they will start to reduce headcount. That could turn into a self-reinforcing cycle that ends up in recession.
Conclusion: the current administration may win some trade battles, but it will be up to the private sector to determine the economic outcome of a trade war. Markets will have their hands full assessing that trade-off of political headlines and micro fundamentals in the second half of 2018.
#2) “As good as it gets” syndrome. Expect someone to come up with a FOMO-like acronym for this one – the notion that US economic and corporate earnings growth both hit their peaks in the first half of 2018. Q2 earnings, for example, will likely show “only” 20% earnings growth versus 25% in Q1. Back half GDP will not likely be as strong as the +3.0% number most expect for Q2. And when growth slows, multiples contract. Stock prices decline, corporate managers start to fire, and the cycle we mentioned in #1 kicks into high gear.
Conclusion: for such a squishy concept, we do worry about this one. The offsetting positive for US stocks is that European growth is even slower, and Emerging Markets will struggle with the trade war issue. So investors with fixed equity exposure will still have to own something, and this calculus points to US stocks. This limits the damage to domestic equity prices, and the US could be spared a recession as a result.
#3) Federal Reserve policy. The decline in the difference between 2 and 10 Year Treasuries since the start of the year is remarkable. The spread today – just 31 basis points – is the tightest since July 2007. History is clear about what happens when that number goes to zero: a recession is on the way. In cases where there is a geopolitical shock, the combination of that event and a flat yield curve makes the contraction in economic output even worse.
Conclusion: expect to hear the chorus warning of a “Fed Mistake” in the second half of 2018 to grow as loud as the finale of an Italian opera. What they may be missing: how would the US stock market respond if Chair Powell did admit to concerns about the economy and slowed the pace of rate hikes? Our prior points describe one potential negative feedback loop that makes this a potentially risky option. Which means this debate will rage through 2H 2018.
Summing up: we don’t see a recession in 2018 or 2019, but we believe the dominant market narrative will revolve around this topic in the back half of 2018