As we pass the midpoint of the year, trade wars and tariffs continue to dominate the headlines. These most recent efforts by President Trump to make America great again through the renegotiation of trading terms with our trading partners has led to not so great returns for foreign stocks. In particular, emerging market stocks finally succumbed to the ongoing trade war news. These stocks were down 8% in the second quarter as measured by the MSCI Emerging Market stock index. Considering the incredible return in emerging market stocks last year (up 37%), their current pause should not be surprising. While some market pundits have expressed concern about slowing growth in foreign economies, the expected growth in emerging market countries is still projected to far exceed that of their developed market brethren.
There is a perception that emerging market countries have export driven economies and that they could be most impacted by a trade war. While this is true of some countries, a notable exception is China. China has remarkably transformed its economy from an export driven economy to a consumer driven economy. As reported by asset management firm Matthews Asia, domestic consumption now accounts for the majority of China’s economic growth and more than half of its GDP (which has been the case for several years now), and Chinese exports to the U.S. accounts for only 19% of total Chinese exports.
The need for better trading terms with our trading partners was well-summarized by Brian Wesbury with First Trust: “According to the World Trade Organization, average tariffs in the U.S. are 3.5% compared to 5.2% in the EU, 9.9% in China, 4.1% in Canada and 7.0% in Mexico. It’s time for tariffs to be lowered around the world and the U.S. holds a lot of power.”
U.S. and established foreign market stocks were less impacted by the trade war rhetoric. Large company stocks as measured by the Standard & Poor’s 500 were up 3.4% in the second quarter, while established foreign economy stocks as measured by the MSCI EAFE index were down just 1.2%. Bonds as measured by the Bloomberg Barclays U.S. Intermediate Government/Credit index were virtually unchanged.
The biggest risk associated with an escalation in tariffs would be a negative impact to corporate earnings. Hopefully the tariff issues are resolved soon, at which point I believe we would see a sigh of relief in the stock market (meaning a nice move higher). In the meantime, the near-term outlook for corporate earnings remains very bright with earnings growth expectations being in the 20%+ range. Seeing as earnings drive stock prices, this is of great importance to investors. Earnings are being driven higher by the recently enacted tax reform, share buybacks, and a strong economy at full employment. I believe some analysts’ rosy earnings expectations beyond this year to be a bit suspect, as year over year comparisons will become more difficult with the benefits of the tax reform having already been realized.
In my prior quarterly update I stated that I believed the likely direction for stocks to be sideways for awhile. So far, this has been the case with respect to the S&P 500. Until we have some clarity with the trade war issue, I don’t know that this will change. U.S. small company stocks, however, broke out to new highs during the second quarter, fulfilling my expectation at the beginning of the year that their time was due. My expectation that value stocks would come back into favor has so far turned out to be less prescient, at least with regards to large company stocks, as technology companies continue to dominate the large-cap universe.
This year marks the 10 year anniversary that I have been writing quarterly market updates for our clients and interested parties. Although I had previously written quarterly updates while working for a money management firm in Sacramento, I did not begin providing regular updates to clients again until the financial market turmoil of 2008. It is interesting to go back through these letters and see history unfold. These updates have been well received by recipients and have also served to help me formulate investment strategy grounded in my outlook for the capital markets. I welcome your feedback and the opportunity to discuss these updates with you in greater detail should you desire to do so.
I wish you and your family an enjoyable summer.
Glenn S. Rank, CIMA®
Certified Investment Management Analyst®
President, GSR Capital Management
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