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What Is Behind the Equity Sell-Off?

Wells Fargo Investment Institute - 3/26/18

Key takeaways

  • Investors are concerned about the negative implications of a potential trade war, the effect of privacy breaches at social media companies, and the magnitude of Federal Reserve (Fed) rate increases in 2018.
  • We believe that these concerns are premature, if not exaggerated. Our interest-rate outlook is benign for equities, and we recommend market-weighting Information Technology allocations. On trade, even if a new (riskier) negotiating regime has begun, the first moves appear to be negotiating tactics, not the large and blanket tariffs that historically have started trade wars.

What it may mean for investors

  • Given the recent pullback in stocks and our favorable forward outlook, we believe that investors should start averaging into equities during this period of downside volatility.

Download the report (PDF)

The renewed U.S. equity market selling has focused on several factors. Investors now are:

  • Concerned that the recent U.S. steel and aluminum tariffs will accelerate into a broad trade war and increasing protectionist behavior across the globe
  • Increasingly sensitive to the rate at which the Fed may raise interest rates this year and next
  • Feeling more cautious with respect to the Information Technology sector.

Trade war or change in negotiating strategy?

New U.S. tariffs on steel and aluminum—and, more specifically, on an array of Chinese products—have triggered retaliatory Chinese tariffs on U.S. goods and further warnings from European and North American trading partners. This policy path presents clear risks that the U.S. and other large trading nations ultimately could sink into rounds of competitive tariffs that shrink global trade and economic growth (i.e., a trade war). For each trading partner, a trade war could raise domestic production costs, broadly reduce economic output, lower corporate revenues, and pressure margins. 

We regard a trade war as a low risk. The U.S. already has granted temporary exemptions on the steel and aluminum tariffs to Canada, Mexico, the European Union, and South Korea. Trade reduction is, so far, less easy to predict between the U.S. and China, but the two countries initially have been very cautious. The $60 billion in U.S. tariffs on Chinese goods represents a negligible dent in Chinese economic output. Chinese tariffs announced on Friday against the U.S. are even smaller—and amount to roughly $5 billion in trade. These tariffs would be implemented only if the U.S. and China fail to agree on the deeper issues, which include the large U.S. trade deficit with China and Beijing’s rules requiring U.S. companies to share their proprietary technology with Chinese business partners. China has offered to negotiate on the latter point.    

Companies and investors may need time to decide whether a more competitive international negotiating strategy is now replacing (or merely complicating) the post-war multilateral system and the authority of the supranational World Trade Organization. It is not clear yet how (or if) the new negotiating regime will develop, but sentiment is likely to remain sensitive, until a consensus emerges that the current trade system is not about to be overturned. Meanwhile, it is not unusual for markets to jump to the worst-case scenario even if the current facts do not justify such a leap in logic. 

We would become more concerned about a negative growth impact from trade negotiations if we were to see rising tariffs on the goods that bulk the largest in the exchange between the U.S. and its main trading partners. These categories include electronics and machinery, particularly autos and parts. Even if a new (riskier) negotiating regime has begun, the first moves appear to be negotiating tactics, not the large and blanket (i.e., across all traded goods) tariffs that historically have started trade wars. 

Fed policy is an unlikely equity market threat this year

The negative U.S. equity-market reaction last week also followed the March 21 Fed policy decision. The Fed’s 0.25% hike in the fed funds target rate was expected, but the latest survey of individual Fed policymakers suggested that most anticipate a faster pace of fed funds rate increases in 2019 and 2020. Nevertheless, the survey of the Fed policymakers is not binding and does not reliably predict future rate decisions. Fed projections often change, and the new Fed chairman has a strong emphasis on raising rates only if the economic data would support a fed funds rate hike. We remain convicted in our three-rate-hike base case. 

Our view for broader and stronger economic growth this year, with only slightly higher interest rates from current levels, is favorable for equity valuations—especially after the latest decline in equity prices. Our Investment Strategy Report published on March 19 compared equity and bond yields over multiple business cycles and found that the 10-year Treasury yield might have to sustain levels exceeding 3.5% (far above what we believe is likely this year) before compelling a year-end 2018 S&P 500 Index target range below our current year-end target of 2800-2900.  

Notwithstanding further Fed rate hikes this year, we recommend caution regarding lower-credit-quality exposure—as we believe that the risks outweigh the potential rewards. Our outlook is bullish on the economy, mildly bullish on equities, and cautious on fixed income.

Which sectors underperformed in last week’s U.S. equity sell-off?

During the latest sell-off, Real Estate and the defensive sectors (Consumer Staples and Utilities) outperformed the S&P 500 Index, while the Financials, Industrials, and Information Technology sectors underperformed. This pattern reversed the relative year-to-date performance (and also reversed the performance trend over the past 12 and 24 months).  A number of reasons explain the defensive selling among cyclical sectors.

Financials: The Financials sector has been very sensitive to increases in interest rates. The Fed’s recent rate hike, combined with lower long-term yields, is perceived as a negative for interest margins. Last week brought a further increase in the cost that banks pay to borrow from each other. Some investors may have sold Financials on fears of a new Financial-sector crisis; yet many other indicators of financial stress remain benign. There is, for example, no global shortage of U.S. dollars, as there was in 2008 and 2012. In addition, credit default spreads remain low, indicating that bank stresses are not leading to default fears. Instead, it is much more likely that government borrowing needs and corporations moving to cash (possibly as a prelude to equipment spending, stock buybacks, or dividend payouts) are reducing cash in the banking system. Such liquidity hiccups are not uncommon but may have triggered reflexive memories of 2008.  

Fundamentally, we favor Financials based upon a few simple and steady factors. Lending growth typically rises with economic activity, and we look for a stronger economy this year. We expect that spreads between lenders’ cost of funds and their lending rates will widen with additional borrowing. Almost all major financial companies expect additional earnings support as their effective tax rates fall from 28%-29% to an estimated 18%-19%. Valuations in the Financials sector also have trailed the rest of the market. When combined, these factors support our forecast for an earnings growth rate exceeding 20% and a Financial-sector valuation of 13.8 times forward earnings.   

Industrials: Fears of a trade war almost certainly fall heaviest on the Industrials sector, because of their large share in global trade. Machinery companies may be the most vulnerable to a trade war, but they should benefit the most from the economic improvement and tax reform that we see as much more likely than a trade war. Except for gross margins, all margins and returns (operating margin, profit margin, return on assets, and return on equity) are above the long-term trend. In addition, free cash flow has moved back to the long-term upward trend. We look for Industrial-sector earnings to grow at a mid-teens rate this year, compared to a low-single-digit growth rate in 2017.   

Information Technology:  This sector was prominent in the equity sell-off as investors responded to a privacy breach at one of the largest social media companies. Despite this specific concern, other factors still broadly support this sector. Late-cycle consumer and corporate spending should benefit earnings growth. The sector’s effective tax rates are already low and may benefit only marginally from statutory tax reduction, but Information Technology companies have substantially more overseas earnings to repatriate than many other S&P 500 companies. We believe that an evenweight (neutral) position is appropriate for this sector given its growth opportunities within this economy, alongside stretched valuations. We expect mid-teens earnings growth for 2018 (but valuations have risen to 34.9x versus a 20-year median of 22.0x).

U.S. small- and mid-cap equities fared better

Overall, we believe our economic forecasts indicate meaningful top-line growth for small- and mid-cap equities, and tax reform should significantly boost profit margins in these two asset classes this year. Small- and mid-cap equities also are more heavily tilted toward Financials and cyclical sectors, which tend to do well as economic growth accelerates and interest rates rise. Yet, the Russell Midcap Index and the Russell 2000 Index even have outperformed the S&P 500 Index since the start of this year—and especially during the recent correction. We believe that this is because tariffs should be less detrimental to small- and mid-cap companies (due to their domestic focus). Additionally, Information Technology (and particularly social media) is a small weighting in these two indices, so any new privacy or cyber-security regulations should fall more heavily on large-cap technology companies. 

While the overall equity-market volatility could impact sentiment and the valuations that investors are willing to pay, our small- and mid-cap forecasts already assume that multiples will revert to less than the historic median—so our outlook already is fairly conservative. Less regulation and higher fiscal and private spending could represent upside potential, while a general economic slowdown or political risks from midterm elections in the U.S. could act as downside risks.

What should investors do now?

Drama can create opportunities. Our 2018 Outlook report highlighted a supportive economic environment—but noted that political risks and declining cash available for investing could produce more frequent and wider equity price swings this year. We now reiterate our call to pay particular attention to risk and reward. While we still see solid fundamentals in cyclical sectors, the recent equity selling has produced divergences that we believe create value. We recommend that investors:

Favor cyclicals: The cyclical fundamental recovery seems secure, and the decline in stocks—and a modest decline in the 10-year U.S. Treasury yield—both make stocks appear attractive today, particularly our favored cyclical sectors (Financials, Consumer Discretionary, and Industrials). We believe the recent downside volatility offers a good opportunity to put money to work at better valuation levels.

Restore target allocations across global equity markets: The strong performance of the S&P 500 Index has attracted cash into large-cap stocks in recent months, but we recommend allocating into small- and mid-cap U.S. equities, and into international markets, if current allocations are below their long-term targets. Investors should look to allocate from areas that offer less reward relative to risk, including cash, defensive equity sectors, and low-credit-quality bonds. 

Average in: While we expect higher equity prices globally in the balance of this year, political surprises likely will produce more frequent price swings than occurred last year. This environment should favor putting money to work on a regular (but periodic) basis. If “averaging in” is handled in a disciplined way, new allocations are unlikely to always come at new price highs or lows.   

It may help to remember that corrections may take time to play out—but that they also can occur amid a longer-term equity market upcycle. Investors may recall that the economic cycle continued through the 2010, 2011, and 2016 equity corrections, but that those episodes also involved months of equity-market swings and choppiness. Additional drama should not surprise anyone, if markets are digesting the potential impact of new Fed leadership, tariffs as trade negotiation tools, and new regulations for Information Technology companies.