There are tailwinds benefiting and headwinds hindering stock markets. It’s difficult to know whether the tailwinds or the headwinds will prevail. Even if you’re pessimistic, keep your high-quality stocks, but accumulate cash you can deploy in a stock market setback.
The S&P 500 (Standard & Poor’s 500-stock index) has reached a record high. That matters because Canadian stocks usually follow the direction set by US stocks. In fact, the S&P/TSX Composite index is less than 300 points short of setting a record high of its own. The question is, will this aging bull (or rising) market continue, or is it nearing the end? The stock market benefits from favourable tailwinds but also faces unfavourable headwinds. It’s an open question whether the pluses outweigh the negatives.
The biggest tailwind is the strong US and developed world’s economies. This raises company profits, which is an important factor setting stock prices. In the second quarter of 2018, nearly fourth-fifths of stocks in the S&P 500 earned more than expected. Their second-quarter profits are expected to have jumped by about a quarter from a year earlier. This makes the valuation of US stocks appear more reasonable. But if company earnings growth slows down more than expected, stock prices could fall.
Company profits and interest rates are up
The biggest headwind is higher interest rates. The ‘Fed’ (US central bank) has already raised rates twice in 2018 and is expected to do so two more times this year. Higher rates can hurt economic growth and company profits. Central banks have been compared to bad hosts who take away the punch bowl just as the party gets going. Also, higher interest rates drive up the US dollar, which is leading to debt crises in some emerging markets (see below).
A second headwind is that the yield curve is flattening. Short-term interest rates usually equal or exceed long-term interest rates just ahead of a recession. As a result, it’s a good idea to monitor the yield curve.
A third headwind is that the Fed will reduce the size of its balance sheet. It bought huge amounts of bonds under its ‘quantitative easing’ program. This injected cash into the financial system. As the Fed sells these bonds, it will drain cash from the system. This could hurt the price of financial assets. On the positive side, selling lots of long-term bonds can lower their price and raise their yields. This could keep the yield curve from flattening too much.
A fourth headwind is trade tensions. The US has imposed tariffs on many products that it imports. This is true for its allies (such as Canada, Mexico and the European Union) as well as its rivals (such as China). These countries have retaliated by imposing tariffs of their own on American exports. These trade disputes could escalate and spiral out of control. If pugnacious President Trump carries out threats of imposing tariffs on Canadian auto parts, Canada’s stock market could fall. Keep your high-quality stocks and accumulate cash.
The rising dollar is a risk
The US central bank is raising interest rates. As we noted above, it has raised rates twice so far in 2018 and is expected to raise rates two more times this year.
Higher interest rates have raised the US dollar against most currencies. This makes it harder for emerging markets to service and repay their US dollar debts. Due to distrust of many emerging market currencies, they’re required to borrow and pay back in US dollars.
Turkey is the best-known problem. Its lira is down by about 37 per cent relative to the US dollar. This makes its debts crushing. Other emerging markets with weaker currencies and high US-dollar debts include Argentina, Brazil, Russia, South Africa and Venezuela. If they’re brought to a standstill, the world economy will slow. This could hurt stock markets.
This is an edited version of an article that was originally published for subscribers in the August 24, 2018, issue of The Investment Reporter . You can profit from the award-winning advice subscribers receive regularly in The Investment Reporter .
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