World stocks hit a new correction low Friday, closing down -11.0% from their January 26 high and giving financial commentators more negativity to chew over.[i] As they did, a common theme emerged: an argument that stocks are only now catching on to the risks of tariffs, Fed rate hikes and a fading tax cut sugar high, and more pain lies in store as these alleged negatives take their toll. In a vacuum, the trifecta of a trade war, tighter monetary policy and phantom earnings growth might sound like the stuff bear markets are made of, but we see a huge flaw with this thesis: It presumes markets aren’t at all efficient. Surprises move markets, and we have a hard time seeing how three topics that have hogged financial headlines for the better part of a year have much surprise power.
“Markets are efficient” is a quick way to say “markets near-instantaneously incorporate and reflect all widely known information.” Now, people can debate the speed at which stocks price in new developments. It could be microseconds, minutes, hours or maybe even days or weeks if it is a slow-moving event. But to say stocks haven’t yet come to grips with things financial media have yapped about for a year is to say said media are firewalled from the rest of society. That Susie Saver, Sally Stockowner and Steven Swingtrader are somehow oblivious to anything that is going on in the world. They don’t catch any glimpse of front-page headlines, nightly news teasers or social media alerts. They don’t hear snippets of conversations or news bulletins while they are out and about. They don’t have friends who occasionally say “dang, did you hear about those tariffs” or “man, that tax cut was great for business, but it sure seems like it will wear off soon.”
Perhaps there are a handful of people who have managed to avoid any and all seemingly bad financial news. If so, we are a tad jealous. But most folks are aware. Even if you don’t watch CNBC, Fox Business or Bloomberg or read The Wall Street Journal or any major daily’s business page, this stuff seeps in. We know, because we sometimes get questions about it from our non-CNBC-watching friends and relatives. “Aren’t those tax cuts just fake growth?” “Isn’t that trade war going to make everything too expensive?” “Are we going to get French-style gas tax hikes that take gas to $7 per gallon?” “If they keep raising interest rates, isn’t that bad?” The zeitgeist is like a big, extra-absorbent paper towel sopping up everything in earshot. The chatter permeates, and no one is immune.
So the question becomes: Do any of these issues have enough hidden firepower remaining to cause a bear market? Do they still pack an unexpected wallop? To us, the answer still seems to be a solid “No.” Tax cuts’ profit-boosting mojo always had a temporary tilt to it. That is just plain math. Tax cuts amounted to a sizeable year-over-year cost cut for businesses. It was a one-shot deal. Without such an easy cost cut on deck for 2019, earnings growth will rely on revenue growth and probably much tamer than this year’s torrid pace. But slower profit growth isn’t necessarily bad, especially when it is just math driving it—not an actually negative factor. And it isn’t going to take anyone by surprise. Not only have financial commentators discussed it ad infinitum, but analysts have incorporated it into their official earnings expectations. That is all well-known public information. Investors buying and selling are aware of it. It has factored into their decision, so it is factored into stock prices.
As for tariffs, the story is similar. Is there a risk the trade truce President Trump and his Chinese counterpart, Xi Jinping, reached last weekend could fall through? Of course—in geopolitics, nothing is certain. But even if it turns out headlines aren’t overreacting to both sides’ inconsistent statements and a Chinese corporate executive’s arrest, we are still left with the same worst-case scenario that has preoccupied headlines for months: tariffs on all bilateral trade between America and China. As we have shown in painstaking detail in past commentaries, if that happens, and if Trump follows through on threats to tax all auto imports, the total tariff bill would be about 0.3% of GDP (using IMF GDP estimates). This is nowhere near big enough to offset annual economic growth and cause a recession. It is annoying! It adds costs for businesses! It might make some products cost a bit more! But it also might not, if companies’ recent successes at avoiding tariffs are any indication. Plus, seeing as how headlines have spent months warning of higher costs and other effects, this too lacks surprise power.
Finally, rate hikes. Thanks to the near-universal fascination with central banks post-2008, we suspect there isn’t an investor on Earth who hasn’t considered what might happen if the Fed keeps raising short-term rates. The Fed’s own forecast shows Fed members expect three rate hikes next year if economic data meet their expectations. Thanks to the bizarre obsession with odd yield curves this week, investors are also well aware of the risk of the Fed overshooting and inverting the yield curve. There has also been plenty of chatter about higher interest rates’ knock-on effects on corporate borrowing costs. That fear resurges any time corporate interest rates tick up. This isn’t sneaking up on bonds or stocks.
The nice thing about false fears? They create an easier hurdle for reality to beat. If your typical “consensus” of financial observers foresees tariffs and rate hikes delivering a one-two punch to companies that are already struggling for new sources of earnings growth to replace tax cuts, what happens if the economy just ambles along instead? Maybe tariffs and slower lending from America’s flattish yield curve cause growth to cool some. But slower growth isn’t contraction. We suspect that would be just the sort of positive outcome people aren’t broadly talking about now. Wouldn’t that be bullish for stocks?
None of this is to say the correction must end now and 2019 will for sure get off to a flying start. You can’t predict short-term movements. But we think it is important to understand what moves markets—surprise—and why any potential surprises are likelier to be good than bad. That is key, in our view, to navigating stretches like this without doing anything hasty that could jeopardize your goals.So take a deep breath, and enjoy your weekend. Toughing out this week’s ups and downs is hard work—you deserve a break.
[i] Source: FactSet, as of 12/7/2018. MSCI World Index return with net dividends, 1/26/2018 – 12/7/2018.
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