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Are Stocks Taking A GAP Year?

By

Jeffrey Kleintop

CFA, Senior Vice President, Chief Global Investment Strategist

Jeff specializes in analyzing international market trends and their financial implications. He's frequently cited in a range of national media outlets including The Wall Street Journal and The New York Times. He has an MBA from Pennsylvania State University.

May 29, 2018

Member for

10 months 4 weeks
Submitted by jib.butterworth on Tue, 05/29/2018 - 15:01
Are Stocks Taking A GAP Year?
Key Points

Gains in the global stock market have taken time off this year to consider GAP concerns: growth, agreements, and policy.

Unlike recent high school graduates, the gap year for global markets may not last a full year if the growth and trade concerns become temporary and fiscal policy stimulus moderates monetary policy tightening.

Graduation can create jubilance and anxiety about what is to come, but for investors the best course of action may be to stay calm.
 

It is now graduation time for many high school students. But not all of the new graduates are headed to college right away. Gap years are growing more popular with students taking a year off to mature before taking on the next step in their education.

As of the summer’s start, stocks also seem to be taking a gap year. While 2017’s big effort generated a 22% gain, stocks haven’t moved far from where they started in 2018, as measured by the MSCI World Index. Are stocks taking a year off as the economic cycle matures before taking the next step? We need to look at causes of this gap year so far which has included concerns over growth, agreements, and policy.

G = Growth

Global growth momentum may have peaked in January. The widely-watched global composite Purchasing Managers Index (PMI) of business activity has been sliding since January. Economic growth measured by GDP slowed during the first quarter in many countries. And, most importantly for investors, analysts’ earnings per share estimates for the next 12 months flattened out after the sharp rise in January as U.S. corporate tax cuts were enacted, as you can see in the chart below.

Earnings growth has moderated

MSCI AC World Index expected earnings per share over next 12 months

Source: Charles Schwab, Factset data as of 5/24/2018.

A = Agreements

Trade agreements have been a major topic in the media this year as demonstrated with a leap in the use of the phrase “trade war” in news articles, as you can see in the chart below. Concerns over material changes to trade agreements or abandoning them in favor of new tariffs is likely to have contributed to the pause in stocks this year. Although this year’s trade disagreements have fallen well short of a trade war, with more than half of the sales of global companies in the MSCI World Index tied to international trade even a small risk of an actual trade war needs to be monitored.

“Trade war” became a hot topic this year

Weekly number of major news stories containing "trade war"

Source: Charles Schwab, Bloomberg data as of 5/24/2018.

P = Policy

Stocks may have also paused in response to the ending of U.S. monetary policy stimulus. While the Fed has been tightening for some time, only this year has the policy rate moved above inflation, ending monetary policy stimulus and turning the focus to tightening as the real fed funds rate crosses zero. This can be seen in the chart below of the real federal funds rate, which is the federal funds rate less the pace of inflation tracked by the Fed’s favorite measure, the core personal consumption expenditures (PCE) deflator. Currently the pace of core PCE is 1.88%. In June, the Fed is widely expected to raise the fed funds rate to a matching range of 1.75% to 2.00%.

Fed finally ends monetary stimulus, ECB may follow

Fed finally ends monetary stimulus, ECB may follow

Source: Charles Schwab, Bloomberg data as of 5/24/2018.

In Europe, we anticipate that QE will end in the second half of 2018 with the European Central Bank (ECB) may continuing to follow the path of the Fed on real policy rates (with the typical lag of about 275 days seen over the past 10 years), as you can see in the chart above.

Gap closing?

Will all of 2018 end up as a gap year or will stocks resume their progress? We believe the “gap” may be narrower than a whole year. Here’s why:

  • Global growth measured by GDP is expected to reaccelerate in the second quarter for many major countries by the consensus of economists tracked by Bloomberg, as you can see in the chart below. This may help to sustain the rise in earnings per share for global companies.

GDP is expected to rebound in the second quarter for major countries

GDP is expected to rebound in the second quarter for major countries

*Bloomberg-tracked economist consensus forecast
Source: Charles Schwab, Bloomberg data as of 5/18/2018.

  • The risk to trade agreements is balanced by the reality that world trade growth has sustained the fastest pace in years, as you can see in the chart below.

World trade volume growth has sustained a rapid pace in 2018

World trade volume growth has sustained a rapid pace in 2018

Source: Charles Schwab, Bloomberg data as of 5/24/2018.

  • Monetary policy is beginning to tighten in the U.S., but fiscal policy stimulus (tax cuts) is helping offset the economic impact. More broadly, global financial conditions remain favorable to growth, as you can see in the chart below.

Financial conditions remain favorable to growth

Financial conditions remain favorable to growth

Source: Charles Schwab, Bloomberg data as of 5/24/2018.

Other concerns may emerge to keep stock markets volatile such as the latest developments in Italy’s ongoing attempts to form a government. But if the major concerns that caused this gap continue to fade as they have since this year’s low in March, stocks may not end up taking a year off from gains after all.

 

 

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