Trade: Two Steps Forward, One Step Sideways
World trade took center stage last week, hitting a number of milestones. Most significantly, the United States and China finally signed a “phase one” deal, with China committing to increase purchases of U.S. goods and services by $200 billion over the next two years. The Treasury department also removed the designation of China as Currency Manipulator, which although largely symbolic, is a notable improvement. In addition, in a bipartisan vote, the U.S. senate passed the U.S.M.C.A. (new NAFTA), in line with expectations, largely removing the uncertainty around North American trade.
Across the pond in Europe, the United States and France announced a digital tax/tariff truce until the end of the year. France will hold off on the proposed digital tax, and the United States in response will not levy retaliatory tariffs on French imports. At this point, the European Union remains the main region at risk of seeing additional tariff threats over the next several months. We have seen the Trump administration heavily critique the E.U. for their Airbus subsidies and even threaten tariffs on automobile imports repeatedly. With that said, we anticipate an improvement or some form of resolution soon. Last week, the newly appointed trade commissioner of the European Commission, Mr. Hogan visited D.C. to meet with U.S. officials. In addition, President Trump is at Davos this week and is expected to meet Mr. Hogan again, and the new president, Ursula von der Leyen. Our view is – just like China and France have finally come to the table, the European Commission will negotiate a trade truce or some sort of deal with the United States to avoid additional tariffs.
2010s: Profits with Little Volatility
This is the second installment of a series on the past decade and potential implications for investors in the future. Click here to read the first installment.
Reflecting on the past decade, investors who have remained committed to the equity markets have little to complain about. The last time the S&P 500’s 10-year risk adjusted returnsi were this good, Gunsmoke topped the charts as America’s top TV show. During the past decade, the S&P 500 provided an annualized return of 13.3%. This is not as high as the ’80s or ’90s, when stocks returned 17% and 18%, respectively. However, this decade, stocks provided double-digit returns with below average volatility (i.e. the standard deviation of quarterly returns). The 2010s were the first decade without a bear market. There were six separate corrections of 10% or more, but the market never fell more than 20%; the threshold used to define a bear market.
Source: Factset, Ibbotson’s Haverford Trust. Decade measured from 12/31/09 to 12/31/19. Index returns are provided for illustrative purposes only. Indices are unmanaged, do not incur fees or expenses and cannot be invested in directly.
Despite the relative ease with which the markets have risen during the past decade, we believe this bull market has also been the most derided in history. Even optimistic investors have been described as reluctant bulls since the early days of this unprecedented run. Investor skepticism was understandable. Following a decade of no returns, sandwiched between two severe bull markets and the Great Recession of 2008, no one predicted a 10-year bear free market advance.
Just because we have enjoyed stellar market returns doesn’t mean that the next 10 years have to be sub-average, but history shows us that it does increase the probability. Following the buoyant 1950s, returns were below average for the next two decades, but still positive. The 1980s were followed by another banner decade in the ’90s, although we all know how that ended. There are several differences between today’s market and the 1990s. First, as we have pointed out in our recent Annual Outlook, we see little irrational exuberance in the market. One example would be the relatively rational market for initial public offerings. In contrast to the 1990s, companies with suspect paths to profitability have seen their newly issued share prices stagnate. Also, the 1990s ended with many of the largest companies in the index trading at multiples in excess of 50 times earnings. That is not the case now. In general, company balance sheets are healthier and cash flow generation stronger than in the past.
Source: Strategas Research Partners
However, equity prices as measured by price to earnings ratios are elevated. Earnings multiple are higher than average. Depending on the source and the method of calculation, they are generally in the 70th to 90th percentile of normal historical ranges. Investors should not expect continued multiple expansion to fuel gains. Earlier this decade, we often used the term “coiled spring” to describe the market. That spring has sprung. Earnings growth and capital allocation (i.e. dividends and stock buybacks) will most likely be the drivers of positive returns next decade.
At Haverford, we counsel investors that volatility is the price of the ticket to the greatest show on earth. Volatility is the price you pay to be an investor in equities. Following one of the least volatile decades for equity markets in history, we will be sure to restate this axiom frequently and fervently in the new decade, lest we and our clients forget.
i Risk adjusted return calculated using the Sharpe Ratio. (Equity Return – Risk Free Rate) / Standard Deviation of Returns.