The volatility that followed talk of a trade war between the US and China has brought value back to the S&P 500, according to Mike Bell, global market strategist at JP Morgan Asset Management.
The US market was widely regarded as being expensive at the start of the year, a situation that was exacerbated when the S&P 500 rallied by 7.5 per cent in dollar terms before January was out.
However, the decision by US president Donald Trump to impose tariffs on imports – initially on niche items such as solar panels, then on commodities such as steel and aluminium – has coincided with a sharp fall in the index. Data from FE Analytics shows it began April down by almost 10 per cent from its 2018 peak, although it has halved these losses since then.
Performance of index year-to-date
Source: FE Analytics
Yesterday Maurice Obstfeld, the IMF’s economic counsellor, said “the first shots in a potential trade war have now been fired” and warned the global trading system “is in danger of being torn apart”.
However, Bell is sceptical about the impact of the tariffs and said investors need to put the potential consequences into context.
“Generally, humans aren’t very good at judging things as a proportion of very large numbers,” he explained.
“In the same way it is hard to judge how many people are in a football stadium at any one time, it becomes very tricky for us to conceptualise what is going on when numbers in the billions of dollars are being thrown around.
“We have seen markets selling off in a panic on the potential for trade wars, but the most aggressive numbers that have been floated are 25 per cent tariffs on up to $150bn worth of goods.
“So 25 per cent of $150bn is about $37.5bn. Obviously that seems like a large number, but again we need to put that in perspective – that is about 0.3 per cent of Chinese GDP, which last year was $12.8trn. That same $37.5bn is about 0.2 per cent of US GDP, which last year came in at $19.7trn.”
Bell said this highlighted how concerns about the trade war have been overblown – he admitted it is not irrelevant, it is just that the numbers aren’t big enough to warrant the panic seen in markets over the past few months.
“My broad view is that this trade war is a little bit like a WWE wrestling bout – an awful lot of talk, not a lot of damage likely to be done,” he added.
Bell said that hysteria around this issue has taken the attention away from what is happening at the fundamental level for stock markets – and here the picture is improving, with earnings being revised sharply higher just as equities sold off.
Data from JP Morgan shows US earnings growth is now expected to reach 19 per cent for 2018, compared with 12 per cent at the start of the year.
“So those upward revisions that you’ve seen coming through in earnings expectations at the same time that stock prices have fallen have meant that, actually, the old refrain that was true at the beginning of this year that US equities looked a little bit expensive isn’t really the case anymore.
“Actually US equities are trading at about 16.5x 12-month forward earnings, which compares with a long-run average since the beginning of 1990 of 15.8x,” he explained.
“These are slightly above that long-run average, but not really stretched. And when you look at the rest of the world, you can see that everywhere else, valuations are below their average since 1990. Because equity markets have gone up a lot since 2009, people are of the opinion that they are expensive.
“But valuations are cheaper than they were at the beginning of the year – once investors assess that this is more of a trade skirmish than a full-blown war, we think they will take advantage of that valuation opportunity that has opened up.”
Bell said it is a turn in the economy rather than high valuations that has the potential to hit the stock market, but noted the picture is far from gloomy here either.
The market strategist pointed to a variety of economic indicators including consumer confidence, capital expenditure and unemployment as reasons to be optimistic. He said, however, that while these all suggest a recession is unlikely in the US over the next three-to-six months, they all show we are late on in the economic cycle.
Bell said this means higher inflation poses a threat and this is one risk that investors appear fully alert to.
"Higher US wage inflation would cause the Fed to tighten monetary policy faster than expected, having implications for the wider economy and equity markets," he added. "However, we expect wage acceleration to be moderate, leading the Fed to raise interest rates another three times this year, only once more than the market expects.
“Interest rates aren’t anticipated to pose a problem for the economy this year.”
Karen Ward, chief market strategist for the UK and Europe at JP Morgan Asset Management, said that while we are late in the cycle, the outlook for the global economy hasn’t deteriorated enough to justify becoming negative on the outlook for equities.
“While retaining exposure to the upside from risk assets still seems appropriate, investors should think about the type of risks ahead and consider what strategies will protect their portfolios should these risks materialise. Government bonds may provide some shelter from the risk of recession but not if the risk is higher inflation,” she added.
“Alternatives, with the ability to hedge market risk, may play a supportive role in portfolios at this stage of the cycle given the wide range of risks ahead.”