US small caps may have legs
This area of the market has had strong first-half performance, and we believe it continues to have potential as we round out the year, particularly if trade rhetoric remains ongoing, which seems likely over the near term. In addition, tax reform benefits should also lift small caps over the next several quarters.
Trade tensions remain a critical tail risk
Trade tensions with China have escalated and continue to be a source of uncertainty for markets. While the implemented tariffs are, thus far, not economically significant (the USD 34 billion implemented on both sides as at 6 July amounts to less than 0.5% of either economy), the risk of escalation remains a looming unknown. If the US administration pursues close to USD 400 billion in tariffs, for example, China could retaliate, and perhaps use strategies beyond tariffs on US imports, which only amounted to USD 130 billion in 2017. While this is certainly a risk, we see the sell-off in Chinese equities, combined with recent statements from the Chinese government around intending to keep its currency stable, as indications that China does not prefer a trade escalation or other retaliatory measures.
Mid-term elections could provide an inflection point
As we continue through 2018, we see the US mid-term elections on 6 November as critical to the market path. Historically, the period before mid-term elections has been volatile for markets, and the period afterward has been robust, regardless of party winners, as marketplace uncertainty is lifted. We see the potential for a strong year-end in the markets as well, particularly as we would continue to gain clarity around policy and the current administration. Furthermore, sidelined bipartisan issues such as infrastructure reform could re-emerge as a focus area as we get closer to mid-term elections, which may also boost market sentiment.
The Federal Reserve is on a normalisation path
Even if we remove trade tensions and politics, one key driver of the US economy over the next 1-3 years remains: the Fed. The Federal Open Market Committee has been clear that it intends to continue its normalisation path, with its median “dots” now indicating four rate hikes in 2018, pushing the US economy toward a later-cycle stage. With the fed funds rate moving higher and the Fed balance sheet shrinking, the Fed is removing liquidity from the financial system; the implications for this include elevated volatility and limited multiple expansion in equity markets. In addition, we have seen the yield curve continue to flatten, approaching multi-year lows. (See Exhibit 3.) (Although our analysis shows that a flat or even inverted yield curve is not uncommon towards the end of a Fed tightening cycle.) And while the inversion of the yield curve is historically a recession indicator, we typically do not enter a recession until 6-18 months after inversion has occurred. Nonetheless we continue to monitor Fed movements and the downward trajectory of the yield curve as part of our in-house late cycle monitor.