We are growing accustomed to wide daily swings in the Standard & Poor’s 500 and the Dow Jones Industrial Average. Triple-digit moves in the latter and double-digit changes in the former are no longer reasons for elation or alarm. The volatility can result from an unexpected economic report or a tweet from the White House. Big moves in either direction are usually followed by opposite moves and year-to-date the indexes are basically flat. In the first quarter, the S&P closed in excess of 1% in either direction 23 times, a rate exceeded only in the volatile years of 2008 and 2009. These were periods in which the market returned -37% and +26% respectively. At the beginning of the year I thought sentiment was euphoric and equities were ripe for a 10% correction. We have now had that correction and investor sentiment has changed from euphoria to concern. In my opinion, however, sentiment is not yet at a point which would support a sustained positive move in the market.
In the meantime, there has been a shift in some of the fundamental factors that influence equity prices. The disappointing payroll report for March indicated that the economy may be losing some of its momentum. The Institute for Supply Management reports for both manufacturing and services are still positive but showing signs of rolling over. European industrial output declined for the third consecutive month. Delivery times are becoming extended, indicating that companies are under pressure, which usually leads to a rise in product prices. Personal consumption expenditures have bottomed and prices are headed higher. So far this has only had a moderate impact on interest rates. The 10-year Treasury yield has reached a peak of 2.98%. Data from the Investment Company Institute suggests investors have been withdrawing funds from U.S. equity mutual funds and ETFs and placing the proceeds into the perceived safety of fixed income investments. Some of the largest flows have been going into longer-duration funds. The China / U.S. trade dispute has caused some investors to reprice growth expectations. China, the world engine for growth, was already slowing its economy down to deal with the non-performing loans on the books of its banks.
I remain of the view that 2018 will be a positive year for equities, primarily because of performance in the second half and driven by earnings growth. The tax cut should enable the S&P 500 to come in with earnings of $160 in 2018. At current market levels, the index is only at about 16 times earnings, which is favorable at present interest rates. If yields rise or the earnings outlook deteriorates, the prospects for equities would change, but signs that this shift is about to happen have not yet appeared. I still believe a recession and/or a bear market is at least two years away.
There are, however, some larger issues worth exploring. The first is debt at the Federal level. In the year 2000, total U.S. government debt was $6 trillion and the blended interest rate (or debt service) was about 6% or $360 billion. Today, the debt is $20 trillion and the debt service is about $450 billion or about 2.25%. So the debt has more than tripled but the debt service has only increased 25%. If the economy were growing at 3%, you would think the policy makers in Washington would recognize that a favorable economic period is a good time to reduce the debt or, at least, not add to it. Unfortunately, that is not what is happening. The Tax Cut and Job Creation bill will probably increase the existing budget deficit from $700 billion to $1 trillion annually.