Equity markets finished the second quarter on a down note as financial markets became jittery about the prospect of escalating trade tensions. While there hasn’t been a sustained plunge, concerns about tariffs and their impact on the economy have contributed to increased volatility in 2018 relative to last year. Clearly, investors are increasingly focused on equity market risks.
Nevertheless, despite trade concerns and the market retreat in the latter part of June, U.S. equity markets delivered solid second quarter performance on the prospect of continuing economic growth and strong earnings prospects. The S&P 500 Index erased the negative returns of the first quarter and increased a robust 3.43%. Smaller companies again outpaced larger companies as the Russell 2000 Index was up more than double the S&P 500 Index, returning 7.75%. Small cap companies have benefited from the perception that they are more sheltered from trade tensions given the predominance of U.S. revenues.
Non-U.S. developed market stocks, as represented by the MSCI EAFE Index, significantly underperformed U.S. stocks. Concerns related to the trade war impact, a strong U.S. dollar and the risk of an end of synchronized global economic growth led to a negative return of -1.24% for the Index.
In this quarter’s commentary, we’ll take a closer look at escalating trade tensions and the implications for markets and sustainable investing.
What exactly has happened? The opening move occurred in late 2017, when the U.S. International Trade Commission filed the first industry petitions alleging injury from unfair imports since 2001. Here are actions that followed:
Escalating trade tensions have market- and company-level implications, and accordingly, investors need to factor these implications into investment decisions.
At the market level, we are examining how a potential trade war is intertwined with other risks on our radar, including any impetus for a slowdown in economic growth and the potential for rising interest rates.
We remain vigilant in the identification of any risks that point to a slow-down in economic growth that equity markets have not yet priced in. Higher tariffs are an additional risk to consider. They have the potential to offset the impact of fiscal stimulus from the tax cuts and create uncertainty for management teams to commit to capital spending, both of which can lead to slower economic growth.
The risk of rising interest rates now needs to also factor in the impact of tariffs along with evolving Federal Reserve policy to raise rates to combat an increase in inflation. Tariffs will raise the prices of imports contributing to a one-time increase in inflation, but if a trade war escalates and the Federal Reserve becomes concerned about economic growth, we believe it could slow any planned tightening. In the event of a severe, destabilizing escalation in trade tensions, U.S. Treasuries would benefit from a flight-to-quality and interest rates could fall, in our opinion.
At the company level, the impact of tariffs needs to be integrated into fundamental analysis to assess the range of possible impacts on earnings.
One consequence of tariffs is the increased probability of layoffs, particularly in manufacturing. Not much has happened yet because the tariffs are in reality only a few months old. But the portents are ominous; the Peterson Institute indicates that imposing tariffs of 25% on automobiles and parts could cost nearly 200,000 jobs.
How companies treat their workers, throughout the value chain, is a key component of sustainability analysis, and one that some people interpret as “no layoffs.” In fact, though, a no-layoff policy is something that companies may not be able to sustain.
What really speaks to a company’s commitment to sustainability is not whether it lays workers off, but how.
“A company that values its workers will provide assistance to those displaced, give them plenty of notice, and do what it can to help them regain employment.”
It is also important to workers, customers and other stakeholders that when the company is in distress, everyone shares it—including executives.
But a larger consequence of any trade war, and one that we are even more concerned about, is the potential loss of the international comity we have enjoyed for years, and that enabled the world to develop institutions like the World Trade Organization, the United Nations, the Organisation for Economic Co-operation and Development (OECD), and other groups that work internationally to create conditions of fairness and transparency.
One of the most concerning losses of the new era of suspicion and retaliation could be the United Nations Framework Convention on Climate Change (UNFCCC), the group that every year meets to agree to new strategies to combat greenhouse gas emissions and promote adaptation to a warming world. Other efforts to address poverty and environmental quality could also suffer in a world where international cooperation is undermined by “me-first” policies.
As investors, we have very little power to directly address the problem of waning cooperation among countries. What we can do, and keep doing, is invest in companies that undertake programs to reduce emissions, like the 137 that have already committed to go 100% renewable. Making a more sustainable world isn’t easy if governments are at loggerheads, but it is neither useful nor necessary to despair: we can keep working to reduce climate change, promote gender equality, and make workplaces all over the world safe and fair through the companies we invest in. And we will continue to do so.
The S&P 500 Stock Index is an unmanaged index of large capitalization common stocks.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom. Performance for the MSCI EAFE Index is shown “net”, which includes dividend reinvestments after deduction of foreign withholding tax.
The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.
One cannot invest directly in an index.