With competing tailwinds and headwinds the U.S. market has been range-bound since the January correction. As we enter the second half of 2018, it is interesting to note that the S&P is still in correction mode from its January high. Only the 1994-95 correction went longer without turning into a bear market (a decline of 20% or more by definition). The tailwind of the Tax Cuts and Jobs Act of 2017 has been dampened by the headwinds of trade protectionism, rising deficits, a flattening yield curve and tightening financial conditions. In this stage of the economic cycle, a flattening yield curve is normal as the U.S. shifts from quantitative easing to quantitative tightening. However, with the Fed signaling two and possibly three more rate hikes this year and the European Central Bank moving toward policy normalization, the tide of global liquidity is receding.
Trade concerns continue to dominate the headlines with the U.S. placing $34 billion worth of tariffs on China, but placing more on its allies, the European Union, Canada and Mexico. While this may be a drop in the bucket for a $20 trillion economy, the “second derivative" effects could be more serious, with consumer and business confidence shaken, a potential decline in spending and capital investment and a resulting short-circuiting of the economic expansion. While contentious trade negotiations have occurred in the past and been relatively short-lived, the current conditions are closer to a full-scale trade war than at any time since the 1930's.
Last year's lack of volatility was the exception, not the rule, and rate increases and tighter monetary policy typically increase volatililty in the markets and is consistent with late-cycle tendencies. Adding to increased volatility is the fact that history been not been kind to the stock market during midterm election years in which the average maximum drawdown since 1950 has been -17%. Although the secular bull market is intact, we are growing more concerned about the forces that are dampening current growth and could negatively impact the current expansion.