Quarterly Commentary

Q2 2018

Technology stocks carried the US market to a positive return in what otherwise was a tough quarter. The US economy is buoyant – consumer spending is robust, unemployment has fallen to 4% and corporate earnings have handily beat expectations. The economic backdrop elsewhere is less encouraging – the synchronous global growth story is unravelling. Political turmoil has resurfaced in Europe, most visibly in Italy. Escalating trade tensions also impacted the quarter’s returns. The degree to which today's trade threats materialize into a full-blown trade war will be an important factor in shaping returns in the current quarter and beyond.

We stand reminded that such circumstances generate volatility and temporary dislocations between perceived and actual vulnerability. We don’t know how the rising crescendo of trade war threats and retaliation will play out. But we are diligently monitoring the risks assumed in each portfolio and we are ready to seize opportunities as they arise.

Quarter in Review

A decade of strong performance has boosted technology’s weighting in the S&P 500 from 16% to 27%, by far the largest of the S&P’s eleven industry groups. Four companies account for 44% of the tech sector’s market cap: Apple, Microsoft, Google (each up about 11% during the quarter), and Facebook (up 25%). These large tech firms have come to be viewed as capable of delivering superior earnings growth regardless of economic, regulatory or trade conditions.

The industrial and financial sectors are this year’s laggards - each down 2% in the quarter and 5% year-to-date. Within the industrial group are big multi-nationals sitting in the cross-hairs of new trade tariffs, including Boeing, GE, Honeywell, 3M and Caterpillar. Financials also fell victim to the trade friction. The earnings of the large banks that dominate the sector are driven by the strength of the economies in which they operate as well as the level and shape of the interest rate curve (higher and steeper is better, but the curve continues to flatten).

Nowhere were trade war jitters more evident than in China where the Shanghai Composite plummeted nearly 15% in the quarter. The Chinese economy is dependent on exports, and almost 20% of those exports go to the US. Other emerging economies are not specifically targeted but are vulnerable to a US-China spat - emerging market shares fell 8%.

Current Events

Last quarter we wrote that few expected a trade war to unfold. That’s no longer true - US leaders have moved beyond rhetoric to implementation. Retaliation has been swift.

Trade tensions are nothing new. Imbalances between the US and China have been festering for years. Beyond addressing the trade deficit, the Trump administration wants China to end its policy of asking US companies to hand over proprietary knowledge in return for gaining access to China’s markets. American businesses and workers may be willing to take some short-term pain to achieve long-term gains. However, current threats and actions go well beyond recent norms, such as the extension of steel and aluminum tariffs to our neighbors and allies in the interest of national security. Arguably, the EU, Canada and Mexico might otherwise have helped the US by ganging up on China.

Initial impacts of the tariffs are surfacing in the form of higher raw material costs and production bottlenecks due to extended supply chains. Effects will vary by industry: How much does demand shrink in response to price increases? Are there substitute products? How long would it take to get new manufacturing facilities up and running in the US or elsewhere? Short-term responses should be isolated and are not particularly worrisome because of the underlying strength of the US economy. The effects of escalated trade actions would be felt more generally. Trade wars zap business confidence, sidelining capital spending plans, while artificially increasing the cost of producing and getting goods to end consumers, thereby reducing demand.

Share prices of obvious trade war “losers” have been under pressure since mid-June. Attention may shift to sectors not previously considered as vulnerable. With almost 60% of revenues being generated overseas, tech is exposed to foreign regulation, which could intensify if US tech is targeted by rivals. In a more general way, tariff escalation would likely dampen growth expectations and could cause a downward revaluation for equities and other economically sensitive assets.

We hope our fears prove to be misplaced. The leaders of the US and China are highly motivated, one devoted to fulfilling campaign promises while facing mid-term elections, and the other, recently anointed as leader-for-life, intent on furthering China’s transformation into a global powerhouse. Both wish to look tough, and for both there are good reasons why they should ultimately act to avoid a mutually disruptive outcome.

We can envision a few responses that might help contain any damage. A growing outcry from American farmers and manufacturers could convince the president to change course. Republicans, until recently champions of free trade, could find a way to limit the president’s trade-related powers. The best outcome, in our minds would be a commitment to negotiate that would allow both leaders to save face and declare victory.


Expanding global trade has been a positive tailwind for the US and world economies for decades. Unlike other recent worries, a trade war is an adverse exogenous event, similar in some respects to the OPEC oil embargo of 1973. While the course of markets is shaped by the interaction of countless factors, an escalation of current actions into a full-blown trade war would burden investors with additional risks.

Weekly funds flow data indicate that trade uncertainty is already motivating some to sell. Should it appear that trade risks are abating, a relief rally could develop. This illustrates why it is important to stay invested – even in situations when caution is warranted.

Mindful of current market conditions, we are making tactical adjustments to our process accordingly:

  • We are requiring more upside potential to make a commitment to a stock.
  • We may be quicker to take profits.
  • We are in no hurry to invest in those sectors that are most exposed, nor to jump into a tech sector that has reached new highs in valuations and market weighting.
  • We are identifying businesses that don’t appear to be directly exposed to tariffs with share prices that appear to have already been penalized.
  • Our strategy – the process by which we invest – has not materially changed over time and now is no exception. We are not in the prediction business but rather in the business of managing risk and exploiting opportunities.