Equity Outlook  |  Q2 2019

Market disruption and the risk no one is talking about

Shep Perkins, CFA, Chief Investment Officer, Equities

Market disruption and the risk no one is talking about

Investors are not worried about inflation. That is one reason I believe it's a key risk for equities. Given the subdued inflation trends over the past decade, the market has been more concerned about deflation, which can be driven by falling commodity prices, lack of wage growth, efficiency gains from innovation, and global trade. It is logical, with the current environment of slowing global growth and the recent yield curve inversion, to disregard the potential for inflation. However, it is worth considering whether pressures finally may be building.

First, a pickup in economic growth seems probable. Interest rates have pulled back, China is implementing stimulus measures, and we are likely to see a resolution soon for some aspects of the U.S.–China tariff conflict. Second, consider energy prices. After peaking in mid-2018, oil prices fell dramatically later in the year, further dampening inflation concerns. However, production cuts from OPEC could continue to move oil prices higher. At the same time, geopolitical uncertainties, particularly related to U.S. sanctions on Iran and Venezuela, could lead to a minor supply shock and a spike in prices.

From a labor market perspective, there has been a notable pickup in wage inflation in the past six months. It could be that the combination of low unemployment and increasing labor participation has finally reached a tipping point and the economy is finally seeing real labor market tightness.

Tighter labor market conditions, combined with a boost in global economic growth, could surprise the market with a considerable amount of inflationary pressure. This would weigh on equity markets for several intertwined reasons. For one, interest rates would rise and the "Fed put"— the Federal Reserve's willingness to keep the federal funds rate low — would be jeopardized. The Fed would be inclined to hike rates, and higher rates naturally slow the economy. This, in combination with higher wage pressure, would squeeze corporate profits. Moreover, as rates rise, market price/earnings multiples would be more likely to contract than expand as bonds and fixed income securities become more attractive relative to stocks. High-growth stocks would be particularly vulnerable in this environment, as their elevated P/Es have the farthest to compress. Lower corporate earnings and a falling market P/E is a painful combination for equities.

"Innovation creates a huge opportunity, with no guarantees. The winners could be the new disruptors or the entrenched players that embrace innovation."

Disruption in the supermarket

Constant innovation is a potential opportunity for equity investors. The market potential can be huge as companies develop better, faster, cheaper — and groundbreaking — products and services that can be adopted globally. Most of these innovations have higher margins and low capital intensity, especially software. Of course, there are high risks too. As many innovative growth companies command high valuations, they are assuming some level of success that is sustainable. Yet, this is far from certain. Also, innovation can be disruptive in a negative way for existing businesses. This threat of technological disruption has weighed on long-standing firms whose stocks have shifted from growth to value. And it has hurt stocks of some traditional value-oriented firms that are losing market share to innovative growth companies.

Grocery retailing is not known to be a dynamic growth segment of the market. But technology disruption has arrived for this traditionally sleepy, low-margin business. Recent changes are significant — and they bring opportunities and challenges for equity investors. Examples of disruption include online ordering/in-store pickup, two-hour grocery delivery services, driverless delivery programs, and online grocery purchases even in cities without a physical grocery store presence. These innovations have boosted e-commerce sales considerably and are coming from new entrants to the grocery industry as well as existing players.

This brings challenges to legacy grocery companies, primarily increased supply due to new entrants and price discounting by these new players to attract business. It seems likely that both incumbents and challengers will increase their investment, the former to protect their positions and the latter in an attempt to gain market share. Online grocery shopping represents a negligible share of the market today. It has the potential to grow in much the same way online apparel shopping has, and to capture double-digit share in the coming years. Innovation has the potential to create substantial opportunity, with no guarantees. The winners could be the new disruptors or the entrenched players that embrace innovation.

Still many questions around tariffs and trade

In this report one year ago, we first cited "Trump, tariffs, and trade" and U.S.–China tensions as a risk in equity markets. News headlines suggest we are closer to a favorable resolution for some aspects of the trade conflict. A partial solution could limit further tariff increases and possibly reverse some of the tariffs put in place last year. However, this outcome is uncertain, and more aggressive tariff measures could be enacted.

There is reason for some optimism, as President Trump's negotiating stance seems in part dictated by stock market momentum. Stock market weakness due to the lack of any trade deal may prompt him to capitulate to some degree. At the same time, China is not in a particularly strong negotiating position. According to some data, China's economy experienced a pronounced decline in 2018 — much slower than the country's reported 6.5% GDP growth would suggest. Auto sales, for example, were down close to 20% at the end of the year. The Chinese government has enacted a series of stimulus measures, a sign that the economy is indeed weak. Ironically, a combination of a weak U.S. stock market and a struggling Chinese economy could help cement some type of deal, most likely geared toward the U.S. trade deficit.

Even if some agreements are reached, the U.S.-China trade relationship is complex. There are many unresolved issues relating to manufacturing competitiveness, intellectual property, and cybersecurity, which could lead to export controls on critical technology and defense items. We expect the underlying trade friction to be sustained for years, not months.

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