Are geopolitical risks beginning to impact stocks? While 2017 was marked by low volatility and little consideration for risk in general, the first quarter of 2018 feels different. As the volatility and unpredictability of the Trump Administration increases, and as we are firmly in the last innings of a long economic growth cycle, investors today appear more risk-focused and seem to react to the news flow with an almost knee-jerk reaction. Some of the re-pricing of risk is justified, others not so much. Whatever the case, markets are no longer willing to give the benefit of the doubt. Our suspicion is that market participants are beginning to realize the probability of a political mistake is rising (hence, the geopolitical risk premium needs to be repriced), exacerbating investor jitters around how much longer the economic cycle will last.
Take Caterpillar’s 1Q 2018 earnings announcement. CAT had a classic beat-and-raise quarter: it beat 1Q consensus estimates by >30% and raised its full-year guidance by >20% (+16% vs consensus). However, during the call, management’s comment that 1Q18 could be a “high watermark” for the year sent shares down 10% intraday. This, combined with the 10-year U.S. Treasury yields fast approaching 3% (at the time of this writing now above 3%), pushed market indices down 1.5%-2.0%.
Bears point to the fact that this signals a cycle peak; bulls point to the fact that the comments were misinterpreted—namely that, management comments were only pointing to 1Q being the peak quarter for the year. Bulls do have a point: when looking at most metrics—revenue, units sold, customer CAPEX ($) spent, replacement cycle, etc.—CAT’s end-markets are closer to trough than mid-cycle (let alone peak). A research analyst put it bluntly: Oil & Gas Engines, Power Generation, and Latin America Construction Industries (in total representing ~15% of sales) are at levels below 2009 lows and entering just the 3rd quarter of recovery.
But CAT is not a small-cap company (obviously). It is watched closely by buy- and sell-side analysts, competitors, suppliers, and customers all over the world. In fact, $3.5 billion worth of CAT shares traded in just one day.
So, what gives?
Well, geopolitics. The risks are extremely elevated, and in combination of being in ‘late cycle,’ they have the potential to overwhelm any case the bulls can make. Brexit, NAFTA, China trade spat, North Korea, rising yields, Syria, Iran, Amazon-USPS (AMZN being one of the largest capitalization stocks, hence non-trivial impact to market indices)….we likely missed a few others such as elections (globally), but you get the point.
Interestingly enough, many of these were sparked by Trump’s tweets and “unique” style of statesmanship. Thus far, Trump’s “art of bluffing” and real actions (versus tweets) suggest significantly milder results than their respective threats entail (“The Making of Donald Trump” and/or “Trump Revealed” are good reads). That said, the stakes are significantly higher than what Trump has ever faced, and a small miscalculation on Trump’s part (if in fact there are any calculations behind the tweets) could spell disaster for markets, and more importantly, to real lives.
In our view, that is what markets have come to realize: Trump’s unpredictable and potentially disastrous policies are real and tangible. And with rising rates (which to some degree is driven by Trump’s policies: tax reform and deficit notwithstanding), investors have woken up from the 2017 slumber to become more skeptical and skittish; markets are no longer complacent; and bears are looking for signs of an impending recession.
The next couple of months ought to be a bumpy ride. NAFTA, Mnuchin’s trip to China, the North Korea summit, the May 12 deadline for reinstating Iran sanctions, and the ebbing supply of Treasuries should find some resolution by summer. That’s when the World Cup begins and perhaps markets could be lulled away for a few months again. What wishful thinking.
As international equity investors, the team at R Squared Capital Management (former team at Julius Baer / Artio Global) utilizes fundamental and macro analysis in our quest to correctly identify structural tailwinds and headwinds at the geographic, sector and company levels.
FROM THE DESK OF LUIS AHN
Luis Ahn is a Partner and Analyst at R Squared Capital Management.
Prior to joining R Squared, Luis was a Senior Analyst at Bloom Tree Partners.
Luis received an MBA from The Wharton School and Bachelor of Science in Quantitative Economics and Computer Science from Tufts University.
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