The first quarter was a tumultuous one. Investors began the year with optimism, the net bullishness of the American Association of Individual Investors indicators reached a level not seen since 2010. Growth which in the past decade had been patchy or fragile seemed to have deepened and broadened. The only quibble investors had was that asset prices were high.
In February a strong wage and jobs report sparked fears of inflation, justified but much too early in our view, which saw the return of volatility. The VIX which had much of 2016 and 2017 in the 10 – 15 range spiked to over 35 and seems likely to settle into a 15 – 20 range. Shortly following, the US stoked fears of trade war by initiating tariffs on a select number of imports which set off retaliatory rhetoric by China and Europe. Equity markets have fallen off the year’s highs, credit spreads have widened and bond yields have risen.
The S&P 500 index ex tech has lagged the S&P 500 by some 3% per annum over the last 10 years, and by more than that more recently. Tech has been the leader of returns and it was tech that came under pressure with the Facebook data scandal. At around the same time Europe was preparing a 3% e-commerce tax. Uber and Tesla’s autopilot accidents are likely to face heavy scrutiny and could face onerous regulation despite accident rates for autonomous vehicles being below that for human operated vehicles. In the wake of the 2008 financial crisis, banks and financials came under intense regulation which saw them underperform the S&P 500 by as much as the S&P ex tech lagged the S&P500. Globally the tech sector appears to be vulnerable to increasing regulation on a number of fronts including a) privacy and data protection, b) tax arbitrage, c) the impact of artificial intelligence. Given the ubiquity of tech in our daily lives, it is likely more issues will arise on the regulators’ agendas. Might tech be the next over-regulated sector with profitability squeezed into utilities territory?
We observed that banks underperformed the broad market for most of the last decade as profits sagged under the weight of regulation and increased capital requirements. Last Friday, the US banks reported mostly buoyant earnings, ahead of forecasts and indicating strong growth. Net interest margins had not risen as quickly as the market had expected but loan growth has begun to recover. Lower tax rates, higher interest rates and fully recapitalized balance sheets should boost potential for banks. Further, the rotation of the regulatory attention from banks to tech should also ease the regulatory burden for banks. The market reacted poorly despite the strong set of results of the Wall Street banks, probably as expectations had risen ahead of themselves in the last few months. We think its early days for the banks. Loan growth has been dented by the switch to capital markets, but rising rates could impact investor demand for fixed coupons.