The second half of 2018 will be tough for investors as they grapple with rising trade tensions and higher interest rates, according to Goldman Sachs. However, companies with strong balance sheets like Facebook and NVIDIA should do well in the tough times ahead as they can better deal with higher borrowing costs and overall volatility.
Equities posted a mixed performance to start off the year, as the enthusiasm over strong economic data and solid earnings growth was dampened by worries about an impending trade war between the U.S. and its key partners. This, along with the prospects of higher rates, sets up investors for a potentially rough second half.
“While trade tensions have fluctuated for much of 2018, the situation has escalated during the last month. The White House recently proposed new tariffs on auto imports totaling $275 bn and tariffs targeting Chinese imports worth $400 bn,” David Kostin, chief U.S. equity strategist at Goldman Sachs, said in a note Friday.
Equities felt the bite of rising trade tensions again on Monday, with the Dow Jones Industrial Average falling more than 100 points to start off the second half.
The Dow declined 1.8 percent in the first six months of the year, while the Nasdaq composite and S&P 500 rose 8.8 percent and 1.7 percent, respectively. Stocks also fell into correction territory earlier in the year, pushing the major indexes off record highs, on concerns of rising interest rates.
“Rising interest rates and escalating trade tensions have contributed to an increase in equity volatility in 2018,” Kostin said. The “10-year US Treasury yields have risen by 44 bp YTD to 2.85%, and our economists expect they will continue to rise to 3.25% by year-end 2018.”
The 10-year Treasury yield rose slightly to 2.855 percent on Monday.
The Federal Reserve has already raised rates twice this year, and investors are expecting at least one more rate hike before year-end. However, Kostin said the Fed could tighten monetary policy a lot faster than the market expects through 2019. “The fed funds futures market is pricing just 3 additional rate hikes through the end of 2019 compared with our economists’ expectation for 6 hikes,” he said.
Kostin said stocks including Chipotle Mexican Grill, Intuitive Surgical, Facebook and NVIDIA should do well in the second half, however, given their strong balance sheets can withstand higher borrowing costs. These stocks have all outperformed the S&P 500 this year, rising at least 10 percent.
Goldman uses a metric called the Altman Z-Score to determine the strength of a company's balance sheet. The score takes into account five ratios: working capital to assets, retained earnings to assets, earnings before interest and taxes to assets, sales to assets and market cap to liabilities. The higher the score, the stronger the company's balance sheet.
“Thematically, strong balance sheet stocks have outperformed this year as short- and long-term interest rates have risen,” Kostin noted. “We expect strong balance sheet stocks will continue to outperform given record-high net leverage for the median S&P 500 stock and tightening financial conditions.”
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