Fight Trade Wars with Fundamentals

On Friday, May 10, the U.S. followed through on its threat to raise tariffs from 10% to 25% on $200 billion worth of China’s imports to the United States. 

In a fully anticipated response, China announced it will hike tariffs on $60 billion worth of U.S. imports starting on June 1. 

Markets pulled back from all-time highs on this news, as global growth expectations are adjusted back. 

While investors attempted to digest this new development, the markets experienced a correction, which, after the strong gains so far this year, some may feel is overdue. 

Increased volatility is nearly assured during periods of uncertainty such as these. But for those paying attention in the last 14-plus months, volatility should come as no surprise. 

With strong corporate and domestic economic data, there have been multiple periods of sharp upward gains within the last year and a half. But these rises can cause inflated valuations, which in turn can lead to intense pressure during periods of uncertainty. We have seen clearly during recent market pullbacks that markets will react quickly to any new set of circumstances that call into question the current state of economic stability and the rate of global and domestic growth. And, as usual, stocks and sectors that rose the most on the way up declined the most in the correction.

Thinking about where we are in the overall market cycle, most would agree that we’re in the latter innings of a decade-long bullish market cycle. We must remember that these cycles don’t simply end because markets return to what some might consider fair valuations. They end when the markets become overvalued. This is how virtually every market bubble has been created—and subsequently popped—as valuations simply couldn’t back the underlying corporate fundamentals.

I am not signaling the end of this bull market as we know it, and neither is the vast majority of the Street. In fact, the underlying fundamentals on both the economy and the companies have been pretty stellar up to this point. 

What we do need to realize, though, is that companies are going to be under increasingly more pressure to keep up and maintain long-run profitability. When markets face intense downward pressures, it is generally those higher-quality, more fundamentally sound companies that withstand the storm and emerge on the other side.

Our research has studied how quality as a factor has performed leading up to and during market drawdowns.  

Figure 1: Factor Performance in Market Cycles

This analysis shows that during a market drawdown—which we quantify as a 10% drop in the S&P 500 Index—quality as a factor has outperformed the S&P 500 every monthly period dating back to 1997. This is, by far, the best-performing factor in a drawdown period. Likewise, in the 12 months leading up to a drawdown, quality outperformed the S&P 500 in 75% of the months dating back to 1997.

Since the beginning, WisdomTree has recognized the important role these quality fundamentals can play in your overall market exposure. Our belief that a fundamentally weighted approach can produce attractive returns with less risk and expense than active management made us a pioneer in factor-based investing. We have implemented this philosophy across multiple asset and global Fund families, whether it be through our more defensive dividend-weighted strategies, our lower P/E, higher-quality approaches, our fundamental corporate bond strategies or even our new multifactor equity approaches.

In short, remember that reactionary markets are not a time for panic but a time for opportunity. Consider how improving the underlying fundamentals can help you navigate what would otherwise be rather uncertain markets.