The second quarter of 2018 can be called a lot of things, but boring isn’t one of them. The potential for a trade war between the United States and China heated up in April as China responded to the threat of U.S. tariffs on Chinese imports by warning of the same magnitude of tariffs on American exports. In addition, trade tensions with our allies such as Canada, Mexico and the European Union led to uncertainty in the markets. Favorable corporate earnings reports helped calm some of the global economic angst investors were feeling and U.S. stock markets saw positive results in the quarter as investors ultimately chose to remain optimistic despite the push/pull of good news and bad news:
- Historically low unemployment
- U.S. corporate earnings (+20%) and revenues are strong – tax reform and deregulation are helping stimulate the economy
- Stocks are still cheap to bonds
- Growth companies not as dependent on strong economic growth are continuing to outperform
- Small caps are outperforming as strong earnings and lack of foreign exposure are drawing new investment dollars
- Foreign central banks are keeping interest rates low for another year – this is a positive for maintaining long-term U.S. interest rates at current levels
- Previous tensions with North Korea have faded into the background
- Trade war anxiety pressuring global markets, especially emerging markets
- European economies are beginning to show signs of slowing – international stocks are showing losses this year
- Stronger dollar in 2018 is unwinding some of the weak dollar benefits of 2017 – hurting U.S. exporters
- Industrial companies tied to the growth of the economy and exports have sharply underperformed
- Oil prices are at a five-year high
- The Federal Reserve is planning to raise short-term interest rates by another 1.25% by the end of 2019 to 3.25% – this may slow the economy
- Our federal debt is now over $21 trillion and may make it more difficult to fund infrastructure projects and government programs in the future
Overall, growth still looks healthy and corporate earnings are growing strongly, but there are several potential political risks (trade, U.S. mid-term elections, North Korea) to markets over the second half of the year. The strength of the U.S. economy is also causing the Fed to gradually remove the punch bowl of easy money (low rates). The U.S. fiscal stimulus should keep growth going strong into 2019, but once the fiscal sugar rush wears off at around the same time that tighter monetary policy could start to bite, the economy could be left nursing a hangover heading into 2020. The currently healthy economy, balanced against trade concerns and the late stage of the U.S. economic cycle, argues for a balanced approach to risk but with an overall bias to stocks vs. bonds.
The U.S. inflation rate rose from 2.4% to 2.8% for the quarter as we are starting to see some signs of inflation and that is why the Federal Reserve has been raising short term interest rates to cool down the economy a bit and hopefully put the brakes on inflation. In the big picture though, inflation is still well in line with the last several years and does not appear to be a problem for now.
Over the next year, as we progress deeper into the late stage of this economic cycle, it will pay to be a bit more cautious with a focus on those areas of the stock market not as dependent on a strong economy for their earnings growth such as healthcare, technology, and targeted consumer cyclicals. Despite their poor performance in 2018, we believe the compelling valuations found in international stocks warrant exposure to both developed and emerging markets.
So, all things considered, we remain on the “push” (optimistic) side of the ledger for the time being but continue to monitor the markets for possible early warning signs of slowing growth ahead. We are hopeful that the current imposition of trade tariffs by U.S. and the corresponding retaliatory tariffs by our trading partners will give way to lasting agreements that will invigorate the global economy for years to come.
Second Quarter Winners
U.S Stocks, Oil, and REITs
Overall, the second quarter saw the tech-heavy NASDAQ gain over 6.5%, only to be bested by small caps of the Russell 2000, which grew by almost 7.8%. The S&P 500 also closed the quarter 3.4% ahead of its first-quarter closing values. The Dow didn’t fare as well, finishing the quarter up by 1.3%. Prices for 10-year Treasuries rose by the end of the quarter, pulling yields down by 13 basis points. Crude oil prices closed the quarter at about $74.25 per barrel by the end of June, almost $10 per barrel higher than prices at the close of the first quarter. Regular gasoline, which was $2.648 per gallon on March 26, climbed to $2.833 on the 25th of June.
An interesting winner in the 2nd quarter was US REITs (Real Estate). After rising rates hit REIT stocks hard in the first quarter they have come back strong in the spring quarter, rising 8.5% to get back to even for the year. Real Estate stocks often don’t do well when interest rates rise because their yields may start to look less attractive to investors than other investments such as bonds. Thus, REITs may get sold to buy other investments. However, research has shown that REITs aren’t always negatively affected by rising rates, and the 2nd quarter seems to be proof of that.
Second Quarter LosersInternational Stocks, Bonds, and Gold
Trade concerns have weighed heavily on international equity markets, especially on China and other emerging market countries. European equities have also been affected, with auto companies suffering on fears that U.S. tariffs could be applied to car imports. The conclusion of this scuffle is hard to predict, but the longer this drags on the greater the risk that it starts to impact sentiment more broadly. Further U.S. interest rate increases, or dollar strength could put additional pressure on the most vulnerable emerging market economies. However, the market has shown some ability to distinguish between the weak and the strong, with Indian equities up over the quarter.
After bonds produced positive returns in nine of the past ten years and have experienced a thirty-six-year bull market, 2018 has been a challenge for bond holders due to rising interest rates. When interest rates rise, longer term bonds are hit the hardest and shorter-term bonds fare the best. It is just the opposite when rates fall. The yield on the 10-year treasury started the year around 2.4% and rose up above 3% for a few days before falling back to around 2.85% at June 30. For the 2nd quarter, though yields held relatively steady and bonds have started to recover a bit.
A notable theme this quarter has been the widening in investment grade credit spreads. With corporate leverage elevated in the U.S. investment grade market and interest rates rising, we remain cautious on the outlook for these bonds.
In contrast to longer-dated bonds, ultra-short bonds have been able to take advantage of rising short-term interest rates to return almost 1% for the year and International bonds (except for emerging markets), have risen for the year as well. Emerging Markets bonds have been affected by the stronger U.S. Dollar and rising interest rates. Since many emerging markets countries’ debt is denominated in US dollars, rising US interest rates make it more expensive for them to service their debt.
A strong US economy gave the Federal Reserve (Fed) the confidence to raise interest rates again in June and signal two further hikes to come this year, followed by three more next year. In contrast, after a string of disappointing data and still low core inflation, the European Central Bank (ECB) announced that interest rates will not be going up until at least the summer of next year, although they did confirm that eurozone quantitative easing would come to an end by the end of this year. At the end of last quarter, markets were convinced that the Bank of England would raise rates in May. However, May and then June came and went with no action. Nevertheless, a bounce back in UK retail sales, combined with the lowest unemployment since 1975 and surveys indicating firming wage pressure, suggest that rates will rise this year and next unless Brexit negotiations prove disruptive. Against this backdrop, international government bond returns have been broadly flat other than in Italy where rates have risen due to political concerns.
Gold closed the quarter at roughly $1,254.20, noticeably lower than its $1,329.60 price at the end of March.