Second Quarter 2018 Market and Economic Review
After briefly going into a market correction in early 2018, U.S. equity markets continued to rebound and avoid going back into correction territory during the second quarter.
A market correction is defined as a decrease in value of more than 10 percent from a 52-week high.
Of the three main U.S. stock indices, the S&P 500 and Dow Jones Industrial Average are close to even for the year after the big run-up in January. The Nasdaq Composite index is up a notable 10.1 percent for the year, reflecting strong performance from technology stocks.
Other sectors that have done well are small and mid-size U.S. companies, up 8 percent and 5 percent year-to-date. This can be attributed to several things.
Strong domestic economic growth is helping all companies. This is strengthening the U.S. dollar, which has helped smaller companies with a majority of revenue derived from the U.S. and not in a foreign currency. Second, with concerns of a trade war looming, smaller domestic stocks are seen as less vulnerable. A third factor is the impact of corporate tax reform. Companies that do most of their business in the U.S. benefit more from domestic tax cuts than multinational corporations since a higher percentage of their revenue is derived in the U.S.
Looking at U.S. bond yields, the second quarter saw yields on 10-year U.S. Treasury notes rise (prices fall) for the fourth consecutive quarter, to a nearly seven-year high of 3.109%.
Prospects of higher economic growth and increasing inflation have contributed to the rise in interest rates.
While rising interest rates signal strong economies, this environment can hurt prices of existing bonds since the newer bonds would pay higher yields. The best way to limit risk from rising rates is to move to shorter-term bonds, which keeps investors from locking in lower yields over long timeframes. This is a strategy we have utilized as interest rates have risen. Bonds remain an important element of a well-balanced portfolio, though, as they provide valuable diversification and a counter to stock market volatility.
Overall, international equity markets have struggled this year.
The threat of a trade war and geopolitical tensions are the main reasons for this decline. Despite the overall trend, some regions saw a rebound during the second quarter.
China continues to be the main target of trade actions, even as it relates to the NAFTA renegotiation, and Chinese markets are feeling the impact. The Shanghai composite index is in bear market territory, defined as down more than 20 percent from its 52-week high.
European stock markets rebounded in the second quarter, rising 2.4 percent after a 4.7 percent decrease in the first three months of the year. The UK stock market performed quite well during the second quarter jumping 8.7 percent, its biggest quarterly advance since the first quarter of 2013. European stocks have largely remained at attractive valuations.
The market performance benchmarks, listed in the table below, are the same benchmarks as those in the Risk/Return and Account Analytics sections of client quarterly performance reports. By comparing your portfolio’s return to the benchmark with the closest risk/return characteristics, you get a more accurate reading of portfolio performance than using a less diversified benchmark, such as the S&P 500 index since it includes not only large U.S. stocks, but smaller stocks and international investments.
* Each benchmark is allocated based on assumed Risk Profile of underlying indices.
**Benchmarks include a mixture of ICE BofAML US 3-month Treasury Bill Index, Barclays Global Aggregate Bond Index, Barclays US Aggregate Bond Index, MSCI EAFE Index, and the Value Line Composite Stock Index (Geometric).
At the June Federal Open Market Committee meeting, the Federal Reserve Board of Governors elected to raise the target range for interest rates by another .25 percent, up to a range between 1.75 percent and 2 percent. The decision to raise rates resulted from strong U.S. economic growth, growing wages, and inflation continuing to move closer to the Fed’s long-term 2 percent target.
Some investors worry about the Fed raising rates so quickly that it hurts economic growth. However, history shows that in order for this to happen, the Fed needs to raise rates above the nominal GDP growth rate, which represents total spending in the US economy, including inflation. With nominal GDP growth conservatively projected at 5 percent, it would take the Fed three years to push interest rates above 5 percent at the current pace. In summary, Fed policy is nowhere near becoming “tight”, when the Fed takes action to slow down an overheated economy.
On the fiscal policy front, President Trump continues to use economic leverage as a catalyst for trade concessions as well as geopolitical concessions.
China continues to be the main target of U.S. trade actions, even as it relates to the NAFTA renegotiation. Overall, we see Trump imposing tariffs as a negotiating tool, not as a strategy to give U.S. companies an unbalanced advantage. Most countries have higher tariff rates than the U.S. in order to protect domestic production of goods. With the European Union, Japan, and China all having more protectionist trade policies than the U.S, the U.S. is in a stronger negotiating position, especially since it is a larger net importer.
If other countries do not agree to negotiate and a tit-for-tat trade war occurs, current estimates are that it would shave 0.2 percent off U.S. GDP. With the U.S. economy growing around 3 percent, a recession caused by a trade war is unlikely. Also, the U.S. is a consumption-based economy, consuming over 80 percent of the goods we produce. Production-based countries whose economies depend on exports would be far worse off than the U.S.
With NAFTA negotiations, the biggest sticking point is where the auto parts that are used to assemble cars originate from. The U.S. position is that more of the parts for autos should be produced in the U.S., Mexico, and Canada. Mexico and Canada currently do not agree.
Over the last two decades, auto manufacturers have moved operations from the U.S. to Mexico in order to import parts from Asia, assemble and install them, and then ship the completed cars into the U.S. through NAFTA without duties. In 2016, $74 billion of the annual trade deficit with Mexico was from the auto sector alone.
Cheap labor costs notwithstanding, without the existing NAFTA loophole there would be much higher incentive for American auto manufacturers to put their auto plants in the U.S.
As trade negotiations progress, our hope is that the squabbling can be resolved sometime soon without giving tariffs a ton of time to work through the system. Our hope is to move closer to no-tariff free trade, which is the most efficient economic system.
In the meantime, tariffs are inflationary. As long as they continue, the tariffs will help our investments that respond well to inflation. By holding securities that are hedged by inflation and diversifying across different regions and companies, our investment models are positioned to navigate the trade tensions that are occurring.