Third Quarter 2018 Market and Economic Review

On the heels of strong economic data, record company earnings, and an uptick in volume, each of the three main U.S. stock indices reached all-time highs during the third quarter of 2018. Bonds, international stocks, and emerging market stocks are mostly negative for the year.

The NASDAQ Composite surpassed 8,000 in late August, largely propelled by big gains in popular technology companies like Google and Apple. After reaching 8,000, the NASDAQ is about 1 percent off of all-time highs.

In late September, the S&P 500 and the Dow Jones Industrial Average, which track the largest U.S. companies across all industries, reached new all-time highs for the first time since January’s quick break-out and subsequent correction.

In addition to large companies, small and mid-size U.S. companies continue to do well in this economy, helped by a strong U.S. dollar and the impact of corporate tax reform.

Most bond indexes are negative on the year, and these decreasing bond prices have been the primary headwind for diversified investors in 2018. This trend is due to an environment where interest rates are increasing.

When new bonds pay more interest than old bonds, the prices for old bonds decrease. Yields on 10-year U.S. Treasury notes traded above their highest levels since May in advance of the September Federal Reserve meeting, where interest rates were increased by 0.25 percent. Yields then decreased but stayed above 3 percent when the Federal Reserve’s preferred inflation measure, the personal consumption expenditures price index, remained unchanged during August.

International and emerging market stocks are mostly down for the year and have been another constraint for investors with diversified asset allocations.

European stock markets continued to rebound in the third quarter after a poor performance in the first quarter, with the Stoxx Europe 600 index rising 0.9 percent. There is a historical relationship between company earnings and stock prices; thus, European stocks remain at attractive price levels.

Emerging markets, which consist of developing markets such as China, Brazil, Indonesia, and Chile, have struggled this year due to a strong U.S. dollar, threatened and actual tariffs, and a decrease in the Chinese economic growth rate, which causes a ripple effect in countries with close economic ties. The Shanghai composite index, which tracks the Chinese stock market, has fallen 15.4 percent year to date. Spain, Chile, and Belgium’s stock markets have fallen over 6 percent year to date.

While most are down, some international stock markets are up for the year, such as Japan, India, and Israel. In a sector like international stocks where there is significant variability among returns, while not guaranteed, an active management strategy can yield results by allocating more to the markets most likely to succeed in the short-term.

The market performance benchmarks, listed in the table below, are the same benchmarks as those shown 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 like the S&P 500 index. These benchmarks include not only large U.S. stocks, but smaller stocks and international investments.

Economic Review

As analysts expected, at the Federal Reserve’s September Federal Open Market Committee (FOMC) meeting, interest rates were increased by 0.25 percent. During the recession of 2008-09, the Federal Reserve decreased interest rates to stimulate lending and borrowing. The Federal Reserve started a rate hike cycle in December 2015 as the economy regained its strength and has raised rates seven times since then, once in 2016, three times in 2017, and three times in 2018.

With the September rate hike, interest rates now sit at 2 percent to 2.25 percent. Based on the “dot plot” of where Federal Reserve members see interest rates going, the consensus is three rate hikes in 2019 and two rate hikes during 2020. This expected reduction in the frequency of rate hikes is encouraging. It alleviates a concern of investors that the Fed might raise rates too quickly, which can cause reduced investment and slowing economic growth.

The U.S. economy continues to report above-trend data. GDP for the second quarter of 2018 was reported at 4.2 percent, the fastest growth rate since 2014. Looking through the first half of 2018, GDP has grown 3.2 percent.

Consumer confidence rose to its highest level since September 2000, while small business optimism rose to its highest level ever, crossing levels not reached since the 1980’s.

Federal Reserve surveys of manufacturing businesses have been coming in above expectations, with capital expenditure measures showing that companies are planning to increase purchases in the months ahead. This confidence may reflect the willingness of businesses to invest more aggressively in an attempt to improve efficiency as the labor market tightens.

Wage growth on a nominal basis has increased in 2018. However, inflation has increased as well, bringing inflation-adjusted, real wage growth to just 0.1 percent at the most recent reading. Wage growth is often delayed as most employers raise wages once per year, so we will have to wait and see if more acceleration in wage growth occurs.

After more than a year, in what was a last-minute negotiation, the U.S., Mexico, and Canada reached a tripartite trade agreement on September 30th. The partner nations will scrap NAFTA and call the new deal the United States-Mexico-Canada Agreement (USMCA). The agreement must be passed by Congress to go into effect. Since this happened just days before we wrote and distributed this email, we will look at the full details of this agreement and will follow-up with more information at a later date.

With U.S. markets at all-time highs, and as financial media lists out the achievements of the highest performing indexes, regions, and sectors, remember that markets often revert to their long-term mean. While the economy and company fundamentals are strong, trade tensions and political risks could derail recent market gains. Diversified asset allocations, created with a clear idea of the objective behind the investment, have historically proven themselves the best strategy available for long-term investors to mitigate portfolio risk.