Second Quarter 2018 Commentary – Summer School

School is out for summer and all of the important grades have been locked in for the first half of 2018. The most recent earnings season grade for corporate America was an “A” as profit growth amongst S&P 500 companies was higher than any time since 2011 and nearly 75% of the stocks in the index beat their estimates, with a boost from lower tax bills. U.S. household wealth surpassed $100 trillion earlier this year for the first time, which means households have nearly doubled their net worth from the low in 2009. And with unemployment dropping to 3.8%, there are now more job openings than bodies prepared to fill them. All of these things receive high marks. To the contrary, the growing threat of a global trade war has caused certain asset classes to reprice. We also face a lack of market breadth this year, which removing the industry parlance, means that only a few companies are driving the majority of the return, mostly high-growth technology companies. Markets tend be weakest when they are narrow. Eventually another pocket of the equity universe will have to keep global markets trending higher. Through the second quarter, the market received a passing score but improvements will be needed to hold that grade.

After a negative first quarter, U.S. equities have officially recovered all of their losses from the market correction earlier this year. For larger companies, the S&P 500 is up a modest 2.6% for the year, however, its small cap counterparts are up nearly 10%, with more than 90% of that return coming this past quarter. A strong argument can be made that small caps have been bigger beneficiaries of the new tax bill. Companies in the Small Cap 600 Index had an average tax rate roughly 4.5% higher than companies in the S&P 500 over the past three years. Additionally, smaller companies do less business in foreign markets, making them less susceptible to any sanctions related to trade. 2018 has been a year of trade tensions and given small caps tend to generate 80-90% of their sales inside this country, they have been looked upon more favorably by investors.

As it has been said, you can never have the good without the bad. Foreign equities were not able to keep pace with U.S. equities as international developed stocks finished down about 1% for the quarter and emerging market stocks finished down about 8%, leaving them down nearly 20% from their January high. Much of the current emerging markets debate circles back to any perverse outcomes related to trade wars, most notably negative consequences tied to China, which makes up 30% of the emerging market index. Adding insult to injury, the U.S. dollar rallied 5% in the second quarter – emerging markets tend to carry large amounts of dollar-denominated debt, thus increasing the cost to service that debt. While these losses have hurt investors’ wallets, we argue they also create opportunity. Emerging markets relative valuation versus the S&P 500 is almost at a 15-year low, and it’s fair to believe the reasons behind that are associated more with headline risk (bad press causing uncertainty) than structural risk. If you buy quality things at low prices, you put yourself in a good position to earn above-average returns. At a high level, emerging market stocks fit into this framework.

Fixed income experienced a bumpy first quarter followed by a more mild second quarter. Taxable bonds finished slightly negative while municipals rallied nearly 1% to recoup some losses after their worst first quarter in 15 years. In mid-June, the Fed hiked interest rates for the second time this year and indicated two more increases were likely before year end. As the Fed continues to raise rates, their actions have been responsible for lifting short term bond yields to their highest levels in over nine years. However, the Fed’s influence on longer term bond yields is minimal, which has created a scenario where short term and long term bond yields are within waving distance of each other, causing the yield curve to flatten. It’s important to listen to what the bond market is telling us, and currently it’s saying there is little fear of rapid inflation, as long-term bond investors’ would require higher yields to compensate for inflation eating their returns. In terms of the economic data, the “Goldilocks economy” narrative remains strong as the economy is not too hot nor too cold, with the data generally confirming moderate growth and mild inflation. Real Estate, an asset class that was down nearly 10% in early February, rallied more than 6% in the quarter to nudge itself into positive territory for the year.

While the U.S. stock market is up modestly year-to-date, it doesn’t hold a candle to last year’s rally. To some extent, investors started incorporating higher expectations for growth last year, pushing equity prices higher. Put simply, last year’s strong equity returns were pulling forward a lot of the good things (embedding it in the price) we are living through this year. Despite solid report cards from most companies in April and May, investors are collectively taking a pause. Following an outstanding year for equities like 2017, one of the big takeaways had to be the impact it had on investor psychology. After living through 12 straight months of positive equity returns with no decline of more than 3%, it’s easy to forget that markets are complicated and constantly performing a balancing act between the present and the future. As volatility hovers at levels 50% higher than this time last year, the market seems poised to keep the talking heads loaded with topics for debate.

And while the individual grades can be debated, the overall grade is a passing score. Improvements will be needed if investors are going to reap their 10th straight year of positive U.S. equity returns. Ultimately, you can’t pay any price for an investment and expect to get a positive result. A point will come when investors in high-flying growth companies become motivated to “de-risk” and take profits, at which point some other equity asset class will have to take leadership to abate the selling. Whether that happens could be the grade worth watching over the next year.

 

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