2nd Quarter 2018: Market Commentary

Market Commentary

The S&P 500 Index was up 3.4% in the second quarter, bringing the year to-date return to 2.7%. Recall that returns in the first quarter were slightly negative and that the first quarter was marked by a dramatic surge out of the chute followed by a sharp correction of 10% that started at the end of January. A return to the January high for the S&P 500 remained elusive during the second quarter as the market reacted to headlines on trade and interest rates. However, small cap stocks were particularly strong in the second quarter as the Russell 2000 was able to break through to new all-time highs with a 7.8% return. Volatility was more contained through the spring than in the first quarter but still elevated relative to the unusually calm markets we saw last year. Foreign stocks did not fare as well. Emerging market stocks in particular struggled, as the MSCI Emerging Markets Index lost 8%. Some of the negative performance of foreign equity can be explained by the strengthening US dollar. With the US Federal Reserve being the only major central bank tightening monetary policy and with economic growth slowing among most major nonUS economies, the US Dollar Index (DXY) rose 5% in the second quarter relative to other global currencies.

Italy puts EU on edge

Political developments in Italy raised stress levels around the European Union in June when the populist Five Star Movement and anti-EU League parties formed a new government coalition—the 64th government since 1945. Five Star wants to create a monthly income for all Italians while the League wants to cut income taxes. Both parties want to lower the pension eligibility age. Together, these changes could add an estimated $200 billion to the already large annual budget deficit.

If Greece threatened the stability of the EU in 2011, Italy poses an even larger threat. Italy is the third-largest economy in the EU and ninth-largest in the world. Any stumble there could induce the European Central Bank to postpone plans to curtail its quantitative easing program early next year.

Borrowing costs are rising

“The economy is doing very well,” declared Chairman Jerome Powell following the June Federal Reserve meeting. Accordingly, the Fed raised the Fed Funds rate another quarter of a percent for the second time in 2018 and seventh time since December 2015, bringing the overnight rate up to 1.75% – 2.00%. These moves have pushed interest rates higher but the current rate level is still relatively low as the Fed’s neutral rate is around 3%. As of the June meeting, the majority of Fed committee members were expecting a total of four rate hikes in 2018—a sign the Fed expects continued economic growth and isn’t putting too much stock into predictions of a full-blown trade war.

One of the reasons cited for the recent rate hike is that some businesses are reporting trouble finding qualified job seekers. The unemployment rate stands at 3.8% as of May’s reading—the lowest rate since 1969—and is still trending lower across all areas of the labor market. Any further improvement in the labor market may result in wage pressures and a pick-up in inflation, which could signal that the economy is beginning to overheat as it usually does late in the economic cycle. This may prompt the Fed to raise rates at a faster pace and even overshoot the 3% neutral rate.

As the Fed has steadily raised rates, the difference between short- and longer-term Treasury yields has narrowed. Historically, when the three-month Treasury yield has risen above the yield of ten-year Treasury (referred to as a yield curve inversion), it has been a reliable warning sign of an impending recession. When the curve has inverted, a recession has generally started within two years. We aren’t there yet but it is something we are watching closely.

In the interim, the Fed will likely keep pushing interest rates higher as long as the economy and the stock market continue to do well. That raises borrowing costs for everyone but doesn’t necessarily mean stock prices will fall as a result. In fact, the stock market generally rises during periods when the Fed is hiking rates, as you can see in the accompanying chart. It shows market returns during periods when the Fed raised rates by more than 1% over the past 35 years.

Tariff rhetoric ratchets up

While tariffs on hundreds of billions of dollars’ worth of imports have been discussed by the Trump administration, thus far, tariffs on just $34 billion in Chinese imports have been enacted since the March steel tariffs. As retaliation, China enacted their own tariffs, in this case on $34 billion worth of US exports. While a large number, it equates to less than 0.2% of our GDP.

Though we are currently talking trade on three fronts— China, Mexico and Canada (NAFTA), and Europe—we haven’t yet devolved into an all-out trade war. As you can see from the world map of global tariff rates, the US has a long way to go before we are truly considered a protectionist country and trade restrictions have a major impact on our economy.

The back-and-forth rhetoric is having an effect, however, as many businesses are delaying new projects and wage increases due to trade worries. The Atlanta Federal Reserve Bank recently cut their previous GDP growth estimate for the second quarter from 4.8% to 3.8% as a result. The trade situation is likely far from over. We are still hoping for a negotiated resolution because we’ve learned from history that no one tends to win in a prolonged trade war.

Earnings growth is built into market prices

S&P 500 earnings are expected to grow by 20.5% in 2018 according to FactSet. And yet the S&P 500 Index is up just 2.7% for the year. In what may seem like a contradiction, stock returns are usually lower when earnings growth is high. Conversely, returns are usually higher when earnings growth is low or negative. This is because the stock market is forward looking. Expectations for future earnings are usually already reflected in current market prices.

The stock market detests uncertainty, so we are likely to continue to see bouts of volatility while the trade situation plays out. That’s not the worst thing for investors because whenever there is broad consensus that “everything is great,” the market tends to be set up for failure. The general mood to start the year was very positive and the market shot higher. But then it only took one better-than-expected wage-growth reading to set off a 10% correction.

A high level of uncertainty (fear) may mean that market participants see an above-average probability of a pending recession or slowing earnings growth but this uncertainty also creates an environment where unexpected good news can potentially move stock prices higher.