The old adage “Sell in May and go away!” was not good advice this year. From May through September, large company stocks as measured by the S&P 500 posted a return of 11%, bringing the YTD return up to 10.6%. Small company stocks have also had a good year. The Russell 2000 Index of small caps was up 11.5% year-to-date through the end of the third quarter. Foreign stocks have continued to trail the US; the MSCI ACWI Foreign Stock index is down 3.3% for the first three quarters of the year. The performance disparity between US and foreign stocks is significant and reflects a number of factors. First, the US economy has been performing better than those in much of the rest of the world. Second, a rising dollar resulted in unfavorable currency conversions for owners of foreign stocks. And finally, much of the gain of US indices (the Dow Jones industrials, the S&P 500) has been driven by the performance of a few very large companies such as Microsoft, Boeing, Amazon, Apple, and Google, which have large weightings in the commonly-used indices and which have had outsized returns this year. After this divergence of performance, foreign stocks now look cheaper than US stocks on a valuation basis (price to earnings, price to cash flow, etc.).
|Market Index Returns as of September 30, 2018|
|Index||3rd Quarter||YTD||1 Year||3 Years||5 Years||10 Years|
|S&P 500 (US Large Cap)||7.7%||10.6%||17.9%||17.3%||14.0%||12.0%|
|Russell Midcap (US Mid Cap)||5.0%||7.5%||14.0%||14.5%||11.7%||12.3%|
|Russell 2000 (US Small Cap)||3.6%||11.5%||15.2%||17.1%||11.1%||11.1%|
|MSCI ACWI X-US IMI Net (Foreign Equity)||0.4%||-3.3%||1.8%||10.1%||4.4%||5.6%|
|MSCI EM (Foreign Emerging)||-1.1%||-7.7%||-0.8%||12.4%||3.6%||5.4%|
|Barclays Aggregate Bond||0.0%||-1.6%||-1.2%||1.3%||2.2%||3.8%|
|Barclays Muni Bond||-0.2%||-0.4%||0.4%||2.2%||3.5%||4.8%|
|Past performance is not an indication of future performance.|
Back in February of this year, the US Bureau of Labor Statistics reported that January hourly wages grew at a higher-than-expected 2.9%. This report immediately sparked inflation worries and sent US stocks down 6% in just two days. A similar BLS report of 2.9% wage growth for August saw no such reaction because so far, rising inflation just hasn’t materialized. History has demonstrated that this Goldilocks scenario won’t last forever.
The US Federal Reserve has worked to stay ahead of inflation. The Fed once again raised the Federal Funds rate target range by 0.25% last month, to 2.00%-2.25%. The Fed Funds rate is the interest rate at which banks can lend excess cash balances to other banks overnight. When the Fed raises the Fed Funds rate, as it has eight times over the last three years, interest rates rise on short-term bonds, making it more costly to borrow money. The Fed’s goal is to moderate the rate of economic growth in order to keep inflation in check. The Fed has communicated that the current target range of 2.00%-2.25% for the Fed Funds rate is a “neutral stance,” neither stimulating nor hindering economic growth.
With US unemployment holding below 4%, there are now 659,000 more job openings in the US than unemployed workers—a record level since the Labor Department started tracking openings. With fewer workers available for a growing number of jobs, wages will likely continue to rise more quickly than we have seen over the past decade. After all, wage growth of 2.9% is still only about 1% in real terms when you adjust for inflation. As wages move higher, the Fed will likely continue to push interest rates up, at least through 2019.
The “trade war” with China continues to dominate headlines. So far the US has imposed tariffs on $253 billion in Chinese imports, which accounts for about half of the $504 billion in products the US bought from China in 2017. China, on the other hand, has imposed retaliatory tariffs on about $100 billion in US exports, which covers a much higher percentage of the $129 billion in goods China imported from the US in 2017. Pockets of disruption are showing here in the US. For example, President Trump already enacted a plan to provide farmers up to $12 billion in relief to mitigate damage from Chinese tariffs. While tensions with China are intensifying, the US has made progress in trade negotiations with South Korea, Mexico, Canada, and Europe.
While the trade dispute with China is far from over, it’s unlikely to escalate further prior to the mid-term elections. According to many polling organizations, Democrats are projected to win a majority in the House of Representatives while Republicans are projected to retain the Senate. This is not unusual; according to PolitiFact, the party of the sitting president has lost, on average, 32 seats in the House and 2 seats in the Senate in mid-term elections since 1862. A split Congress would likely ensure that policies like tax reform and deregulation, enacted by the current Republican-led Congress, would stay in place. Gridlock in Washington has historically been good news for the stock market.
This bull market has persisted long enough that the historic collapse of Lehman Brothers, now 10 years in the past, seems like but a distant memory. Bull markets don’t, however, die of old age. It’s usually a recession that finally ends the run and the run will end at some point. The economy seems to have enough momentum to continue to expand, at least in the near term. US GDP grew 4.2% in the second quarter and is expected to have grown more than 3% again in the third quarter. Some are suggesting that the entire decade of the 2010s will pass without a recession—something that’s never happened in a calendar decade in the history of our great country. The slow but steady growth we have seen since the financial crisis has sustained economic expansion while also preventing the economy from overheating. It appears that we are now closer to the turning point however, with headwinds more apparent (higher interest rates, wage pressures, surging oil prices) and with pockets of weakness (softening auto sales and a sluggish housing market in parts of the country).
With valuations still above historical norms, stocks may not perform at the level we’ve grown accustomed to over the last few years. Rising yields on savings and a strong labor market will be good for American households but rising interest rates, energy prices and labor costs are likely to put pressure on corporate profit margins. Likewise, friction in international trade may increasingly impact the bottom line for multi-national corporations. Since 2009, the US stock market has run ahead of the US economy, but we should be prepared for a time when Main Street finally does better than Wall Street.
Our recent portfolio actions are intended to position clients for what may come. Benton quoted Cicero in his article. I’ll jump on the bandwagon and conclude with another Cicero classic that is relevant to our work:
“Before beginning, plan carefully.”