As we reach mid-year of 2018, we are seeing a very different tone to the markets than we did at the end of last year. Since February 2016, we have seen a global synchronization with Central Banks around the world providing liquidity and accommodative monetary policy, strong Institute for Supply Management (ISM) manufacturing production readings, positive GDP in most major markets and fairly strong employment.1This led to positive equity markets around the globe and very little volatility.2In the first quarter, we saw volatility spike3and then come back down, with news like trade wars,4Fed hikes5and the meeting with North Korean president Kim Jong Un dominating the news and the tone of the equity and bond markets. During the second quarter, we saw a decoupling between the U.S. equity markets and the international and emerging markets with the U.S. markets continuing to show strength even while several issues have impacted the international and emerging markets.6sup>
With U.S. companies continuing to show positive earnings growth and benefitting from fiscal stimulus, stocks rebounded over the second quarter of 2018. The S&P 500 was up 3.4% for the quarter with consumer discretionary and technology stocks leading the way. U.S. small-cap stocks were the big winners with the Russell 2000 index up 7.8% as investors focused on domestically oriented companies.7sup>
Internationally, both GDP growth and ISM manufacturing production numbers are still positive, but slowing.8Furthermore, ECB is planning for stopping bond purchases, Italian voters elected a new government that wants to leave the European Union and the large German bank, Deutsche Bank, is struggling. The MSCI EAFE index was down -1.2% for the quarter.9</Furthermore,>sup>
Emerging markets were hit hard during the quarter and were down -8.0%. 10Several factors played into the decline. China, which is 33% of the MSCI Emerging Markets benchmark, was down 20% from its peak on January 26, which is considered a bear market.11China is facing trade tensions with the U.S. and is trying to control the excessive domestic leverage situation and slowing growth.12Brazil, Turkey and Argentina faced devaluations in their currencies during the quarter. As a result, there were significant outflows from emerging markets.13
The 10 year U.S. Treasury bond yield ended the quarter at 2.84%. The yield started the quarter at 2.74%, reached a high of 3.10% and settled back down by quarter end. The bond market is in a tug-of-war between growth and a potential slow down in the U.S. Some might question, even with the Federal Reserve hiking short-term rates, whether the longer end of the yield curve will follow. Right now we are seeing the yield curve flattening, which may be an indication that the Fed will have to put on the brakes. With rising yields, the bond indices have been impacted with the Barclays Aggregate Bond index down -0.2% for the quarter and -1.6% year to date. Munis, Treasury Inflation Protected Securities (TIPS) and high yield were positive for the quarter while long-dated fixed income was more impacted.14sup>
The Federal Open Market Committee (FOMC) raised the discount rate by 0.25% from 1.75% to 2.00% at the June meeting and are expected to raise rates two more times in 2018.15The Fed watches the dual mandate of full employment and inflation.16The unemployment level is at 3.8% and inflation is hovering around 2%.17If the Fed is behind the curve and inflation increases too quickly or raises rates too frequently, we would be concerned that it could push the economy into a recession. The yield curve, which shows the different levels of interest rates at different bond maturities (2 year, 10 year, 15 year, 30 year), is flattening and if it inverts (2 year is higher than 10 year) it is a leading indication there could be a recession in a year or two. However, we believe there still could be room in this cycle and we do not see worrisome signs of a recession brewing.
Trade has dominated the headlines since the beginning of the year. President Trump has announced that he will impose tariffs on $50 billion of imported good from China out of the $500 billion in total imports.18The U.S. imports $130 billion from China and China has responded with $35 billion in tariffs on U.S. imported goods.19President Trump has said that he is doing this to cut the trade deficit with China and also due to intellectual property being stolen by the Chinese. It was thought that the two sides could reach a compromise, but in our opinion, it is not looking so certain. It could get ugly as U.S. companies sold $280 billion20worth of goods and services in China last year through local subsidiaries and China could go after U.S. companies doing business in China. Also, U.S. farmers are being impacted as one of the U.S. largest exports to China is soybeans.21
Before the China tariffs were announced, President Trump also announced tariffs on imported steel and aluminum. Most of the U.S. imported steel and aluminum comes from Canada and the European Union (EU), which have been the U.S.’s closest allies.22If the trade war escalates between the U.S. and other countries, it could potentially cause the GDP to be impacted and a slow down in the economy.
One of the big stories has been the rise in oil prices this year with a barrel of oil reaching $8023during the second quarter. Both supply and demand characteristics have been favorable for oil. The global economy has been strong and thus there has been higher demand for oil. On the supply side, OPEC has production curbs in place and there have been shut downs in Venezuela and Iraq.24At $80 a barrel, it is profitable for U.S. oil producers, so we expect that the supply will increase over the remainder of the year. In the near term, we may see oil prices continue to climb, but they could decline next year as we reach a supply/demand imbalance.
After having the U.S. dollar decline in 2017, which was beneficial for U.S. multinationals and emerging markets, we saw a U.S. dollar increase over 4% since April.25The U.S. dollar has appreciated versus other currencies as a result of the Fed Reserve raising interest rates, growth, and the potential trade wars. Emerging markets are particularly impacted by a rising U.S. dollar as debt denominated in U.S. dollars becomes more expensive to service and dollars flow to more attractive investment opportunities. There is concern that with the U.S. tax reform and dollars being repatriated from overseas along with the Fed continuing to tighten U.S. monetary policy that the U.S. dollar will continue to appreciate. Thus, contributing to more emerging market woes and trade difficulties.26
New S&P Sector
Later this year, S&P is adding a new sector dedicated to communication-related companies and it will replace the telecommunications sector. The new sector will be comprised of stocks that are currently classified in the telecom, technology, and consumer discretionary sectors. This change could affect more than $60 billion in exchange-traded fund (ETF) assets.27It will have only 60 components and will be the third largest sector based on market value, comprising 13.2% of the S&P 500’s total.28Walt Disney Co., Netflix, Comcast, Facebook and Google-parent Alphabet will be classified under this new sector.29While telecom has been a perennial underperformer, this new communications sector is expected to perform quite well.30We will be watching to see how the market trades around this change in the sector composition.
While there are a number of headline-grabbing stories, we continue to focus on the fundamentals of the various economies and individual companies. We think the U.S. appears to be a safe haven right now with challenges in the emerging markets and peaked growth in Europe and Japan. The U.S. equity markets still look positive with strong earnings from U.S. companies; while the fixed income market will continue to be choppy, with Treasury 10 year bond interest rates fighting to get above the 3%. Overall, we remain cautiously optimistic on the outlook for the year and continue to find interesting investment opportunities.