It was not a quiet summer for the equity or bond markets and we continued to see a major divergence between the developed markets and the emerging markets. For the third quarter, U.S. large cap stocks led the way, up +7.7% for the S&P 500 Index while U.S. small cap stocks were also positive, up +4.7% for the Russell 2000 Index.1 For most of the year, U.S. small cap stocks led the U.S. equity markets because of what we believe are the benefits from tax reform and being isolated from the tariff issues. However, in our opinion, as strong second quarter earnings were reported and more clarity was reached with the implementation of tariffs between the U.S. and China, U.S. large cap stocks outperformed small and mid cap stocks. Other developed markets rebounded during the quarter after a shaky start to the year. The MSCI World Index ex US was +0.7% for the quarter.2 Meanwhile, the Emerging Markets struggled as a whole with the MSCI Emerging Markets Index down -1.1% for the third quarter and -7.7% year-to-date.3
The U.S. has been viewed as safe haven in the world. The U.S. economy is quite strong as evidenced by a number of factors including +20% earnings growth during the first and second quarters,4 4% GDP growth in the second quarter, 5 strong employment numbers,6 and strong consumer confidence.7 As a result, this economic momentum helped Technology, Consumer Discretionary, and Health Care, which have been among strongest sectors and saw the highest earnings growth.8 In particular, the FAANG (Facebook, Apple, Amazon, Netflix, Google) stocks in addition to other technology stocks have been significant drivers of performance for the S&P 500, with technology alone contributing 43% of the year-to-date return.9 This has created a large dispersion in returns between the growth and value indices. The growth indices are dominated by technology while the value indices are dominated by financials. For the top 200 stocks in the U.S. by market capitalization, there is a 13.8% difference in performance year-to-date between growth and value.10 As you move down the market cap spectrum that spread between growth and value narrows, but is still at historically high levels.11
The developed markets have been mixed in terms of performance. In our opinion, Europe has been farther behind in its recovery than the U.S., and with the accommodative monetary policy, as set by the European Central Bank (ECB) several years ago, it has allowed Europe to stabilize. However, a number of factors have affected Europe from political elections in Italy,12 the continued discussions on Brexit13 and issues with the large German Bank, Deutsche Bank.14 From a valuation perspective, Europe looks good relatively and there should be the opportunity for some stable growth, but we expect that it will be at a lower level. Emerging markets as a whole have been down for the year, but individual countries have behaved very differently. What has fueled some of the issues in a few of these countries has been the significant amount of liquidity in the global markets and low interest rates, which have allowed countries to borrow high levels of debt. Now the U.S. is raising interest rates and removing liquidity, which is resulting in a higher U.S. dollar and putting pressure on the currencies and debt of countries like Argentina, Turkey, and South Africa.15 China, which is the second largest economy in terms of global GDP and the largest constituent of the MSCI Emerging Markets Index, is facing slowing growth and the stock markets are reflecting that.16
During the summer, Treasury bonds were trading sideways for several months, but they moved up quickly in September. The 10-year Treasury yield ended the quarter at 3.05%,17 and yields are expected to continue to increase from here. The U.S. Federal Reserve raised the discount rate at its September meeting by 0.25% and it is expected that the Fed will raise rates again in December.18 In addition, the Fed is telegraphing multiple rate increases for 2019, but the market is forecasting that the Fed will stop raising rates sooner than that.19 The interest rate spread between the 10-year Treasury bond and the 2-year Treasury bond continued to narrow with a low spread of 24 bps.20 It appears that the spread is increasing slightly, which is a good sign. As we have written before, if the spread inverts where the 2-year Treasury yield is higher than the 10-year Treasury yield, it has historically foreshadowed a recession with a lead-time on average of 15 months.
Globally, central banks are increasing interest rates in reaction to what is happening in the U.S. A higher U.S. dollar, which impacts many foreign countries with depreciation of the local currency and higher inflation, is requiring the local central banks to step in with higher interest rates to offset the impact.21
Tariffs and Trade War
President Trump was trying to bring a number of countries to the negotiation table to reset old trade pacts. He was able to negotiate agreements with the European Union, Mexico, and Canada, but he has been unable to get one of the U.S.’s largest trading partner, China, to come to the table. One of the big topics is related to intellectual property and preventing China from taking it from U.S. companies. Since a sit-down or an agreement is not forthcoming, President Trump announced in September 10% tariffs on $200Bn in Chinese imports with the rate rising to 25% in January 2019.22 China retaliated with tariffs on $60Bn of imported U.S. goods.23 Interestingly enough, Apple products have been excluded from the tariffs.24 However, if negotiations are not reached by January when the tariffs are expected to increase to the 25% level, economists are forecasting that GDP will be impacted in 2019.25
The price of oil is now at $75/barrel and some forecasters are expecting $100 per barrel over the next year.26 Global demand has been relatively high and supply has been somewhat constrained. Russia and Saudi Arabia had agreed to constrain production and Venezuela and Syria are not producing. What is remarkable about the whole story is that the U.S. is now set to surpass Russia as the world’s largest producer of oil.27
Where do we stand?
It is our opinion that we are in an unusual period of time. The U.S. economy and markets are doing very well and valuation levels are not extended. However, we have had two quarters of 20% earnings growth driven primarily by the tax reform, we are now facing tariffs and a trade war, and the Federal Reserve is unwinding quantitative easing (removing liquidity from the market) and raising interest rates. While we do not believe this cycle is over, we are expecting that earnings growth and GDP will not be as strong in 2019. We regularly talk to companies and understand the broader macro economy to get a feel for where we are in the cycle.