“You get caught up thinking about the future, you lose sight of the present.” Antonio Brown
The 2nd quarter of 2018 was a busy one on the policy front. U.S. interest-rate hikes continued, the ECB announced plans for its QE program, Italy began digesting the results of its March vote and global-trade tensions escalated. Investors in U.S. stocks and some real assets were pleased; other investors in non-U.S. stocks and high-quality U.S. bonds did not enjoy similar performance benefits. Most investors spend too much time trying to guess the effect of public policy when they should be focusing on the data. Following is a summary table of Q2 market results:
“A person often meets his destiny on the road he took to avoid it.” Jean de La Fontaine
All of the data we reviewed in last quarter’s update – leading economic indicators, the global PMI manufacturing composites, equity earnings, the yield curve, inflation and unemployment – still indicate continued growth. While we are in the later cycle of a growth phase, we see global policy uncertainty as the major issue clouding the near-term investing outlook.
Rising nationalist sentiment, the nascent ‘trade wars’ and a cold shoulder from the U.S. to its long-term trade and political allies have combined for an uncertain outlook for global growth. Inconsistent government policies around the globe have shifted investor focus from expansion to safety, and made the job of global central banks even more difficult. As a result, investors are trying to ‘guess’ when the next U.S. recession will occur to reposition portfolios, while simultaneously benefitting from the ‘tech boom.’ The early results of these changes have hurt some U.S. and non-U.S. stocks hard, especially in emerging markets.
Recession fears and a steepening yield curve do NOT imply a very near-term equity correction. As this graph below indicates, stocks have done well for the 12 months following an increase of 100 basis points (one percentage point, or 1.0%) in the U.S. Treasury 10-year yield:
We also observed that the current U.S. policy cocktail of tariffs, taxes and trade uncertainty promotes opportunities in other market segments beyond U.S. large-cap stocks. This graph below illustrates this theory: U.S. smaller-cap stocks have more exposure to domestic U.S. growth (i.e. higher revenue exposure), paid more in taxes than larger-caps (i.e. more benefits from the recent tax legislation) and have performed better when U.S. interest rates have risen in the past:
Many investors often overlook non-S&P 500 segments of the market, but all stocks are not the same. A brief analysis of the differences between U.S. large-cap and small-cap stocks (represented by the S&P SmallCap 600) is detailed below. Note that the tax and trade issues mentioned above contributed to the strong sector returns in the S&P SmallCap 600 index, which does not have securities overlap with the S&P 500 index.
Another way to view the Q2 market dynamic is by reviewing the performance of the utilities and real estate sectors. Both sets of these two large- and small-cap sectors had negative performance in Q1, and both rebounded strongly in Q2 to post positive returns for the year through June 30. These sectors are more insulated from the ongoing tariff, currency fluctuation and overseas revenue issues discussed above than other companies, such as global conglomerates.
“Planning is bringing the future into the present so that you can do something about it now.” Alan Lakein
Our outlook hasn’t shifted from the prior quarter. We still find political and trade issues looming larger in driving market sentiment. Certainly, the data we have been reviewing is strong, but emotions often dictate market moves. We believe stocks, while a bit rich in some areas, still offer compelling value compared to bonds. The U.S. Treasury 10-year bond ended the quarter at a 2.85% yield, just above the Q1 yield of 2.74%. A falling unemployment rate and slowly rising inflation have not prompted the Fed to radically alter its course, and stocks posted another excellent earnings quarter. We still see value in stocks given where we are in the growth cycle and with the valuation changes in international equities.
Our deepest concern is the future nexus when 10-year Treasury yields break through the 3.50% rate and stock earnings and revenue growth begin to slow. While we believe this event is a ways away, the amount of corporate and government debt necessary to satisfy the next three years refinancing needs may hasten a trigger event to cause volatility in the markets. Despite this prediction, we still expect a cautious Fed to continue raising rates with a few years of a steady ‘one hike per quarter’ pace ahead.
Finally, we are relieved by the return of more ‘normal’ volatility in the bond and stock markets, which should afford more opportunities to active investment managers. Active management is a substantial component of our diversified portfolios, and market environments such as these are excellent hunting grounds for managers to add value in our portfolios with discriminate stock selection.
As always, we implore our clients to take a long-term outlook on their investment portfolios. Having an appropriate and well thought out asset allocation is the best way to achieve your investment goals.
We welcome your comments and questions.
—Your Wealth Management Team at JJ Burns & CompanyDownload Market Commentary
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