While the first quarter of 2018 reintroduced volatility into the markets, the second quarter seemed to offer a glimpse of stability. Riskier assets in general saw strong returns while the more conservative fixed income markets were flat/slightly negative. The U.S. economic picture remains robust with historically low unemployment and growth projections in the 3% range for the year. These strong dynamics have yielded elevated consumer confidence and support optimistic expectations that the good economic news will continue. Corporate balance sheets are strong, capital expenditures are rising, and earnings are expected to grow high double digits this year as the benefits of the Tax Cuts and Jobs Act are fully realized. To balance the optimism, there are legitimate concerns surrounding protectionist trade policy (tariffs), rising debt levels/deficits, and the stubbornly flat yield curve that has resulted from the tightening of financial conditions. We will dive into those topics below. The overall message we want to relay in this letter is that we appear to be in a normalizing economic/market environment that took almost 10 years to achieve after the financial crisis.
The GDP growth for the first quarter of 2018 registered at 2.0%. While this may seem below-trend, the first quarters of 2017 and 2016 were reported as 1.2% and 0.6%, respectively. Unemployment dropped to a cycle low of 3.8%, and for the first 5 months of the year the economy created 1.04 million new jobs. The just released employment report for June showed 213 thousand new jobs. Moving forward, estimates for second quarter GDP growth range from 2.8% to 4.0%, giving us reason to be optimistic this growth trend is not yet abating. Wages, as measured by the US Average Hourly Earnings from the Bureau of Labor, rose at a 2.7% annualized rate, slightly above trend. The resulting consumer confidence readings also continue to be positive, as can be seen in the chart below (since 2017 we have been in the top quartile):
The behavior of the consumer is a major driver of future economic activity. Therefore, with very low unemployment, rising wages, and high consumer confidence, one can paint a very rosy picture for the U.S. economy.
On the flip side, we look to the actions of the Federal Reserve and the current shape of the yield curve. The Fed did raise the overnight rate by 0.25% on June 13th to a range of 1.75% to 2.0% and indicated that we can expect up to two additional increases during 2018. When the economy is moving ahead at a brisk pace, employment conditions are tightening, and inflation expectations increasing, the Fed historically has increased the Fed Funds rate to keep inflation tethered to their 2% target. If not implemented perfectly, the Fed can inadvertently send the economy into a recession by tightening monetary conditions too aggressively. The yield curve normally inverts (i.e. short-term yields are higher than longer-term yields) prior to a recession and we are close to this situation currently. Investors are closely watching the relationship of the yield of 2-year Treasuries to 10-Year Treasuries. The yield curve is normally upward sloping, meaning an investor will earn more yield for taking additional time risk. The curve flattens or even inverts when the market believes we are heading for a monetary policy induced recession. In February of this year, the 2-10 spread was as wide as 77 basis points; as of the end of the June it was closer to 30 basis points. The bond market is clearly worried that if the Fed moves too far too fast with raising rates, the economy could reverse course and enter recession.
The chart above clearly shows the yield curve inverting prior to every recession going back to the 1970s, and the curve trend today is heading in that direction. We will point out there are unique causes for the recessions in each of these periods, and today we see no reason to believe the economy is weakening. Simply put, the yield curve could have it wrong this time, however we are not prepared to take that position until it becomes clear how high the Fed intends to take the overnight rate.
The headline risk, as it relates to the global economy, is the tariff discussions between the U.S. and our trading partners. It is too early to say whether these protectionist policies will negatively affect our economy. As we mentioned in our last letter, we believe these headline risks are a negotiating tactic aimed at achieving a fair trading system. It seems clear that our trading partners enjoy applying tariffs to U.S. goods when it is politically expedient. However, when the U.S. discusses reciprocating (charging the same tariffs that our trading partners do) it is not well received. Below is a WTO chart of the average tariff applied by member countries:
Clearly, the U.S. is one of the least protectionist trading partners and it appears the current Administration is intent on balancing trade on a global scale. Regardless, the Federal Reserve has noted that some manufacturers are becoming troubled by these discussions and it may result in slowing production. As of now, the Fed commented the tariff issue has not shown up in the economic data, and they will not slow the tightening monetary bias based on an “unobservable input.” We are hopeful this issue will abate as calmer heads prevail.
The S&P 500 rebounded in Q2 after the negative Q1 performance to post a positive 3.4% total return. Year-to-date, the S&P 500 is now up 2.7%. The prospects of strong earnings growth and reasonable valuation levels (more below) helped to push equity markets higher, though the continued talk of increased trade tariffs kept quarterly market gains in check.
For the second quarter, seven of the eleven economic sectors in the S&P 500 posted positive results. The Energy sector (up 13.5%) was the best performing sector during Q2. Demand for oil continues to increase at a time when supply disruptions from Venezuela (economic turmoil) and Iran (sanctions) are also hampering oil exports. The Consumer Discretionary (up 8.2%) and Technology (up 7.1%) sectors were the next best performing sectors during the quarter and are also the two best performing sectors year-to-date (up 11.5% & 10.9% respectively). These two sectors make up roughly 60% of the Russell 1000 Growth index, which helps explain the continued outperformance of Growth over Value as seen in the chart above.
The two sectors that were hit the hardest in Q2 were the Financials and Industrials sectors (both down 3.2%). Financials have been hurt by the flattening yield curve as lending margins are compressed by higher borrowing (deposit) costs. Industrials have been impacted by increased tariff talk out of Washington and the ensuing retaliation efforts by many countries. The U.S. holds a lot of negotiating power, but a protracted trade war would not benefit anyone.
The market for Initial Public Offerings or IPOs, has been robust so far in 2018 (chart to the right). Industry participants say that global IPO pipelines are as strong as they have been since before the financial crisis and the discounts between private market and public market valuations have vanished. In fact, according to Dealogic, companies that have gone public in the U.S. are trading on average 22% higher than their IPO price. While SS&A does not participate in IPOs, it is a good measurement of sentiment.
According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is 16.1x, which remains in-line with the 5-year average and well below the recent peak (of 18.4x). In addition, consensus earnings expectations call for 20% earnings growth in 2018, with an additional 10% growth in 2019. The backdrop for equities remains constructive, but we would like to see more participation out of certain sectors and styles (i.e. Value).
The taxable U.S. Bond market returned an uninspiring 0.04% in the second quarter, as measured by the Barclays Intermediate Government/Credit Index (GVI). The tax free municipal market returned a more robust 0.9% as measured by the S&P Municipal Index. The bond market is responding to the measured pace the Fed is taking in normalizing monetary policy. As we have noted, the Fed controls the short end of the yield curve, and the market’s view of inflation expectations controls the longer end of the curve. As the economy continues to grow and employment conditions tighten, inflation has historically risen as well. The chart below shows that inflation expectations have moved ahead of the 2% goal of monetary policy, and with this reading we expect short rates to continue to move higher.
This activity on the short end of the curve is putting pressure on all bond prices. The good news is that we are now able to invest at the highest level of yield in nearly 10 years. We are seeing the most value in the 4 to 5 year space with yields in the range of 2.75 to 3.25% for taxable bonds, and over 2.0% for tax-free municipals. We continue to take our time in building a portfolio and reinvesting cash in this environment as there is very little additional yield by buying bonds with maturities longer than 5 years. If things play out as we expect, staying relatively short will pay off as investors will be able to reinvest at higher yields in the intermediate term. We may even see short rates above 3% if the economy is strong enough to handle the Fed’s normalizing process.
The economy remains strong with unemployment, consumer confidence, and rising wages leading the way to above trend growth. As always, there are headwinds and most of these seem to stem from political issues which are notoriously difficult to predict. However, market prices seem to have accounted for many of these situations and both the stock and bond markets appear to be in an acceptable range.
We are also pleased to announce that we have again added to the depth of our research and portfolio management capabilities. Andy Clark, CFP® joined our team in April bringing extensive equity research and portfolio management skills to our team. Andy has over 15 years of experience in the industry with past roles as VP of Investment Research and Financial Advisor. Andy grew up in Upstate NY and graduated from Binghamton University with a B.S. in Financial Economics. He also earned his CFP® certificate in 2009. Outside of work, Andy and his wife enjoy traveling with their three boys. Andy is active in sports, including water polo and coaching youth swimming, and as an outdoor sportsman.
As always, we greatly appreciate your continued support and for the opportunity to serve you.