First Quarter 2018 Investment Commentary
The first quarter of 2018 marked the return of volatility to our financial markets. Following the momentum of an upbeat 2017, U.S. stocks got off to a heady start in January, gaining 5.6%+ by month’s end. Near the end of that month, though, the mood of the market changed after the Fed announced that wages were rising and confirmed that a series of interest rate increases would likely follow. The Fed meeting was followed by the resumption of market volatility aplenty, leading Vanguard founder and guru, Jack Vogel to mention that he has never seen anything quite like the ups and downs that we’ve experienced of late.
Markets were further rattled in March as a looming trade war between China and the U.S. stoked more market volatility. The administration announced $60 billion in tariffs for Chinese imports, with a focus on steel and aluminum products. China retaliated in early April by imposing tariffs on U.S. imports as well as by curbing U.S. Treasury purchases. U.S. companies sensitive to higher import prices on raw materials and certain finished goods experienced pullbacks, with the S&P 500 stock index ending down 1.22% for the quarter.
Technology company shares added fuel to the fire as privacy concerns drove social media shares lower. The technology sector increased its volatility with the prospect of heightened regulation. Technology is a significant sector, comprising over 25% of the S&P 500.
International stocks experienced mixed results, with the EAFE index down 2.2%* for the quarter. Disappointing economic data weighed on European markets, particularly in Germany, while ongoing Brexit negotiations and strength in the British pound hurt the United Kingdom. Emerging market stocks fared better, gaining 1.4%**. EM equities benefited from strength in Brazil, Russia, and Taiwan, and from a weak U.S. dollar that enabled the asset class to generally shrug off global trade concerns.
Economic data released over the past month revealed that key data points were the strongest reported since 1998. In response, the AGG index (the most widely used measure for the total bond market) declined 1.46% with interest rates rising for the quarter.
At the same time as US interest rates are rising, a key European lending benchmark, Libor, has also been rising steadily. The three-month U.S. dollar Libor rate surpassed 2% in early March, its highest level since 2008.
The reported increase in wages heightened concerns that the Fed would quicken its pace of rate hikes, fueling the stock market correction in late January through early February.
Some investors anticipate just two more rate hikes this year, not three. We believe that the move higher in the 10-year Treasury yield this year will be gradual and therefore manageable for the equity markets as inflation remains under control. We are also anticipating that the worst of the tariff pricing fears will fail to materialize.
Since there is clearly a path to higher rates, though, we have taken steps to move client portfolios away from longer term, interest-sensitive bonds, favoring bonds with shorter-term maturities and lower duration, as well as floating rate and other non-traditional bond investments.
Growing Trade Deficit with China
In consideration of our enormous trade deficit with China, along with their persistent infringement on U.S. technology and other intellectual property, President Trump is taking a hard line. Our trade with China has grown tremendously over the past 30 years, from nearly a trade balance in 1985 to a trade deficit of $375 billion in 2017. Imports from China were $506 billion while U.S. exports to China were $130 billion, creating this significant trade deficit.
Over the past twenty five years, China has evolved from a heavy equipment and machinery exporter to a prominent leader in technology product exports. Large international
conglomerates have established an enormous manufacturing presence throughout China, utilizing its cheap labor and quick turnaround times. China’s manufacturing plants are among the most modern in the world, producing large capacities almost entirely for export.
Ironically, China’s purchases of U.S. government debt has helped maintain a low interest rate environment, thus reducing loan rates. This helps U.S. consumers finance big ticket imports such as big screen TVs, cell phones and computers, including those from China.
U.S. Economic Future
An economic condition that helps the United States to retain its economic power is the ongoing development of energy. Although there are meaningful debates regarding environmental concerns, the International Energy Association (IEA) projects that the United States is on track to become the world’s single largest oil producer by 2023. The estimates are based on production growth and supplies generated by U.S. energy producers over the next few years. U.S. daily oil production alone is expected to reach over 12 million barrels per day by 2023, a 20% increase from the current levels of 10 million barrels per day.
Furthermore, president Trump’s recently-passed infrastructure plan calls for the use of $200 billion to try to jumpstart $1.5 trillion in infrastructure improvements over 10 years. This could reshape how the federal government funds roads, bridges, highways and other infrastructure projects. The administration also said it will eliminate bureaucratic roadblocks to completing projects that can tie up new roads for years.
Managing Turbulent Times
So, we are again faced with uncertain times that challenge our portfolio management decisions. We continue to believe that the best approach to handle life’s uncertainty–financial and otherwise–is to proceed in a balanced manner. Said another way, we generally avoid taking large risks for those clients who may have difficulty managing the potential for adverse consequences on their finances.
We often times tell our clients that by balancing risk through asset allocation, we seek to help protect portfolios from the downside. The factors surrounding risk are not always the same. At this time, the risk we face is not that our economy is weak, but rather the risks surrounding the potential for tariffs, rising interest rates and tax reform and the shadow these risks may cast on longer-term growth.
Nevertheless, our base-case outlook is that corporate earnings will continue their ascent and this fundamental factor will drive markets this year. So, our approach is to stay patient, modify asset allocations where we find opportunity, and continue to invest in quality investments. By doing so, we can allow market forces to work and add value over time.
|*All index returns and other statistics are provided by onebluewindow.com, unless otherwise noted.|
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