Third Quarter 2018 Investment Commentary
(Note: After the close of the quarter, concerns about rising rates and tariffs have roiled financial markets.)
The third quarter was perhaps the most productive that we’ve seen for stocks since 2013. The major U.S equity indices all posted gains, with the S&P 500 leading the way–up 7.2% for the quarter and 10.6% for the year-to-date. (The Dow Jones index has gained 8.8% YTD.) Stock earnings have been buoyed by the recent corporate tax cuts and by stable economic growth. In this environment, growth stocks have continued to outperform value-oriented stocks by a significant margin.
In contrast, European and most other foreign markets reacted negatively to the prospect of tariffs and to a possible impasse regarding negotiations with Brexit. Six months remain before the formal separation of Britain from the EU.
The MSCI-EAFE index ended down -1.5% year-to-date. The MSCI Emerging Market index is even more impacted by tariffs with that index off -9.54% so far this year. After a resilient first half of the year, the MSCI China Index slumped nearly 8% this past quarter. The divergence from U.S. markets can be explained in part by the relative attractiveness of the U.S. economy. The strong US dollar detracts from international balance sheets and equity returns, while the tariffs and heightened trade tensions between the US and China have had a relatively smaller impact on the U.S.
The newly imposed tariffs by the Department of Commerce on Chinese imports became effective in late September. The goal of the Department of Commerce is to incentivize U.S. companies to shift production of goods in China back to the U.S. by allowing companies to redirect production prior to year-end, before tariffs are scheduled to reach 25% on Chinese-made products. $200 billion of tariffs will begin at a 10% rate and increase to 25% by year end should the two countries not come to an agreement.
Tension from higher oil prices in September provided a headwind, with oil prices topping levels not seen since 2014. Global energy markets reacted negatively to limited production from OPEC, Saudi Arabia, Russia and the United States.
Risks and Rewards
In spite of positive returns for the first three quarters, risks to the economy and markets remain. These risks include a Federal Reserve that may be perceived as being too aggressive, as well as escalating tensions and tariffs between the US and China. There are also the upcoming mid-term elections, though our view is that they are unlikely to upend financial markets whichever way the results may fall.
On the positive side, second quarter GDP grew 4.2%–the highest growth rate that we’ve seen in the US since 2014. The labor market continues to be strong as the average job gains for the past 3 months stands at 185,000. Wages grew 2.9% year-over-year, and unemployment remains below 4%. Inflation has picked up but appears to remain manageable, with core CPI rising 2.2% while headline CPI (including food and energy) rose 2.7%.
Consumer sentiment reached its second highest level since 2004, improving across all income categories with the expectation of higher wages and continued job growth. While modest levels of inflation helped elevate confidence among consumers, several analysts are forecasting that the positive effects of the recent tax cuts will begin to fade as higher interest rates start to inflate capital borrowing costs, perhaps having the largest effect on small cap stocks.
Fixed Income Rates on the Rise
Stability in growth and employment figures allowed the Federal Reserve to impose its widely anticipated increase in the federal funds rate by another quarter percent. The Fed committee dropped its long-standing description of monetary policy as “accommodative”, and reaffirmed its outlook for further gradual hikes into 2019.
Within the fixed income markets, the 10-year Treasury bond revisited the 3% mark, a level last reached in May of this year. The Federal Reserve also revised its estimates for GDP growth from 2.8% to 3.1% for 2018, but with an eventual slowing to 1.8% by 2021.
The Fed pointed toward another rate increase in December and three more to follow in 2019. The Federal Funds Rate now stands at a range of 2% to 2.25%, the highest in ten years. Borrowing rates are gradually increasing in various consumer sectors including autos, appliances, and home mortgages. This has contributed to a slowdown in the real estate markets.
Data released in September showed wages to be growing at the fastest rate since 2009, while additions to non-farm payrolls remain strong. So far, industrial activity indicators show little impact from tariffs.
Some analysts continue to believe that the current Fed Chairman, Jerome Powell, may have the ability to orchestrate a soft landing–raising interest rates gradually without triggering an economic slowdown. Other market participants note the less accommodative language from J. Powell at the latest September meeting and are concerned that the Fed may overshoot on rates and stunt economic growth.
During a Fed rate tightening cycle yield-hungry investors may seek higher yielding bonds, given concerns about inflation. Investors may assume more credit risk in doing so. As bond rates rise, the price of existing bonds fall, and concerns about higher borrowing costs can precipitate a selloff in equities as well. Although bond yields are pushed higher, the total return from bonds will typically languish during a rising rate environment, until rates reach a level of equilibrium. Year-to-date, the total return of the U.S. bond index (AGG) is down 1.6%.
To sum up, it is a challenge to find attractive fixed income investments, in a rising rate environment. History and experience have taught us that patience is required while markets adjust to a new rate environment. Our fixed income strategy for these conditions entails focusing on shorter duration bonds and funds that include “nontraditional” bond strategies that often have less interest rate risk (albeit with greater credit risk.) Many of these funds have helped to add value by generating a level of positive total returns so far this year. These strategies include floating rate bonds, non-agency mortgage bonds and high yield bonds.
Our approach continues to be to structure portfolios through diversified positions in various stock and bond and alternative asset categories. Although we can tilt our asset allocations to reflect our outlook, we still wish to retain exposure to bonds and the other major asset categories to help manage portfolio risk.
There are presently several positive factors that we’ve outlined for our economy and for financial markets. We’ve also noted some of the risks that could serve to derail the rosy picture painted above. During October we may see a tug-of-war play out between fears of a potential Fed policy mistake that could lead to a slowing economy versus strong third quarter corporate earnings that may be announced during the coming weeks.
We look forward to talking with you about these developments and the positioning of your portfolio.
Clear Point Advisors Inc.
|*All index returns and other statistics are provided by onebluewindow.com, unless otherwise noted.|
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