Roof Advisory Group MarketView 2nd Quarter 2018 – Watch or Read
MarketView 2nd Quarter 2018 – Domestic stocks turned in a respectable showing in the second quarter despite several bouts of elevated volatility caused by escalating trade tensions, political uncertainty in Italy and a spike in interest rates. The S&P 500 Index advanced by 2.9% in the second quarter, pushing the index into positive territory for the first half of 2018.
Equity markets outside of the U.S. were not as resilient. International stocks posted a decline of 2.3% and several emerging market indices posted steep declines and entered “bear market” territory (defined as a 20% or more decline from peak levels). Our decisive tilt towards U.S. stocks was beneficial to performance results this quarter.
Interest rates continued their upward ascent in the first half of the second quarter. Yields on 10-year U.S. Treasury bonds rose to the highest levels in five years and crossed the 3% threshold. However, these higher yields attracted demand from investors seeking the safe-haven status of U.S. bonds and remain particularly attractive to foreign investors who are still facing the prospects of negative bond yields in many segments of their fixed income markets. This increase in demand for bonds kept a lid on interest rates and as a result, intermediate bond returns for the quarter were only slightly in negative territory.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
With new and worrisome headlines swirling around every day, we are not totally surprised that investors’ focus shifted away from the real economy and other important fundamentals. However, these fundamentals are strong and should be part of the conversation. Second quarter GDP growth is expected to top 4% which would be the strongest in four years and almost double the average growth rate experienced during the recovery. Capital investment, housing demand, and business/consumer confidence are all very robust. And the U.S. consumer is ramping up spending after adverse weather and a delay in tax refunds suppressed spending in the first quarter. Corporate earnings results have been stellar. S&P 500 companies posted earnings growth of almost 25% in the first quarter and are expected to continue to show an average of 20% growth for the remainder of 2018.
Investor enthusiasm over these positives was tempered by trade skirmishes and questions about the sustainability of current above-trend economic growth rates.
After adding equity exposure during February’s stock market correction, we entered the second quarter with portfolios positioned at maximum equity levels. We expected to see equity markets stabilize and return to “trading on fundamentals” as the second quarter progressed, and corporations delivered the best earnings results in over a decade. Earnings results were impressive and even surpassed optimistic expectations. However, investors generally shrugged off these solid results and instead focused on whether we are currently seeing the peak in corporate earnings growth.
We are firm believers that earnings and economic growth should be among the main drivers of stock market returns. With such positive results and a lackluster reaction, the near-term upside catalysts look a bit less clear. As a result, we slightly reduced our equity overweight position and ended the quarter at the one step above mid-point equity allocation level.
The equity sale proceeds were allocated to a money market mutual fund. This positioning provides us with some flexibility to take advantage of opportunities on the fixed income or equity sides of the portfolio. In addition, money market funds are now offering yields of close to 2%. This represents a vast improvement compared to the past ten years during which time cash and money market funds offered yields of close to 0%.
While portfolio returns were positive, the second quarter was not the ideal environment for balanced and diversified portfolios. Domestic stocks were the only contributor to positive results with international stock indices firmly in negative territory and fixed income benchmarks posting slight declines. Several key performance drivers are detailed below.
- Domestic stocks – While we do carry some exposure to developed international stocks, our heavy tilt towards U.S. equities was a positive contributor to portfolio results this quarter.
- Fixed income – The majority of our fixed income strategies posted outperformance compared to the broad intermediate bond index with several posting positive returns.
- Financial stocks – After a strong 2017 and a solid start this year, financial stocks were a detractor to performance in the second quarter.
MarketView 2nd Quarter 2018 Closing Thoughts
Midway through 2018 domestic stocks are up low single-digits and intermediate bonds have declined by low single-digits. Not surprisingly, these results have not translated into terrific outcomes for diversified portfolios. We view these mid-year results as disappointing given the backdrop of impressive economic growth and outstanding corporate earnings results. Several negative narratives have developed that have been overhangs to more material market advances. We address several of these topics in more detail below.
Earnings results have been so good that instead of rewarding stocks with higher prices, investors have started to question if we are seeing an earnings peak. We recognize it would be very difficult to see another year of 20% earnings growth in 2019. However, expectations are for continued earnings growth but at a slower growth rate.
The chart below highlights consensus estimates of almost 10% earnings growth for S&P 500 companies in both 2019 and 2020. S&P 500 companies have averaged roughly 7% earnings growth over the past 15 years. And that period obviously includes several significant economic contractions. Point being – we don’t need 20% earnings growth every year for stocks to perform reasonably well.
Annual Earnings Growth Rate – S&P 500
Source: Zacks Investment Research, Inc.
In our view, the “peak earnings” concerns would be more of an issue if stocks were trading at high valuation levels that reflected overly optimistic or unrealistic expectations for earnings growth. But they really aren’t. Valuations are reasonable in the U.S. and international and emerging market equities could be classified as cheap.
Below is a chart that shows the 25-year historical valuation range (vertical shaded bars) for different global equity indices. The purple horizontal lines represent the average historical valuation levels. The blue diamonds represent each index’s current valuation level. We don’t view current valuations as overly optimistic.
Global Equity Valuations
Current and 25-year historical Valuations*
Source: FactSet, MSCI, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management; “Guide to the Markets – U.S.”
*Valuations refer to NTMA P/E for Europe, U.S., Japan and developed markets and P/B for emerging markets. Valuation and earnings charts use MSCI indices for all regions/countries, except for the U.S., which is the S&P 500. All indices use IBES aggregate earnings estimates, which may differ from earnings estimates used elsewhere in the book. MSCI Europe includes the eurozone as well as countries not in the currency bloc, such as Norway, Sweden, Switzerland and the UK (which collectively make up 46% of the overall index). Past performance is not a reliable indicator of current and future market results.
Peak Economic Growth?
The U.S. economy appears to be firing on all cylinders. As we discussed above, estimates for second-quarter GDP growth are currently hovering around the 4% mark. This compares very favorably to the average GDP growth level of 2.2% for the current economic expansion and to the roughly 50-year average of 2.7% GDP growth. However, many investors have focused on the sustainability of current above-trend growth rates.
Economic growth has undoubtedly gotten a measurable near-term boost from the recent tax cuts which aren’t likely to be as impactful going forward. There are also pressures from higher interest rates, higher commodity prices, some signs of inflation and more difficulty finding qualified workers.
We aren’t penciling in 4% GDP growth as our expectation for the long-term. However, we also don’t buy into the view that 2% growth is the best that our economy can do.
Trade tensions intensified in the second quarter. Not only has our conflict with China heated up, but new skirmishes with the European Union, Canada and Mexico have emerged as well. These developments have weighed on investor sentiment, caused bouts of elevated volatility and translated into higher than normal levels of uncertainty.
The uncertainty associated with these trade disputes is likely to be present for some time to come. The difficult part for investors is that there is not a firm end date for the uncertainty. Brexit, the U.S. Presidential election, and various European elections all caused market volatility. However, there was a known resolution date to each of those events. Investors eventually knew the outcome, markets quickly priced in the risks of the outcome, and then moved on. The resolution here is likely to be less definitive and clear-cut.
With all of that said, here are some of our thoughts on the topic.
Headlines about tariffs on $50 billion of goods sound scary and alarming. But this needs to be put into context. U.S. GDP was over $19 trillion in 2017, China’s GDP was over $12 trillion in 2017 and the European Union’s GDP was also slightly over $12 trillion in 2017. The tariffs that have currently been enacted are unlikely to have a significant impact on the U.S. or global economy.
The U.S. is primarily a domestic economy. Exports only represent about 8% of U.S. GDP. As shown below, we have a much lower reliance on exports than other economies.
Exports as a share of GDP
Goods exports, 2017
Source: IMF. “Guide to the Markets – U.S.”
Below is a performance review of the U.S. stock market as well as the main stock index for each of the countries shown in the graph above since the first round of tariffs were announced back on March 1st. Obviously, there are other factors besides trade tensions driving performance results in each specific stock market. But do these results maybe indicate that the U.S. is better positioned to handle the impacts of trade disputes/disruptions? We think that is a logical conclusion.
March 1, 2018 – June 30, 2018
Tickers used for performance calculations: EWZ (Latin America), INDA (India), FXI (China), ERUS (Russia), EWW (Mexico), EWY (South Korea), EZA (South Africa), EWT (Taiwan), SPY (United States), EWJ (Japan), EZU (Europe), EWU (United Kingdom), EWC (Canada). Past performance is not a reliable indicator of current and future market results
As the second quarter progressed and longer-term bond yields declined, concerns about the “slope of the yield curve” or an “inverted yield curve” started to emerge. An inverted yield curve is when long-term bonds offer lower yields than short-term bonds. Historically, the yield curve has inverted when investors sense an upcoming economic downturn or an outright recession and seek to lock in the higher yields of long-term bonds.
Below is a chart that compares the slope of the yield curve at the end of the second quarter (blue line) to the slope of the yield curve at the end of 2013 (gray dotted line). While the yield curve is not inverted, it has flattened significantly, and this has caused some concerns. However, below are some additional variables that we believe are having an impact on the current interest rate environment.
- Outside of the U.S. there are still massive amounts of bonds paying negative yields. German and Japanese 10-year bonds offer investors yields or roughly 0.3% and 0.02% respectively. Given those alternatives, a 2.85% yield on a U.S. Treasury bond looks phenomenal and helps to explain the voracious demand for our longer-term bonds which has kept a cap on interest rates.
- Trade tensions have weighed on investor sentiment and risk appetite resulting in an increased demand for long-term bonds.
- The Federal Reserve has raised short-term interest rates seven times since the end of 2015. Long-term interest rates have risen during this period as well. But have not kept pace with the advance in short-term interest rates.
We share some of the concerns about the possible signaling effects of a flattening yield curve. We are monitoring this indicator closely.
Source: FactSet, Federal Reserve, J.P. Morgan Asset Management. Guide to the Markets – U.S.
MarketView 2nd Quarter 2018 Copyright 2018 by Roof Advisory Group, Inc. All rights reserved.