The U.S. Continues to Outperform
3rd Quarter 2018
U.S. stocks finished significantly higher in the third quarter. In fact, the S&P 500 Index posted its largest quarterly gain in nearly five years, advancing by an impressive 7.2%. In a reversal from the first half of the year, markets largely ignored heightened trade tensions between the U.S. and China, rising inflation, rising interest rates, and political dysfunction. Instead, the focus this quarter was firmly centered on positive U.S. fundamentals surrounding strong corporate earnings, robust economic growth, aggressive share buybacks, elevated levels of business and consumer confidence and evidence of traction from tax reform.
International equity results lagged U.S. market returns by a wide margin this quarter, further expanding the year-to-date performance gap. Developed international stocks (as measured by the MSCI EAFE Index) posted a quarterly advance of 0.8%. Emerging markets stocks diverged even more from U.S. markets with most developing markets posting negative returns for the third quarter.
The widely followed Barclay’s U.S. Aggregate Bond Index finished the quarter with a total return of 0%. Interest rates continued to grind higher on the back of firm economic data, rising inflation, and an additional Federal Reserve rate hike.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
|Asset Class||Index||Q3 Return|
|U.S. Stocks||S&P 500 Index||7.2%|
|International Stocks||MSCI EAFE Index||0.8%|
|Global Stocks||MSCI ACWI Index||3.9%|
|Bonds||Barclays U.S. Aggregate Bond Index||0.0%|
Economic strength and more robust growth rates have been the main drivers of the U.S. equity market outperformance this year. While last year’s “synchronized global growth” theme may have run its course for many foreign economies, most data points and indicators reflect above-trend growth in the U.S.
U.S. GDP expanded 4.2% in the second quarter, marking the fastest growth in nearly four years. Recent economic reports have also pointed to a continuation of very healthy consumer spending and business investment trends. Employment data also continues to show strength with monthly job gains averaging around the 200,000 level over the past year and wage growth figures recently posting the highest year over year growth since the start of the economic recovery.
Corporate earnings also deserve a mention here as results have been outstanding. Second quarter earnings for S&P 500 companies increased by 25%. And expectations for the third quarter earnings growth rate is currently hovering just north of 19%.
While we view the overall economic picture and fundamentals as firmly in positive territory, there are some pockets of weakness starting to emerge. Housing and auto sales are showing some signs of fatigue. These are both interest rate-sensitive segments of our economy and after eight interest rate hikes over the past three years or so, consumers may have started to view buying a new house or a new car as more expensive propositions.
We entered the third quarter with portfolios positioned at the one step above mid-point equity allocation level. Equity markets have now fully recovered from the first quarter correction and what we viewed as a disconnect from fundamentals and valuations. With the backdrop of new all-time highs and equity markets that are now more in-line with what we deem to be “fair value”, we moved from an equity overweight position to a neutral or mid-point stance. We are currently holding some “dry powder” in the form of a money market fund which now offers a yield of roughly 2%. This dry powder positioning provides us with the flexibility to take advantage of future dislocations that we deem to be opportunities.
We also reduced a significant portion of our international equity exposure in favor of U.S. stocks. Our international equity allocation was lowered by roughly 40% in the quarter. While we recognize that growth rates have slowed in many foreign economies and financial conditions are more robust in the U.S., we still want to maintain some allocation to foreign equity markets. This view is mainly supported by diversification benefits and the fact that international stocks are trading at the largest discount to U.S. stocks since 2009.
With bond yields moving to the highest levels in roughly seven years, we started to slightly pare back our ultra-short duration stance by adding a small amount to intermediate-maturity bonds. We are more willing to accept a slightly higher duration risk in fixed income allocations now that the interest rate environment is normalizing, and we are more adequately compensated for the associated interest rate risk. We are in an extremely strong position to continue the process of gradually taking advantage of the rising interest rate environment by extending our bond maturities. We are currently in the process of increasing fixed income durations from an average of 2.5 years to around 3.25 years. As suggested by this incremental change, we view this as a methodical process to be implemented over time rather than an all-in bet on the direction or path of interest rates.
Third quarter performance results were solid, as to be expected with the S&P 500 Index up over 7% for the quarter. However, add to the equation that broad bond indices and developed international equity markets posted flattish quarterly returns and we are pleased with the results.
Healthcare, technology and industrial stocks led the charge and were the most significant contributors to portfolio returns. In fact, the healthcare sector posted its largest quarterly increase since early 2013. This was particularly beneficial for portfolio returns as we maintain a large and overweight position in the healthcare sector.
Our fixed income returns were firmly in positive territory while the broad bond market index (Barclay’s U.S. Aggregate Bond) was completely flat for the quarter. Our complete lineup of fixed income fund strategies outpaced the index and our allocation to Preferred Stocks was a measurable contributor to our fixed income results.
International equity exposure was a clear detractor this quarter. As mentioned above, we pared back our exposure to international stocks in the third quarter and we feel as though our remaining position size is appropriate.
Going forward we think flexibility will be an increasingly positive portfolio attribute. Flexibility to capture dislocations in equity markets should those situations present themselves, and flexibility to take advantage of rising interest rates to increase portfolio yields. We feel well positioned going forward given the liquidity position we have built over the last two quarters and our short duration fixed income stance which allows us to proactively adjust to the changing interest rate environment.
We discuss several relevant and important topics below. We plan on covering each in more detail on our upcoming MarketView webcast. We will be sending out the MarketView webcast recording shortly.
Additional Topics Performance – S&P 500 and Then Everything Else
Most equity investors would agree that 2018 has been a pretty good year so far. The S&P 500 Index has advanced 9% during the first nine months of the year. That result stacks up well with long-term historical average returns. However, a look under the hood paints a less rosy picture. The top five performing stocks in the S&P 500 (which represent about 11% of the index) have accounted for almost 50% of the year-to-date advance. Factor in the results from markets outside of the U.S and the picture turns from bright to downright ugly.
Our equity allocation is heavily tilted towards domestic stocks and even more so after some third quarter adjustments. However, investors that recognize the benefits of a well-diversified portfolio should not expect to be totally insulated from the recent negative performance results of equity markets outside the U.S.
12/31/2017 – 9/30/2018
Sources: S&P 500 (S&P 500 PR), MSCI ACWI (MSCI ACWI NR USD), Russell 1000 Value (Russell 1000 Value PR USD), Japan (MSCI Japan PR USD), Bonds (BBgBarc US Agg Bond), Commodities (Bloomberg Commodity PR USD), MSCI EAFE (MSCI EAFE PR USD), Eurozone (MSCI Euro PR USD), Italy (MSCI Italy PR USD), Emerging Markets (MSCI EM PR USD), China (MSCI China PR USD), Brazil (MSCI Brazil PR USD), Turkey (MSCI Turkey PR USD). Past performance is not indicative of future results.
Update on Trade Tensions/Tariffs
U.S.-China trade tensions escalated further in the third quarter. The Trump administration implemented a 10% tariff on an additional $200 billion of Chinese imports and signaled it would likely move forward with tariffs on the final $267 billion worth of goods that China sends to the U.S annually. China quickly responded with tariffs on an additional $60 billion of U.S. imports. We are rapidly approaching a level where virtually the entire trade in goods between the world’s two largest economies will be affected.
On the positive side, there were numerous agreements reached with our other trading partners. The U.S., Canada, and Mexico reached a deal to restructure NAFTA. President Trump and European Union President Junker announced an agreement to launch a “new phase” of their trade relationship. And the U.S. has reached a revised free trade agreement with South Korea while initiating positive trade negotiations with Japan.
As we mentioned last quarter, the trade dispute with China isn’t likely to be resolved quickly. We are somewhat encouraged by the de-escalation of tensions with several of our large trading partners. And by the market’s muted reaction to recent trade-related headlines. Maybe after six months of constant focus investors have built up a tolerance for new developments in the U.S.-China trade dispute.
Bond Yield Comparison
We mentioned that intermediate-maturity bond yields are more attractive now than they have been in several years. Below is a chart that shows the substantial increase in yields on an investment-grade intermediate-maturity corporate bond index over the past two years.
US BBB Corporate Bond Effective Yield
10/07/2016 – 10/08/2018
Sources: ICE BofAML US Corporate BBB Effective Yield.
U.S. Economy Strong but Housing and Autos Weaken
We outlined many areas of economic strength but also some pockets of recent weakness. Below are five- year charts of both new home sales and existing home sales. Housing activity has slowed.
New Home Sales
9/27/13 – 10/2/18
US Existing Home Sales
9/30/13 – 8/31/18
Below is a five-year chart of U.S. auto sales which also shows a recent slowdown in sales activity.
Total Vehicle Sales
9/27/13 – 10/2/18
These declines all represent contractions from high points and still reflect healthy levels compared to the previous five years. However, we do believe we are starting to see the effects of higher interest rates in these areas.
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