2018 Mid-Year Review and Outlook: What’s Working, or Not, and Why
August 24, 2018
By Scott Bogan
Slightly more than halfway through the year, it is an opportune time to review important events and driving forces behind global capital markets and how that translates to your investment portfolio. We will also share our outlook for the remainder of this year.
Year to date 2018 is proving to be the antithesis to 2017. Capital markets experienced sustained volatility February – June triggered by fears of significantly accelerating inflation from wage growth and geopolitical threats. Investor sentiment has been pessimistic largely due to worries about adverse consequences from trade tariffs and incessant political drama in Washington. Surprisingly, capital markets are showing resilience. Despite sustained confusion and volatility in markets stemming from conflicted investor sentiment, markets are behaving rationally due to exceptionally powerful underlying fundamental forces.
EVENTS AND DRIVING FORCES
- Global Economic Growth: S. economic growth has accelerated as tax reform and deregulation begin to work their way into the economy. Numerous economic metrics are surging: GDP (+4.1% in 2Q), Jobs Growth (+224k/month (3-month average)), Manufacturing and Services PMI (60 vs. neutral benchmark measure of 50). Meanwhile, global growth is solid: Global Composite PMI (54) but has slowed modestly this year after a blistering recovery in 2017. Europe sustained prolonged severe winter weather, labor strikes, and labor shortages. Meanwhile China and related Emerging Market economies have slowed modestly as collateral damage from Trade Tariffs becomes evident.
- Geopolitical Events: Confusion is the dominant theme for capital markets and politicians. The White House’s initiatives with trade tariffs as a tool to renegotiate trade agreements bilaterally causes investors to fear escalation to protectionist trade wars as happened in The Great Depression in response to the 1930 Smoot Hawley Act. Meanwhile political perceptions and confusion are compounded by President Trump’s direct diplomatic engagements with Kim Jong Un, Vladimir Putin, and the U.S. withdrawal from the Nuclear Agreement with Iran, and re-imposing an embargo on Iranian oil sales.
- Central Bank Policies: Monetary policies worldwide are now slowly migrating from a decade of massive stimulus to eventual tightening. Led by its new Chairman, Jay Powell, the Fed has become hawkish this year as it drains more liquidity from the economy via interest rate hikes and balance sheet contraction. The Fed has raised rates 7 times equaling 1.75%, since December 2015. Chairman Powell has indicated that the Fed considers 2.9% to be the “neutral rate” that neither stimulates nor constrains the economy which now has 2% inflation. The Fed recently raised its forecast to tighten more rapidly with five more prospective rate increases by the end of 2019. The Fed is also reducing its bond holdings, “Quantitative Tightening,” by $50 Billion per month for the next few years. India, UK, Canada, have also started withdrawing liquidity through tighter monetary policy. Meanwhile, Europe’s ECB recently postponed the beginning of reducing liquidity and policy tightening until next year as it slowly concludes policy stimulus that began in late 2012. Inflation in Europe is still persistently below the ECB’s 2% target. China and Japan are still in controlled stimulus mode.
- Corporate Earnings and Stock Markets: There is an adage “corporate profits are the mother’s milk of stock markets.” Well, the U.S. stock market is very well fed, owing to the positive impact of Tax Reform and global synchronous growth. U.S. corporate earnings are booming (+28% in 1Q and 24% in 2Q) with broad participation from all business sectors (80% of companies beat EPS estimates in 2Q). Sales are surging (+10% in 1Q and 2Q), and Profit Margins have reached record highs (11.7% vs. 20 year average of 8%). Corporate spending “Capex” is now surging. U.S. stock markets are “climbing the wall of worry” and rising slowly to new highs fueled by these powerful fundamentals, despite the backdrop of negative sentiment largely tied to concerns over Trade Tariffs. Meanwhile, overseas stock markets are struggling, despite solid earnings and sales growth, as investors worry about the eventual adverse impact of trade tariffs; year to date foreign developed equities, “EAFE”, is -5%, Japan’s Nikkei is -4%, and the MSCI Emerging Markets index is -8%.
- Bond Yields and Interest Rates: Rates have risen very slowly in the U.S. (10 year Treasury yield has risen as high as 3.0%) while barely rising elsewhere in the world as “risk-off” sentiment tied to concerns over trade tariffs supports demand for sovereign bonds despite their exceptionally low yields. Fed rate hikes continue to cause the U.S. treasury bond yield curve spread to flatten (currently 30 basis points) as short-term rates (controlled by the Fed) rise faster than long-term rates (controlled by bond market investors). As foreign Central Banks slowly begin to reduce liquidity and eventually raise their interest rates, the “bear market” in government/sovereign bonds will likely worsen. We remain vigilant for an eventual inverted yield curve, which traditionally has been an early warning signal of eventual economic contraction and a recession.
- Commodities: Supply/demand fundamentals are supportive and modest global growth is driving commodity prices higher. Crude oil has rallied YTD + 16% (WTI U.S. crude $70/barrel) as crude inventories are low (-20% Y/Y), U.S. frackers’ rig counts have risen only +9% YTD, and OPEC/Saudi Arabia / Russia are proactively controlling cartel production levels to target $70/barrel oil. Copper has just recently sold off -16% since early June on trade tariff worries, after rallying +50% in 2017 as the global economy recovered from a multi-year slowdown.
These fundamental forces help establish the context to more easily understand an attribution analysis of investment results year to date.
OUTPERFORMERS / CONTRIBUTORS
- S. Growth stocks driven by high revenue and earnings growth, and reasonable valuations.
- S. Mid-Cap and Small-Cap stocks that disproportionately benefit from lower corporate tax rates under tax reform, and whose domestic revenue base makes them less vulnerable to investor concerns over trade tariffs.
- Oil and Energy Stocks benefitting from low inventories and supply production constraints.
UNDERPERFORMERS / DETRACTORS
- Emerging Market stocks adversely impacted by trade tariffs and a stronger US$.
- Developed international market stocks suffering from trade tariff concerns and slower economic activity in Europe and Asia.
- Long Duration Income/Yield Investments struggling with the headwind of Fed rate hikes and “Quantitative Tightening,” specifically longer-dated maturity Government bonds (Treasuries, Sovereigns, Municipals), high dividend paying stocks, and real estate REITS.
OUTLOOK FOR 3Q / 4Q 2018
This is our outlook for key events and driving forces in the remainder of this year:
- Mid-term Elections: Market turbulence and volatility near term August through October as investors become pre-occupied with U.S. mid-term elections. The tight outcome in the Ohio special election in early August is a leading indicator that Republican candidates will be heavily challenged in other Congressional races. If Democrats win control of both the House and Senate, then markets might experience selling pressure at the end of the year, and impeachment rhetoric may intensify. Conversely, if Republicans retain control of Congress, or if it is divided, markets could continue to rally into year-end.
- Trade Agreements and Tariffs: The White House may likely announce new trade agreements in August and September with NAFTA (Canada/Mexico) and the European Union. Meanwhile, meaningful progress with China trade agreement negotiations might not occur until after the mid-term elections, such that Emerging Market stocks, bonds, and currencies will continue to experience headwinds until an agreement is reached. China has little incentive to make commitments right now until they have a better understanding of President Trump’s level of political support in Congress following the mid-term elections outcome.
- U.S. and Foreign Developed Market Equities: Pending mid-term election results, markets could rally in November and December driven by strong fundamentals and fading Trade Tariff headwinds.
- The Fed raises rates at the September and December quarterly meetings.
- U.S. Treasury Yields: Long bond yields rise to approximately 3.25%, meanwhile the yield curve spread (10 year – 2 year) flattens further almost to zero.
We continue to remain focused on constructing investment portfolios that incorporate passive index strategies and actively managed strategies as cost efficiently as possible. We are proactive in our asset allocations and oversight of fund managers relative to developing conditions in capital markets. The remainder of the year will continue to be fluid and dynamic.
Do not hesitate to contact us with market-related questions, or to reach out to your Advisor to discuss how this translates to you specifically.
We always appreciate your trust and confidence, and the opportunity to work for you.
Scott M. Bogan serves as an Investment Advisor/Capital Markets Strategist with Resnick Advisors in Westport, CT. You can email Scott at firstname.lastname@example.org.