Quarterly Commentary: 3rd Quarter 2018 - Markets Return to Normal; Which Means UnpredictableSubmitted by Integras Partners on February 1st, 2019
Markets Return to Normal; Which Means Unpredictable
TYPICALLY, THESE COMMENTARIES FOCUS ON THE CALENDAR QUARTER JUST ENDED.
The first half of 2018 was muted, the third quarter was robust, and as we write in the second week of October, the picture is changing dramatically.
This year started with the world’s two largest economies (the U.S. and China) escalating trade tensions, followed by piling on with increasing tariffs. International markets suffered under these pressures and a stronger US dollar. This summer saw modest international gains but for 2018 the MSCI EAFE Index (the broadest foreign metric) has dropped 1.7% while emerging markets are down nearly 10%.
The S&P 500 Index® was up a mere 3% for the first six months. The Russell 2000 (Small Cap) Index® was up about 11% as investors sought growth in small companies more immune from international exposure. The U.S. Aggregate Bond Index is down 1.6% for the year as interest rates are rising.
When this quarter started in July, worries seemed to evaporate as our stock markets marched upward for almost the full 90 days. The administration reached agreements with both Mexico and Canada (our largest trading partners after the E.U. and China), corporate earnings increased while both consumer sentiment and leading economic indicators improved. During the summer quarter, the S&P 500 was up 7.7%, the Russell 2000 (Small Cap) Index gained 3.6%, and the tech-heavy NASDAQ climbed 7.1%.
WHAT WE’RE NOW EXPERIENCING IS A TRUER PICTURE OF HOW MARKETS BEHAVE.
Trends in place for several years remain in place. Growth continues to outperform value stocks. Quality, “Dividend Growth” names considered the “safer” parts of the market, have underperformed growth stocks by nearly 12% this year. Unsustainable over the long-term, this trend has held since early 2016, and our portfolio strategies remain overweighted to growth given this performance differential.
In previous writings, we have illustrated the serenity that grew among investors during what has become the second-longest Bull Market in U.S. history. Through September 30th, US markets led the world with the S&P 500 up 10.5% and the Russell 2000 gaining 14.6%. For the first two weeks of October, the S&P is down 5.77% and the tech-heavy NASDAQ lost 7.52%
We know the discomfort that accompanies investing in volatile markets. For many clients, we have taken steps over the past year to ensure that needed cash flows are secure.
ECONOMY AND INFLUENCING FACTORS GOING FORWARD
U.S. earnings expectations exceed 20% this year (aided by tax cuts), with economic growth (GDP) close to 3.5%, which is greater than we’ve seen for several years. Strong manufacturing and employment, rising leading economic indicators and additional boosts possible from repatriated overseas cash and capital investment. Negative and potentially negative influences are US protectionism (tariffs), rising short-term interest rates, the narrative of “this is as good as it gets,” and a general decoupling of the US economy from the rest of the world as it strengthens while other major economies are weakening.
While all the above currently influence investor behavior, with think only a few will prove meaningful. While earnings growth may exceed 20% this year, the boost from tax cuts will be gone next year. Therefore, next year’s earnings comparison will be challenged, and shortfalls will be viewed rather negatively. Sorely needed capital expenditures have been subpar vs. expectations and concentrated in technology as opposed to those sectors that add meaningfully to employment and wages – resulting in a drag on GDP growth. Finally, corporate profit margins will be pressured by higher costs (wages, imported components, interest rates & commodities) which will be headwinds to earnings. The markets will be challenged by these various inputs and we expect to finally see the rotation back towards higher quality value stocks vs. the growth names that leading the recent years’ advance.
China is now the primary trading partner with unresolved tariff fears, which won’t happen before the mid-term elections and perhaps much later. They don’t have much room left to increase tariff pressure on the US but do have several levers including currency manipulation and refusal to purchase additional US debt. The bond markets moved meaningfully just this week partly based upon that fear. It’s too early to draw conclusions as to how this will be resolved, and markets accordingly remain on edge.
The market’s October swoon catalysts are rising interest rates and relatively high stock prices. We mentioned that technology stocks have widely led the market this year and valuations have stretched all year. A little blow-off of excess has been needed for some time as a few tech stocks are most responsible for the recent declines. As of mid-October, the average large company stock was down 17% from its one-year high and the average small-cap stock down 24%. So underneath the surface, the recent trend has weakened considerably.
Interest rates are also a concern. The first week of October saw the 10-year Treasury Note rise from 3.05% to 3.25% in just three days, as inflation is proving real. The Federal Reserve is selling $50 billion of bonds off its balance sheet monthly, in addition to raising interest rates. Higher rates make future earnings less valuable, and the market sold off sharply for the second time this year.
Going forward we expect interest rates to continue rising next year and corporate earnings growth will slow to around 9%-10%. Value to eventually take the leadership role from growth and the economy will remain strong. This combination will challenge markets and volatility will increase to normal longer-term levels. Investment returns should be quite modest next year with equity returns in the mid-to-low single digits and bond returns to remain at or below zero.
There is speculation that we’re approaching the end of this market cycle and can expect a 20% move down. We agree that we are getting closer to the end but have yet to see evidence of stress building in corporate credit quality – a telltale sign that the end is near. While bull markets don’t die of old age, like human beings they become more susceptible to stresses later in life. Credit markets are where we see these initial signs, and we recently took a pre-emptive step in our Income Strategy to eliminate our most credit-sensitive assets. While the economy remains robust and no outsized credit stresses exist, higher interest rates eventually take their toll in the form of lower prices and weakening credit quality. We are watching events closely remain poised to widely take equity risk off the table in favor of capital preservation.