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Third Quarter 2018 - Capital Market Summary & Outlook
3RD QUARTER 2018 RECAP AND INVESTMENT OUTLOOK
Capital Market Action Summary
Domestic stocks continued to hit all-time highs in the third quarter as the trade war and tariff rhetoric that had once fueled market uncertainty began to abate. Strength in economic conditions and corporate earnings drove equities to modest gains, both home and abroad. US growth, technology, and healthcare stocks built on their recent trends by outpacing value stocks over the quarter. The risk of a domestic recession remains low and the impact of the recent tax reform continues to reverberate throughout the market in the form of strong cash flows and high levels of stock repurchases, further aiding equity prices. US labor markets have also supported the notion of a strong underlying economy as unemployment rates set new lows and the hint of wage growth continued to drive discussions about inflation.
Abroad, stock performance suffered from a number of geo-political risks. Japan fared the best of all the developed markets and followed much of the US pattern. Concerns in Europe, however, continued as the economic crisis in Turkey, along with uncertainty surrounding the impending Brexit negotiations, spooked investors that were seeking some clarity to the region’s politics. Nevertheless, most international markets saw flat to slightly positive returns. Emerging Markets stood out as the one major exception to these trends, as the majority of these countries continued their recent declines, albeit at a slower pace. Continued trade tensions between the US and China lead to global sell offs in emerging market stocks despite progress in negotiations between the US and Mexico. The potential trade barriers resulting from the US/China negotiations also impacted other export-dependent markets, such as South Korea, given their potential to disrupt the manufacturing and supply chain sectors. Accordingly, emerging markets stocks are trading well below historical averages and much lower overall than those of developed market equities.
Strong economic fundamentals also prompted the Federal Reserve to raise the Federal Funds rate by 1/4 of a percentage point in September. Unlike some of the recent Federal Funds hikes (which resulted in bond price rallies due to an increased expectation that the FOMC’s action would also increase the chance of a recession) bonds sold off leading to a spike in the 10 Year Treasury rate from 2.82% in late August to 3.23% in early October. This was noteworthy as it represented the highest level that the 10 Year Treasury has reached since 2011. One additional note that bears watching is the fact that we continue to see little difference between two and ten year Treasury rates. Historically, this “tight” spread has indicated that bond investors see economic expansion in the short term, but are less convinced of longer term growth. All in all, this correlates with our view that there is little risk of recession in the immediate time frame, but we continue to watch the horizon cautiously as we approach 2020. The recent rate moves and spreads between the two and ten year maturities are further illustrated in the following chart from Merrill Lynch:
Despite the uptick in interest rates, domestic bonds exhibited modest declines. This was reflected in economically sensitive bonds (high yield corporates and bank loans) outperforming the broader market. International fixed income did not enjoy the same reception as US bonds as their values continued to decline over the third quarter. Oil prices also climbed during the quarter despite inventory increases as concerns mounted about the impact US sanctions would have on Iran. The lift, however, was not broad based within the commodities markets and most natural resource products and metals struggled in the face of tariff concerns and an economic slowdown in China. Additionally, the dollar continued to strengthen during the quarter as it has for most of 2018, thereby putting additional pressures on commodities prices. Emerging markets, more than any other investable segment of the marketplace, tend to feel these effects as their governments and corporations generally borrow in US dollars. In short, a stronger dollar leads to an increase in the cost of EM debt in local currencies.
Oil prices also climbed during the quarter despite inventory increases as concerns mounted about the impact US sanctions would have on Iran. The lift, however, was not broad based within the commodities markets and most natural resource products and metals struggled in the face of tariff concerns and an economic slowdown in China. Additionally, the dollar continued to strengthen during the quarter as it has for most of 2018, thereby putting additional pressures on commodities prices. Emerging markets, more than any other investable segment of the marketplace, tend to feel these effects as their governments and corporations generally borrow in US dollars. In short, a stronger dollar leads to an increase in the cost of EM debt in local currencies.
Major Index Returns for the Third Quarter of 2018 S&P 500 Index (Large Cap Stocks): 7.71% Russell 2000 Index (Small Cap Stocks): 3.58% MSCI EFAE Index (International Stocks): 1.35% Barclay’s Aggregate Bond Index (Fixed Income): -.02%
As we have seen over the past few weeks, the stock market is still a fickle beast. We fully expect to see a return to volatility more in-line with historical norms, especially if a change of party control within the house or senate results from the Federal mid-term elections. The additional specter of higher interest rates and continued Federal Reserve action will weigh heavily on the markets as investors adjust their return expectations.
With all that said, we still believe that economic fundamentals will be supportive of US stocks through the first half of 2019. Returns will likely be muted as the Federal Reserve and European Central Bank continue tightening, but growth should be enough to keep equities moving forward. As we approach 2020, the odds of a recession increase, but until then, the continued effects of the tax reform and positive GDP growth should produce positive returns and keep recession fears to a minimum. We believe that the US is heading into the late stages of the economic cycle as evidenced by tight labor markets, inflationary data points and bond market trends. Corporate credit and inventories metrics further support our base case that the US is in the late mid-cycle. Accordingly, we anticipate a move towards risk reduction over the next few quarters.
Despite all of the micro and macro-economic factors to consider, we still believe that geo-political risk is the single largest short term risk that the markets must contend with today. The graphic below from Blackrock summarizes the potential risks and their potential impacts on the capital markets.
While we had once hoped for a bounce-back in European equities as the headwinds in EU have been largely political and valuations remained attractive, that realization unfortunately did not occur. We are now planning to reduce our exposure to European stocks as the US and emerging market equities seem to offer more attractive risk/return profiles. This case is supported by stronger economic fundamentals in the US and less downside exposure in emerging markets after their recent sell off. Investor sentiment may shift, but larger economic trends have been deteriorating despite accommodative European Central Bank policies.
From a metrics standpoint, emerging markets remain well below historic averages and are very cheap on a valuation basis compared to developed market stocks as seen in the chart below:
Our goal of a 3.25% rate on the 10 Year Treasury note has been an important marker for some time and it looks as we will finally approach that range. While it has come with considerable volatility and resistance, our thinking appears correct, and we believe rates may eventually surpass the 3.25% mark move higher to 3.5%. At this point, we feel that much of the interest rate risk has been removed from the bond market and higher yields offer more return in exchange for the same interest rate sensitivity.
What does that mean? We will be replacing the short term bond allocations with more traditional core bonds over the fourth quarter for more yield and as ballast against stocks in the event of an economic downturn. Historically, core bonds generally act as one of the best hedges against stocks market volatility. The shift in bond strategy will be the first action item in our risk reduction plan heading into the second half of 2019.
Past performance is not necessarily indicative of future returns. The performance described in this report is based on investment selections for the period in question. There is no guarantee that these same investments will continue to perform as described. All investing carries a risk of loss, including principal that clients should be prepared to bear. Clients are advised to inform us of any changes in their circumstances as such changes may materially alter the appropriateness of the investments selected by Ferris Capital.