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2018 Q2 Economic Update from Transition Financial Advisors, Inc.

Global stocks declined in the first quarter of 2018 due to a variety of reasons. Worries about rising interest rates, mounting inflation pressures, and escalating trade tensions between U.S. and China all put downward pressure on stock prices. Talk of a potential trade war sent stocks reeling at various times throughout the quarter as volatility came back with a vengeance. The S&P 500 dropped -.8% while the Dow Jones Industrials lost -1.96% for the quarter despite improving economic and business fundamentals.

Fixed income investments also declined as interest rates climbed on higher inflation expectations. As the Federal Reserve launched its first rate hike of 2018 in March, the yield on the 10-year treasury climbed 34 basis points to end the quarter with a yield of 2.74% (remember, as interest rates go up, the price of bonds, particularly longer term bonds, goes down).  Treasury rates climbed even further during the month of April as the yield on the 10-year Treasury peaked right around 3%. Corporate bonds and mortgage-backed securities lost ground as well.

Despite a generally healthy commercial real estate market, REITs have been held back amid heightened short-term sensitivity to interest rates. While rising rates could remain a factor, REITs are not bonds or bond substitutes. In an improving economy, landlords can raise rents as tenants fight for more space, potentially increasing cash flows to offset the effects of higher interest rates. Rising Treasury yields have been historically positive for REITs when accompanied by a stronger economy. While we cannot say when REITs will reverse their recent underperformance, we see them as attractively priced with very good long-term fundamentals.

It is hard to go through a day without coming across some “investment pornography” from the financial media about the excessive volatility of the stock market. One would think the market is crashing every other day. But is the volatility really that extreme? Perhaps the most well known measure of volatility in the stock market is the so-called VIX Index, which is short for the CBOE SPX Volatility Index. It uses S&P 500 index options activity to gauge investors’ expectations of volatility. It represents a 30-day measure and is often referred to as the “fear index” in the financial media. Over the past 10 and 20 year periods, the VIX has averaged 19.87 and 20.34, respectively, according to Bloomberg. For the entirety of 2017, the VIX averaged just 11.09. In Q1 of 2018, its average reading spiked to 17.25, still below its longer-term historical averages. While the surge in volatility is certainly headline news, seeing the VIX index trending back to more normal levels should actually reassure investors that the checks and balances of the stock market are alive and well. Although the 2017 minimal levels of volatility might feel good, they are not normal for markets and therefore are neither healthy nor sustainable.

One factor driving higher volatility is headlines awash with talk of trade wars and tariffs. Although things seemed to have calmed down a bit, for several weeks it seemed there was a contest between the U.S. and China to see who could slap-on the better tariff. Yes, tariffs matter, but only to certain companies and  industries and to  farmers of particular  crops. From an economic  standpoint, they don’t impact markets as a whole and in our opinion, aren’t of such  a magnitude that they will end  the current economic growth cycle. The effects of the recently passed tax cuts alone dwarf those of the tariffs being discussed. It is our view that this is just a way to open up negotiations with various countries where the current administration believes the trade deals in place are too one-sided.

As we have said many times, it is corporate earnings that ultimately drive stock prices. And corporate earnings have been sensational. For Q1 2018, with 53% of the companies in the S&P 500 reporting results, 79% have reported a positive earnings surprise and 74% have reported a positive sales surprise. If 79% is the final number for the quarter, it will mark the highest percentage ever achieved since Factset began tracking this metric in Q3 2008. Furthermore, the blended earnings growth rate for the S&P 500 is a magnificent 23.2%. If this number holds up, it will mark the highest earnings growth achieved since Q3 2010. Earnings estimates going forward call for continued double digit growth.  All in all, the earnings story is great and justifies in part some of the current valuations we are seeing in stocks.

In spite of the great earnings news, we see a bumpy road for the market in the short-term as rising interest rates and inflationary pressures keep investors worried. Yet, we do not believe we have seen the end of the current bull market, which is now in its ninth year. None of the catalysts behind the recent market pullback have changed the larger positive backdrop for stocks.

We also do not see warning signs that we are near the end of the current economic expansion. We see synchronized global growth with plenty of room to run. We see higher interest rates ahead, but strong global demand for fixed income investments should keep yields from rising to above-average levels. We see modest, but positive market returns driven by continued earnings growth and increasing dividends.

Sincerely,

Transition Financial Advisors Group, Inc.

Mitch Marenus, Chief Investment Officer
MBA, CFP® (US), CFA®

Brian Wruk, President
MBA, CFP® (US), CFP® (Canada), CIM, TEP