2018 Q3 Economic Update from Transition Financial Advisors, Inc.
Global stocks rose modestly in the second quarter despite signs of slowing economic growth in Europe and Japan, deteriorating international trade relations, and rising U.S. interest rates. In a volatile quarter, markets came under pressure due to all these factors, but strong earnings growth helped boost investor sentiment and led to gains in most major stock markets (when measured in the local currency).
U.S. equities advanced in the second quarter, as the S&P 500 rose 3.4%, amid heightened geopolitical tensions. Trade tariffs against China, as well as several political allies, preceded retaliatory measures against the United States. Small-cap stocks outgained large caps as investors preferred companies with less dependence on global trade. The U.S. dollar strengthened as well against most currencies, creating a strong head wind for U.S. investors in foreign markets.
Growth companies generally outpaced value stocks as consumer discretionary and information technology were two of the top-performing sectors. Energy stocks, also a top-returning sector, rallied sharply from beaten down prices. West Texas Intermediate Crude has soared 61% in the past year leading shares of Exxon Mobil, Chevron, and Conoco Phillips to double digit gains. The financial sector lost 3% for the quarter and declined 13 consecutive days during late June, pressured by political headwinds and a flattening yield curve.
Rising yields made for mixed results across U.S. bond sectors. Investment-grade bonds declined, hurt by rising interest rates and signs of higher inflation. The Federal Reserve raised the federal funds target rate in June by 25 basis points, to between 1.75% and 2.0%. The Fed also signaled two more rate increases for later in the year, for a total of four. Concerns about more restrictive U.S. trade policy helped prevent longer maturity Treasury yields from rising further.
The synchronized global economic expansion that powered earnings growth in 2017 appeared to have plenty of steam coming into 2018. However, some indicators show signs of slowing growth, particularly in Europe and Japan. European stocks rose 4% in local currency (euro) but declined 1% in dollar terms as a perceived shift to a softer monetary policy by the European Central Bank sent the euro tumbling against the U.S. dollar, accounting for the losses suffered by dollar-based investors in these foreign funds. Political turmoil also weighed on markets as a new populist ruling coalition in Italy raised investor’s fears that Europe’s third-largest economy may consider leaving the European Union.
Economic growth appears to be most robust in the U.S., where confidence remains high and last year’s tax cut continues to put disposable income in the pockets of consumers and corporations. Earlier today, second quarter GDP results were released and showed the U.S. economy growth rate accelerating to 4.1%. Consumer and government spending powered the economy to the fastest pace in almost four years. Although most were impressed with 4% growth, many economists think this is the high watermark for the year and we should expect some deceleration. It is yet to be seen.
We believe, at this juncture, the predominant risk to U.S. and global economic growth is the potential break down of international trade relations between the U.S. and its trading partners. However, we also believe it is important to recognize that this drama has quite a ways to go before we reach that point. There is a chain effect that would need to occur before damage becomes high enough to materially threaten economic growth. The total market size of the existing and potentially implemented tariffs set in motion so far is approximately $450 billion, which in total represents about 3% of the U.S. economy and .06% of the global economy. So at this point, there does not seem to be enough at stake to measurably move the needle in the wrong direction.
By all objective accounts, the first half of 2018 should have been an exceptional six months for stocks. Corporate earnings growth rose well above even the most optimistic of forecasts at the year’s outset. To date, 53% of the companies in the S&P 500 have reported actual results for Q2 2018. In terms of earnings, 83% have reported a positive earnings surprise and 77% have reported a positive sales surprise. If 83% is the final number, it will mark the highest percentage since FactSet began tracking this metric in 2008. Looking at future quarters, analysts currently project earnings growth to continue at about 20% through the remainder of 2018. However, they predict lower growth rates in the first half of 2019.
With the Federal Reserve potentially raising interest rates 4 times this year, it is easy to understand why bonds have lost value this year. As investments, bonds have two primary sources of risk; interest rate risk and credit risk. Interest rate risk is the risk that arises for bond owners from the movement of interest rates, in particular, rising interest rates. Credit risk is the risk to the bondholder that the issuer of the bond will default on its obligations. Credit risk has been low for some time now as business conditions have been improving since 2009 and are quite robust. Rising interest rates have been the primary source of risk in the current environment.
Over the course of the last year, we have taken several steps to mitigate this risk. First, our investment grade bond portfolios, the largest part of our bond holdings, have been re-positioned into funds comprised of very short maturity bonds. These funds are actually called ultra-short term bond funds. Ultra-short maturity bond funds have little to no interest rate risk as there are always large numbers of bonds at or near maturity. When a bond matures, the proceeds are then reinvested into new, higher yielding bonds. Of course, the yield on short-maturity bonds is a bit lower than longer maturities, but the protection from rising interest rates more than offsets the lower yield. Ultra short-term bond funds are one of the safest ways to participate in the bond market in a rising rate environment.
In addition to ultra-short maturity bond funds, we have also increased our allocation to floating rate bond funds. These funds can hold various types of floating rate debt securities including bonds and loans. Floating rate bonds and loans are debt instruments whose interest rate fluctuates with the general level of interest rates, as opposed to paying interest at a fixed-rate. Because the interest rate floats with the market, these bonds have a lower degree of sensitivity to changing interest rates. As interest rates go up, the interest rate paid to the bond or loan holder will reset automatically higher, causing payments to the bond holder to rise. What a fantastic investment to own in an environment when interest rates are going up!
We hope everyone is enjoying their summer, wherever that may be. As always, please call Mitch or Brian with any questions.
Transition Financial Advisors Group, Inc.
Mitch Marenus, Chief Investment Officer
MBA, CFP® (US), CFA®
Brian Wruk, President
MBA, CFP® (US), CFP® (Canada), CIM, TEP