On behalf of the Altium Investment Committee;
In stark contrast to how we started the year, the second quarter was relatively uneventful. While the U.S. equity market has remained in a tight trading range since the February stock market correction, international and emerging markets have experienced continued volatility. Despite an abundance of headline news, including an unprecedented U.S. – North Korea summit and trade-war, U.S. market volatility has subsided.
As it stands today, the global economy is growing and the U.S. remains out of economic recession territory. Investors continue to wait for signs that our domestic economy is heading towards a recession, which is typically accompanied by a downturn in the equity markets. While we echo the sentiment that all recoveries must eventually come to end, we do not see evidence that a recession is on the near-term horizon.
We advise our clients to remain committed to their strategic long-term investment allocations. Further, we strongly believe that a well thought out plan should serve as the blueprint for all portfolio allocation decisions. Our goal is to make decisions based upon a strategic plan and resist the urge to make emotional decisions that may affect long-term results.
Key Headlines During Q2 2018
Domestic equities recover while international markets struggle
In the second quarter, U.S. large cap stocks were up 3.4%, international developed market stocks were down 2.5% and emerging market stocks were down 7.8%. *
The S&P 500 index has nearly recovered all of its losses from its correction in February. As of July 19, the index is down roughly 2.3% from its peak on January 29th.
Short term bond yields increase while longer term rates are nearly unchanged
The Bloomberg Barclays U.S. Agg. Bond Index was down 0.2% in the quarter, indicating flat returns for bond portfolios during the quarter.
The U.S. Federal Reserve raised the Fed funds rate in June for the second time this year, increasing the rate by 0.25% to 2.0%. The Fed has signaled it will raise rates two more times in 2018 and three additional rate increases in 2019.
Short-term U.S. Treasury bond yields increased in tandem with the Fed rate hike during the quarter, while longer-term yields were relatively unchanged. Yields on the 2-year Treasury bond increased from 2.27% to 2.52%, while yields on the 30-year Treasury bond increased from 2.97% to 2.98%.
The spread between yields on the 2-year and 10-year U.S. Treasury, while continuing to trend lower, ended the quarter positive by roughly 0.33%.
Strong corporate earnings has resulted in stable stock price multiples
Price to earnings multiples (P/E) are used to gauge the relative value of a stock or market index. The concern during a bull market is that prices will inflate to levels that result in unsustainable price multiples. However, increasing earnings estimates (directly related to tax cuts), have made valuations look more reasonable.
The S&P 500 Index Forward P/E Ratio is roughly 16.2x, only slightly above its 25-year average of 16.1x. **
Volatility has stabilized
Following a swift increase in volatility to start the year, the U.S. market has remained relatively calm despite a steady flow of controversial news. Please refer to our Q1 communication for additional commentary on current market volatility.
In the graph below we highlight the VIX Index (a measure of expected future market volatility), which saw a significant spike in January and a subsequent gradual decline through the end of the second quarter. Included in the graph below (black line) is the performance of the S&P 500 Index during this time. As volatility has settled, the S&P 500 Index has recovered off its low for the year.
Source: Bloomberg: VIX Index (blue shade) & S&P 500 Index (black line)
What Will Move the Markets in the Second Half of 2018
Investor expectations for an economic recession
Concern over a pending economic recession seems to be the most common worry for investors. We believe that an economic recession will not be a near term event based on economic fundamentals, such as strong employment, general strength of the consumer and positive GDP growth. GDP growth has been above 2% over the past four quarters and market expectations are for GDP growth to remain above 2% over the next year. ***
We continue to watch the indicators that would signal to the markets that an economic recession is approaching. The economy has avoided a recession since 2008, which is the second longest period between recessions in history (trailing only the expansion from 1991 to 2001). An “inverted yield curve” is a well-known indicator used by economists when studying previous recessions. Despite another rate increase by the Fed in June, the spread between 2-year and 10-year Treasury bond yields remains positive by roughly 0.33%; in other words, the yield on a 10-year bond is 0.33% greater than the yield on a 2-year bond. A positively sloped curve has historically signaled inflationary growth, therefore, leading us to believe that we are not yet facing an economic recession.
The chart below depicts how an inverted yield curve (in 1989, 2000 & 2006) preceded the last three recessions (Red shading shown in 1990, 2001 & 2008). This occurs when the yield on the 10-year bond is lower than the yield on the 2-year bond. One takeaway from this study is that while we are approaching an inverted yield curve, we believe we are potentially a few quarters away from it occurring and there could be an additional lag of a few months to a year before a recession materializes.
Source: Bloomberg: 10-year & 2-year Treasury Spread (blue); Economic recessions (red shade)
Corporate earnings and P/E multiples
Corporate earnings estimates from stock analysts tend to start the year high and trend down as the year progresses (analysts tend to be optimistic and have to lower expectations following actual results). This has not happened in 2018 as analyst expectations from tax reform has led to increased consensus earnings estimates. What this means for valuation is that multiples have held steady despite rising stock prices (i.e. rising stock prices (P) and earnings (E) keeps P/E ratios stable). Thus, we have avoided a situation where valuation becomes overheated.
Generally, the markets have adjusted favorably to trade war concerns. We are aware that mid-term elections (November 2018) can affect the ultimate result of this trade “negotiation”. If Republicans lose House majority then it is possible that no major trade legislation occurs during the remainder of the current Presidential term. We remain cautious on rising trade-related market volatility.
When the dust settles we will see if this is more noise than anything else. However, concerns over a trade war could affect the confidence and ultimately spending of consumers and businesses. This is noteworthy because consumer spending is the largest contributor to U.S. GDP and any unsuspecting disruption to consumer spending could shock the economy.
Impact from Fed tightening
How will the markets adjust to Fed monetary policy? Current market expectations are below the Fed’s own rate projections. The Fed’s neutral rate level is 2.75% - 3% (where it considers rates neither tight nor accommodative). Rates above this level can be considered restrictive for markets. At the current level of rate increases, the Fed would drive the Fed funds rate to this neutral level after three more rate hikes. These rate increases are expected in September and December of this year and again in March of next year.
What will happen to longer-term rates? 10-year U.S. Treasury rates may be capped near its current 3% level if demand for U.S. bonds remain strong. Wide international debt yield differentials are a key contributor of this demand. For example, the U.S. 10 year treasury yield is currently 2.5% greater than the German equivalent. Expectations that European Central Bank policy will not change and foreign debt will remain unattractive versus the U.S. Treasury demand may keep rates from increasing.
Can the Fed engineer a soft landing? A soft landing is defined as a cyclical economic downturn, which avoids a recession. The Fed is attempting to do this by maintaining a low unemployment rate while keeping inflationary pressures low. While an unlikely scenario, this could prolong the current economic recovery and subsequent bull market. Even with a flat yield curve (which the Fed is moving towards) it is possible that with reduced inflationary pressures and improvements in economic productivity current GDP growth becomes sustainable.
The current bull market for U.S. stocks remains intact. Corporate earnings are generally strong and corporations have ample room for additional dividends and stock buybacks to boost stock prices. The U.S. economy is in good shape, particularly when measuring job growth and the strength of the consumer. While we continue to watch for the possibility of a central bank misstep, whether in the U.S. or abroad, we are not expecting an economic recession in the near term. Our advice is to remain invested in a well-diversified allocation that is appropriate for your specific situation and avoid over-reacting to volatility or headline news.
As an example of why we recommend staying the course, we have included the following two charts showing long-term U.S. equity market results, as measured by the S&P 500 Index. Over the past 80 years (including 13 recessions), the S&P 500 has returned positive results 77% of the time on a calendar year basis. When measuring a rolling 10 year period, the index was positive 89% of the time.
Source: Bloomberg; S&P 500 Index daily prices
Gregory Slater, CFA, CFP®
Chief Investment Officer
Source: Bloomberg; 2Q 2018 total return, International, emerging market, S&P 500, Barclays Agg indexes
* LC US stocks = S&P 500 Total Return Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
**Price to Earnings multiples; Source Bloomberg. July16th
*** Tradingeconomics.com – GDP historical growth and forecasts
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