On behalf of the Altium Investment Committee;
While public opinion in America is growing more divisive almost every day, it is hard to refute that the economy is functioning at an extremely high level. Recent economic data supports the belief that consumers are healthy, businesses are thriving and both remain confident about the near-term.
What do we expect to happen next? Our expectation is that the economy continues along its path of stable GDP growth for the foreseeable future, as the impact from years of accommodative policy remain present and pro-growth domestic policy is advanced. While concerns of a pending economic recession have mitigated, we are undoubtedly entering a key inflection point in the U.S. equity market as the Fed continues on the path of tightening monetary policy. In fact, as of 10/9, equity assets are down globally to start the fourth quarter and volatility has increased as traders digest the impact of rising Treasury yields.
As we approach the latter part of the economic cycle, we expect more modest broad equity returns over the next few years, with periods of elevated volatility. Asset allocation decisions, portfolio diversification, tax efficient trading and strategic portfolio rebalancing are a few of our investment management techniques that become increasingly more important during range bound and choppy markets.
Key Headlines During Q3 2018
Strong Quarter for Domestic Stocks
In the third quarter, U.S. large cap stocks were up 7.7% and up 10.5% for the year as of September 30*. Contributing factors during the quarter include strong corporate earnings growth, favorable economic data and easing trade-war concerns.
International and Emerging Market Stocks Recover Slightly
In the third quarter, developed market international stocks were up 1.4% and emerging market stocks were down 1.1%. However, for the year, they are down 1.4% and 7.6%, respectively**. A few drivers of this negative performance gap relative to domestic stocks include better U.S. corporate earnings growth, uncertainty surrounding global Central Bank policy decisions, strength of the U.S. dollar and global currency instability. We see several catalysts that could positively impact the outlook for global stocks including higher oil prices (specifically for emerging markets), low relative stock valuations and easing trade war concerns.
Bonds Face Headwinds as Interest Rates Rise
As was widely expected, the Federal Open Market Committee (FOMC) announced another increase in the federal funds target rate of 0.25% during the final week of the 3rd quarter. The FOMC’s statement focused on a labor market that continues to strengthen and economic activity that has been rising at a strong rate. These conditions led FOMC members to express confidence in the economic outlook and a further gradual increase in rates with consensus estimates calling for one more hike this year and three more hikes in 2019.
The impact on the bond market was significant as bond prices fell during the third quarter and the yield on the 10 year U.S. Treasury Bond rose from 2.86% on June 30th to 3.06% at the end of Q3. Most traditional bond indices were negative in the third quarter. The Bloomberg Barclays US Aggregate Bond Index, a widely accepted measure of bond market performance, returned -1.7% over the first three quarters.***
Important themes to watch
Strength of the Consumer
Consumer spending drives nearly two thirds of the U.S. economy, as measured by GDP. In the table below, we highlight a few statistics often used to measure the health of the consumer. In sum, based upon current data, consumers are wealthier than ever and confident in their ability to have stable income. It does not appear that consumer spending is poised to slow down any time soon and since personal consumption is the largest contributor to GDP, we expect modest GDP growth to continue in the near-term.
The Yield Curve, GDP Growth and Recessions
Over the past year, we have written at length about a potential yield curve “inversion” and the recessionary signal that it would provide. In short, while the yield curve has flattened over past few years, spreads between short-term and long-term Treasury yields remain positive. We will continue to keep an eye on this indicator but we do not expect the yield curve to invert over the next couple of quarters.
In addition to a strong consumer, business spending remains strong (another contributor to GDP growth). Corporate earnings have been impressive all year long, driven in large part by years of easy monetary policy, general cyclical recovery and tax reform. With higher earnings, corporations have significantly increased stock buybacks, dividend payouts and general business spending. All of which have direct and indirect positive influences on GDP.
We have combined these thoughts in the chart below. In addition to charting the spread between the 2yr and 10yr Treasury yields, we have added the trend of GDP growth over the past 30 years, covering the past three recessions. In advance of the past three recessions there is evidence of yield curve “inversion” (blue yield spread line falls below the Red zero axis) as well as declining GDP growth (green line). Focusing on current day, the far right side of the chart, spreads remain positive and GDP growth has been stable and is improving. Based upon these indicators, we believe that a recession is not likely in the near-term.
Source: Bloomberg: 10-year & 2-year Treasury Spread (blue); Economic recessions (red shade); U.S. GDP (green)
Impact from Fed Tightening
There are many unknowns during this transition period as the Fed continues to raise rates from the lowest points in history. The Fed is attempting to support the economy and job growth, but also prevent destructive inflation and return rates to a more “normal” state.
We continue to ask, how will the markets adjust to tightening monetary policy and increasing interest rates? Easy monetary policy has been a strong driver of stock market returns over the past few years. Low interest rates pushed investors into equities as the economy recovered and made fixed income assets less attractive. Zero to low interest rates helped ease the short-term debt burden of consumers and corporations, allowing both groups to increase expenditures, which helped restart the U.S. economy. The change in monetary policy to a higher interest rate regime starts to reduce the positive impacts to stock prices and the economy from lower interest rates. We should expect increased market volatility as Fed tightening continues and the market digests future reports on the economy.
Importance of Portfolio Diversification
Diversified portfolios have underperformed relative to U.S. only equity benchmarks this year. Diversified portfolios in this case are considered to have a broad equity allocation including domestic, international and emerging market stocks as well as exposure to a core fixed income asset class. All core fixed income asset classes and most global stocks are negative for the year, which has been a drag on overall performance.
We continue to believe in the long-term benefits of portfolio diversification. As a reminder, the overall goal of diversification is to achieve lower portfolio risk and variability of returns as compared to another investment with the same expected return characteristics. Moreover, for many of our clients, fixed income assets play an important role within their specific plan. Over the past decade, fixed income assets added to overall portfolio performance as rates fell to historically low levels and have recently detracted from performance as interest rates have risen. It is important to focus on the long term benefits of income and capital preservation over a complete market cycle. As interest rates reach more “normalized” levels, fixed income will continue to serve as a core holding, providing income and portfolio stability during periods of heightened equity volatility.
Heading into the fourth quarter it is difficult to imagine a repeat performance of the most recent quarter. However, the current bull market for U.S. stocks remains intact and our domestic economy remains out of recession territory. Future expectations for the stock market are more modest in the near-term and we expect increased volatility as traders become more selective when buying stocks (i.e. buying into defensive stocks versus growth-oriented stocks).
We remain advocates of staying invested within your portfolio allocations that are consistent with the objectives outlined in your specific plan. We do not believe it is prudent to alter our investment philosophy in anticipation of a choppy market. From our perspective, we find it more valuable to focus on portfolio efficiency, tax optimization and risk mitigation, understanding that acting upon emotions and making market-timing mistakes can detract from long-term results.
Should you have any questions, please reach out to us. We look forward to speaking with you soon and we hope that you have a wonderful end to 2018.
Gregory Slater, CFA, CFP®
Chief Investment Officer
Chart A) 2018 Year to Date Total Return of Major Asset Class Indexes
Source: Bloomberg; 2018 year to date total return, International, emerging market, S&P 500, Barclays Agg indexes
* Source: Bloomberg; S&P 500 Total Return Index
** Source: Bloomberg: Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index
*** Source: Bloomberg Barclays US Aggregate Bond Index
**** Home Prices (Source: Case-Shiller U.S. National Home Price Index); Household Net Worth (Source: Board of Governors of the Federal Reserve System (US)); Consumer Confidence (Source: Conference Board Consumer Confidence); Consumer Sentiment (Source: University of Michigan); Household Debt Service to Income (Source: Federal Reserve); Wage and Salaries Growth (Source: U.S. Bureau of economic analysis); Weekly Initial Jobless Claims (Source: U.S. Department of Labor); Unemployment Rate (Source: U.S. Bureau of Labor Statistics)
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