“In the short run, the market is a voting machine, but in the long run it is a weighing machine.” – Benjamin Graham
Review
Financial market volatility continued to ebb and flow during the second quarter. We noted in our first quarter review that the volatility experienced earlier this year would likely persist moving forward in 2018. Therefore, we were not surprised to see the stock market experience many twists and turns due to tweets, trade discussions, and tariffs. However, even with the increased volatility, the Dow Jones Industrial Average, the S&P 500 Index and the NASDAQ Composite all ended higher for the quarter. The broad market gains were led by the cyclical growth sectors. Most notably, stocks such as Amazon, Apple, Home Depot, Facebook, Nike and Microsoft exhibited particularly strong performance during the quarter.
Domestic small cap stocks also performed well during the second quarter. Relative to large companies, small companies have been less impacted by, or benefitted more from two important issues in 2018 – tariffs and corporate tax reform. Small companies are less sensitive to trade war disruptions since they tend to have fewer sales from exported goods. Similarly, small companies tend to have all of their operations located domestically, and derive most, if not all, of their earnings from domestic sales. Therefore, they stand to benefit more from the drop in the corporate income tax rate from 35% to 21%. According to a study by Furey Research Partners and Manulife Asset Management in December 2017, the average effective tax rate in 2017 for profitable companies in the Russell 2000 Index (an index representing small companies) was 32% versus 28% for companies in the S&P 500 Index. That same study estimated the incremental 2018 earnings growth assuming a 21% corporate tax rate to be 14% for small companies versus only 9% for large companies.
After a strong showing in 2017 and a modest first quarter of 2018, international stocks and more notably, emerging markets stocks, ran into a tough second quarter. The main culprits producing the international headwinds were the strengthening US dollar and tariff threats. The US dollar strengthened by approximately 5% against the Euro, British Pound, and Japanese Yen in the second quarter. This impact, along with the larger relative trade threat to our trading partners, were enough to derail international stock returns.
Investment grade fixed income returns have been stuck in a “one-step-forward, one-step-back” environment this year. When interest rates increase, bond investors enjoy a higher current yield on newly purchased bonds. However, the increase in current yield on existing bonds is achieved due to the decline in the value of the bond. Non-investment grade debt posted a positive return for the quarter, but only modestly higher than investment grade debt. Therefore, taking on the added credit risk has not compensated investors with sufficient extra return in our opinion. The lone bright spot in the fixed income market might be money market yields. As a result of the recent Fed rate hikes, an investor can now get approximately 1.9% pre-tax on a money market fund at Charles Schwab. This is substantially higher than many bank savings accounts. If you are holding a substantial amount of cash at your bank, please contact your advisor to discuss your investment options.
Outlook
The current bull market is now more than 3,400 calendar days old. This is the second longest bull market on record behind only the period from 1987 through 2000. Skepticism remains high with many investors keeping cash on the sidelines in anticipation of a stock market decline. However, the corporate earnings outlook remains healthy. In the most recently reported quarter, corporate earnings growth year-over-year reached a new high of 25%. Most analysts are projecting this pace to slow, but continue to be strong, with earnings anticipated to increase by 19% for the second quarter, 21% for the third quarter and 17% for the fourth quarter. Earnings growth is projected to slow considerably in 2019 as compared to the strong periods of 2018, but still continue to increase by approximately 10%.
On the interest rate front, forecasters predict the Federal Reserve will raise short-term rates at least one more time in 2018, with even odds of an additional rate hike before year end. Two more rate hikes this year would push short-term rates up to 2.50%. The 10-year US Treasury yield finished at 2.84% to end the second quarter. This level is only 0.32% more than the two-year Treasury yield of 2.52%, indicating a flattening yield curve. If short-term rates were to rise above long-term rates, we would experience an inverted yield curve. Historically, an inverted yield curve has been a warning sign for the potential of an economic recession in the next 24 months. Investors will continue to monitor the yield curve closely.
Trade tensions and tariff threats have been the wild card for the stock market for most of 2018. As for the impact of trade on the stock market, the Dow Jones Industrial Average (DJIA) will likely be susceptible to sharp swings due to its significant weight in multinational companies such as Boeing, Caterpillar, and 3M. On the other hand, the S&P 500 Index should fare relatively better since the companies in the S&P 500 generate approximately 30% of their sales internationally versus 44% for companies in the DJIA. At this time the tariffs in place are not enough to materially impact US gross domestic product. However, a prolonged and worsening trade war would likely diminish the pace of the economic expansion going forward.
Despite the headwind from rising rates and the ongoing trade tensions, many leading indicators for the overall economy continue to exhibit positive signs. Unemployment is extremely low at 3.8%, wages are rising, and inflation is only moving slightly higher. Real interest rates, which account for inflation, are close to zero, even as corporate profits continue to be robust. These leading indicators will typically begin to show weakness for a year or more before a recession ensues.
Sincerely,
Marietta Wealth Management, LLC