Second Quarter 2018 Key Takeaways
US stocks have been basically flat for 2018. International stocks, including emerging market stocks, and bonds have all experienced losses.
The core reason for the stock markets going nowhere is investor nervousness centered around the Trade Wars. In the short run trade wars hurt everyone, both US stocks and international stocks. In the long run trade wars and/or negotiations can reestablish the balance of power between nations and thus create winners and losers. The problem is that there is uncertainty around who will be the losers.
Normally, when headline news upsets the markets, we counsel our clients that these concerns are overblown. However, real uncertainty exists around these unpredictable negotiations. President Trump’s style is too unpredictable to make a reasoned judgment. If the trade wars continue to deteriorate, real short term damage could be the result. We anticipate higher than normal volatility and/or periods of negative returns.
Having laid out these facts, we have been impressed that the stock market has been very resilient. With every upsetting headline that creates volatility, the market has regained its footing shortly thereafter. Being range bound for short periods of time is not necessarily a bad thing if economic fundamentals continue to improve. The market is building a stronger base off which to build. For example, as earnings continue to improve year-over-year but stock prices are range bound, the “price-to-earnings” ratio falls back into historical norms.
Moving on to the bond markets, in May the benchmark 10-year Treasury yield pierced the 3% level, hitting a seven-year high before falling back and ending the quarter at 2.85%. (Remember that higher yields produce lower bond prices.) For the year, the core bond index total return is down nearly 2%. It would be easy to conclude that we should just dump bonds and invest somewhere else. However, bonds still serve a role in a well-diversified portfolio by lowering overall risk and, most importantly, providing liquidity when cash withdrawals are needed. We have substantially reduced most all our clients’ exposure in bonds and redeployed these resources into real estate.
With the US economy growing above trend and the labor market tight, the Fed continued its gradual path of tightening monetary policy. It raised interest rates again in June, and also forecasted a slightly accelerated path of hikes over the next two years. Whether the economy can withstand that degree of tightening remains to be seen.
Beyond the strength of the US economy, the global economy remains in pretty good shape, with real GDP growth expected to be above trend again this year. However, last year’s worldwide highly synchronized growth has decelerated and may have peaked for this cycle.
Recent US dollar strength may continue for awhile as currency momentum can take on a life of its own. A stronger dollar is a headwind for our international investments as foreign earnings are translated back into our country’s currency at more expensive levels. However, looking a bit further out, there are fundamental reasons to expect that the dollar may weaken: the prospect of a ballooning US federal budget deficit in the coming years, a large US trade deficit, the eventual convergence of central bank monetary policies, and the fact that the Trump administration seems to prefer a weaker dollar.
Second Quarter 2018 Investment Commentary
As we pause to reflect at the midpoint of the year, it seems so far that 2018 has served as yet another reminder to investors that over the short term, markets are driven by innumerable and often random factors that are impossible to consistently predict. In the first quarter, US stocks experienced their first major losses since 2016 and a return to more “normal” market volatility. Many market prognosticators speculated that this could indeed be the end of the nearly decade-long US bull market.
Fast forward through three more eventful months and this time around US stocks have been the net beneficiaries, gaining 3.4% in the 2nd quarter on the back of a surging dollar while the rest of the world has slowed. The dollar’s 5% appreciation translated into a meaningful return headwind for dollar-based investors in foreign securities as foreign currencies depreciated against the dollar. Developed international stocks fell 1.8% and European stocks declined 1.6% for the quarter. Emerging market (EM) stocks fared the worst, dropping 9.6% in dollar terms.
In bond markets, the benchmark 10-year Treasury yield pierced the 3% level in May, hitting a seven-year high. Yields then fell back, ending the quarter at 2.85%, an 11-basis-point increase from the prior quarter end. As such, the core investment grade bond index had a slight loss for the quarter and remains in negative territory for the year to date.
Our portfolios have been stable, but the weakest component has been emerging market (EM) investments. In 2017 international stocks, including EM stocks, enhanced our portfolio returns greatly versus the US stock market. In 2018 EM stocks are sandbagging our overall portfolio returns slightly. In summary, EM stocks have been jittery.
A quick view of history shows that EM stocks gained 12% in 2016 and 32% last year. EM stocks then bolted out of the gates in early 2018 with an additional 11% return through late January. Since then, however, these holdings have declined sharply, and returns are now in negative territory for the year.
The selloff in EM stocks appears to have been driven by a combination of investor concerns about…
- a potential trade war with China (and possibly other global trade partners such as the European Union, Mexico, and Canada)
- how EM economies will manage a deceleration in global growth outside the United States
- a stronger US dollar coinciding with rising US interest rates and tightening Fed monetary policy.
See the addendum on the last page of this report for an analysis as to why we continue to have confidence in emerging market equities.
Market and Portfolio Outlook
It is understandable that fears of a global trade war are rattling financial markets. Any resolution of the current trade tensions represents meaningful uncertainty, with our relationship with China being the most fraught with the potential to seriously disrupt the global economy at least over the shorter to medium term. (The potential for a positive surprise seems more limited, but does exist.) President Trump’s unconventional negotiating approach adds an additional wildcard dimension. The process is likely prone to several more twists and turns before things become any more clear.
Our view on the matter, however, remains broadly the same. It is in the best interest of both the United States and China to negotiate a resolution and prevent trade skirmishes from becoming an all out trade war. However, the potential for a severely negative shorter-term shock to the global economy and risk assets (not just emerging markets) cannot be dismissed. Even absent an actual trade war, the negative impact on business and consumer confidence from the uncertainty and fear of a trade war is a risk to the remaining longevity and strength of the current economic cycle.
The recent dollar strength trend may also continue for awhile. But there are reasons to expect the dollar may weaken looking further out: the prospect of a ballooning US federal budget deficit in the coming years, a large trade deficit, and the eventual convergence of central bank monetary policies – as other central banks start to raise interest rates, thereby shrinking the yield gap versus the United States.
We have anticipated negative events when designing our portfolios. In particular, our strong allocation to real estate investments have buffered volatility and they strengthen portfolio cash flow.
We remain confident in the positioning of our globally diversified portfolios, which we believe are structured to perform well over the long term while providing resilience across a range of potential short-term scenarios. Should the current trade tensions resolve, and the global economic recovery continue, we expect to generate good overall returns..
Alternatively, should a bear market strike, our portfolios have “dry powder” in the form of lower risk fixed-income and real estate that should hold up much better than equities. We’d expect to put this capital to work more aggressively following a market downturn. For example, in our rebalancing process we would naturally buy more US equities at lower prices and expect higher returns sufficient to compensate for their risks.
We continue to study and evaluate our portfolio allocations in this uncertain environment. We are ever mindful that we are investing your hard earned retirement nest eggs.
Our number one goal for all our clients is to make sure they do not run out of money during retirement. Our objectives are protection first and then earning as much as possible within this parameter (depending on your individual risk tolerance). We do this through well diversified portfolios and quality investments, solid financial planning, tax strategies, and sensible withdrawal rates.
Thank you for your continued confidence and trust.
Ron Dickinson , CPA, CFP®, MPA-Tax
Now let’s build a case for continuing emerging market investments in our portfolio allocation.
These macro developments, in particular the risk of a US trade war with China and the rest of the world, are indeed risks to EM stocks, at least in the shorter term. However, these are not new risks, nor do we believe they overwhelm the attractive fundamentals, valuations, and potential longer-term returns of EM stocks.
Based on our analysis, we find that emerging markets are fundamentally better placed today than in past cycles. The sector composition of EM indexes has changed meaningfully over the past decade, from traditionally heavy cyclical industries like materials and energy to more growth-oriented technology and consumer-driven sectors that are less sensitive to shifts in global growth.
Evidence also suggests EM stocks do fine when interest rates in the United States are rising as long as global growth is solid. (Real GDP growth is expected to be above trend again this year.)
As to the underlying fiscal health of EM economies, emerging markets, in aggregate, have much better debt coverage than in the late 1990s/Asian crisis era. Additionally, most EM countries now have floating rather than dollar-pegged currencies, which should help release pressure in these economies and reduce the likelihood of a currency devaluation–driven crisis.
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]