Market Health Report – 2nd Quarter 2019

Second Quarter 2019 Key Takeaways

The first half of 2019 saw robust gains across most types of investment styles, but it certainly wasn’t a smooth ride. Global stock markets got a jump start on the year thanks to progress in US-China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks (announced via Presidential tweet) spurred a sharp market selloff in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and(tentative) signs of re-engagement on the US-China trade front.

The S&P 500 hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the
month – their best June since 1955. They were up 4.3% for the second quarter, and a remarkable 18.5% for the first six months of the year—their best first half since 1997.

Foreign stocks also notched double-digit gains through the first half of the year. Developed international stocks gained 5.9% in June, 3.2% for the second quarter, and 14.2% for the year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains. Emerging-market stocks also rebounded in June, gaining 5.4%. Although emerging-market stocks were only up 0.8% for the second quarter, their first-half gains stand at 12.6%.

Moving on to the fixed-income markets, the 10-year Treasury yield continued to plunge from its
multiyear high of 3.2% last October, dipping below 2% following the Federal Reserve’s June
meeting. (Keep in mind that when rates drop, the value of existing bonds increases.) If you remember the stock market setback last December, it was these 3% rates that have investors concerned about an oncoming recession. This was a near three-year low, and among its lowest levels ever. The 10-year yield ended the month at 2.0%. Bond prices rise as yields fall, driving the core bond index to a 3.0% gain for the quarter and an impressive 6.1% return so far this year. Floating-rate loans gained 1.7% for the quarter and are up 5.7% for the year.

Real estate investments have had an impressive performance so far in 2018 with returns in the 4-6%
range over six months with little to no volatility.

Looking ahead, we still see a high degree of uncertainty and a wide range of plausible outcomes
looking out over the next 12 months (and beyond). Even with the impressive start to 2019, risks have correspondingly increased. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy. While this is for now being offset by easier monetary conditions, the inevitable impact of any additional central bank rate easing is certainly muted.

We are confident that our portfolios and investments will generate attractive returns over the next
five to ten years, and to be resilient across this wide range of potential shorter-term risk scenarios.
Central banks around the world are attempting to add stimulus and hopefully they will be successful. There is even renewed hope by investors that our own Federal Reserve may cut rates. We personally disagree and feel that rates should not be cut. Rates are already historically at low levels, and the more the Federal Reserve relies on this tool, the less bullets they have in the gun to use in the future.

On the other hand, should markets turn south, our portfolios are positioned to be resilient and
weather the storm though our use of bonds, other fixed income alternatives, and real estate.

Second Quarter 2019 Investment Letter

Market Recap

In our year-end 2018 commentary, we emphasized the wide range of plausible macroeconomic scenarios
and financial market outcomes for the year ahead with the potential for either a positive or negative shorter-term path. Through the first half of 2019 we’ve gotten a little bit of everything – signs of both scenarios, though so far, the ups have outpaced the downs.

The first half of 2019 saw robust gains across nearly every asset class—including both core bonds
and equities – but it certainly wasn’t a smooth ride. Among the primary drivers of the market selloffs and
their subsequent rebounds were
on-again/off-again U.S.-China
trade negotiations and two major
shifts in central bank policy.
Large-cap U.S. stocks gained 4.3%
for the second quarter, and a
remarkable 18.5% for the first six
months of the year, largely earning
back what was lost in the fourth
quarter of 2018. Developed
international stocks also experienced
a healthy rebound from 2018
losses, up 3.2% for the second
quarter, and 14.2% for the year to
date. European stocks have done
a bit better, gaining 15.6% on the
year so far. In April, the “Brexit can”
was kicked down the road at least
until October 31, but the risk of a
disruptive “no-deal” exit remains.
Emerging-market stocks, up just
0.8% for the second quarter,
absorbed more of the uncertainty
surrounding global trade tensions.

But for the year so far, they have gained 12.6%. In fixed-income markets, the 10-year Treasury yield dipped below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever, reflecting promises of further easing later this year. These falling yields drove the core bond index to a 3.1% gain for the quarter and an impressive 6.1% return so far this year. Floating-rate loans gained 1.7% for the quarter and are up 5.7% for the year.

Portfolio Outlook

We are pleased with the returns posted in our client accounts thus far in 2019.

Not surprisingly, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the next 12 months (and beyond). We think the macro risks have increased. Trade uncertainty has damaged global business confidence in what by many measures is an already weak global economy. For now, this is being offset by the hope of easier monetary conditions.

The risk of a geopolitical shock on financial markets is also ever-present. Most recently, there is heightened potential for a military conflict with Iran, but there are many other potential geopolitical flashpoints and unknowns: Brexit remains unresolved. The tug of war between democracy, populism, nationalism, and autocracy continues around the globe. The U.S. presidential election next year will likely create additional market uncertainty. China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict. The Middle East (beyond Iran) remains a potential flashpoint, as does North Korea.

To what extent stock markets are already pricing in these fears and risks is also an unknown. On the heels of yet another strong quarter for U.S. stocks, their valuations are looking more stretched than ever. Our analysis of U.S. stock market valuations and expected returns implies the market consensus is factoring in an overly optimistic outlook. It can certainly be said that any investors chasing stocks higher simply because of the tailwind of more monetary stimulus face potential dangers. Our viewpoint is that the impressive gains of stocks will be much less impressive going forward. But historically we have witnessed many periods of time where expensive assets defy logic and continue to get more expensive (for a limited period of time).

On the other hand, we continue to have modestly overweight positions to European and emerging-market stocks. Our analysis indicates their valuations are very attractive relative to the U.S. In our assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth. Our outlook is that European and emerging-market stocks could outperform U.S. stocks. Over the shorter-term, if the global economy starts recovering from current depressed levels—with China’s fiscal and monetary stimulus being a key to that outcome – and if the United States avoids recession, we would not be surprised to see strong returns from stocks, with foreign stocks performing better than U.S. stocks. Further, if the growth differential between the United States and the rest of the world narrows, the U.S. dollar will likely depreciate, providing an additional tailwind to foreign stock returns for dollar-based investors.

On the other hand, if the global economy continues to weaken and the United States falls into a recession and bear market, our portfolios will experience setbacks, but our diversification will protect our clients from the full brunt. When we receive phone calls from nervous clients who have been watching the news, we often remind them that not all of their portfolios are invested in stocks. We diversify beyond stocks into bonds and real estate.

In Closing
As we experienced this past quarter, uncertainty is a constant presence and volatility can return to markets at the drop of a pin (or a tweet) these days. Regardless of our diversification efforts, those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter-term price we pay to earn their higher expected returns over the longer term. This has been an unusually long U.S. economic and market cycle. But we firmly believe it is still a cycle that will turn negative at some point. Our patience, diversification, and investment disciplines will continue to be well rewarded.

As always, we appreciate your continued confidence and trust, and we work hard every day to continue to earn it.

Ron Dickinson, CPA, CFP®, MPA-Tax

[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]

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