Quarterly Market Update – Q2 2018 By: Gabriel PotterMBA, AIFA® 2018.07.12

Key news stories

By fundamental measures – factors including economic growth, inflation, employment, profitability – the economy is healthy.  Financial analysts have been particularly pleased with positive earnings surprises over the past few quarters.  Analysts also expect the new few quarters to benefit as tax cuts improve top-line revenue consumer spending and bottom-line results from improved post-tax margins.  In short, the past few years have resulted in a solid economic backdrop which is currently being given a sugar-high with additional tax breaks. 

While US economic fundamentals are about as attractive as they can be, the markets are only partially reflecting that optimism.  To be sure, the markets are up, but there has been a fair amount of fluctuation.  Why?  First, there will ultimately be a price to pay for today’s tax cuts – future taxes and deficits – but that doesn’t seem to be affecting today’s market sentiment. Second, investors had anticipated some of the gains from the current rosy picture all the way back in 2017, so some of these gains had already been accrued during the past year.  Third, there are some asymmetric risks – like a full blown trade war - which are difficult to valuate.  Imagine a base case, with an 80% probability of occurring, that the economy continues more or less normally for the next year or so.  However, there is a 20% possibility that the trade war escalates from the current $50 billion dollar hindrance (spread between the EU, Canada, Mexico, and China) to a global $500 billion dollar obstruction.  The changing probability of those threats becoming a reality has been the key driver for volatile trading days over the past few months.

Equities

The big story in equities is the reversal of fortune for international equities.  Since the 2008 financial crisis, US equities have generally outperformed international investments.  In 2017, it looked like the tailwinds finally favored international equities.  So what happened to 2018 to put US equities back on top?  First, there is a little bit of a market pause.  For instance, emerging markets were up 31% in local currency terms in 2017 (37.8% in dollar terms).  So, the 2018 year-to-date modest correction of emerging market stock, down -2.7% in local currency terms, is to be expected.  The second factor is the dollar strength.  In short, when the dollar gets stronger, international returns suffer.  Conversely, when the dollar weakens, international returns get better.  Last year, the dollar got weaker, which boosted international returns by roughly 9%, with great variance depending on the currency being compared.  This year, the dollar strength is creating an average drag of about 3% to 4%, again depending on the currency. 

INDEX

2Q 2018

YTD 2018

US Large Cap Growth - Russell 1000 Growth

5.76%

7.25%

US Large Cap Value - Russell 1000 Value

1.18%

-1.69%

US Small Cap Growth - Russell 2000 Growth

7.23%

9.70%

US Small Cap Value - Russell 2000 Value

8.30%

5.44%

Developed International Markets - MSCI EAFE

-1.24%

-2.75%

Emerging Markets - MSCI EM

-7.96%

-6.66%

 


Bonds

The Federal Reserve continues to steadily increase interest rates.  Although the interest rates for different maturity bonds are not moving in tandem (i.e. the yield curve continues to flatten), the bond market is still acting rationally.  In other words, the longest duration bonds – those with the greatest sensitivity to interest rates – are getting hardest hit.  Long bonds have had a bad quarter.  International bonds have a longer duration than US bonds in aggregate (7.7 years vs. 6.0 years, specifically) and they also had to contend with the aforementioned dollar effect, so these bonds had a particularly rough quarter.


INDEX

2Q 2018

YTD 2018

Barclays Capital US Aggregate Bond

-0.16%

-1.62%

Barclays Capital US Intermediate Credit

-0.08%

-1.45%

Barclays Capital US Government

0.10%

-1.05%

Barclays Capital US Gov’t/Credit Long Duration

-1.45%

-4.98%

ICE B. of America/Merrill Lynch High Yield

1.00%

0.08%

FTSE World Government Bond Index (non USD)

-5.11%

-0.92%


Alternatives

Income generating bond proxies, like REITs, were able to recover from their terrible first quarter.  Rate hikes assuredly hurt REITs just like bonds, but improving fundamentals in some beaten up sectors (e.g. commercial retail, shopping center) and stolidity in more resilient sectors (e.g. industrial) have brought optimism back to the fore.  In other news, energy prices have climbed and solidified, boosting average commodity prices.


INDEX

2Q 2018

YTD 2018

Real Estate - FTSE NAREIT All REITs TR

8.32%

1.10%

Commodities - Morningstar Long Only Commodity TR

2.90%

4.36%

Inflation - Barclays US Treasury TIPS

0.77%

-0.02%

Hedge Fund - Morningstar Broad Hedge Fund TR USD

1.49%

2.48%

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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