“We must free ourselves of the hope that the sea will ever rest. We must learn to sail in high winds.”
After such calm waters in 2017, so far this year investors are once again experiencing the high winds and heavy seas that are more typical of the stock market. Indeed, the most widely followed measure of stock market volatility, the VIX (or the Chicago Board of Trade Volatility Index, also known as the “Fear Index”), has fluctuated wildly between a low of just under 10 on January 2nd to a high of 37 in February before settling back down most recently to around 15. Contrast that to 2017 when, for the entire year, the measure barely budged from a historically low level of 10. Despite all of the movement, the S&P 500 Index has notched up a fairly lackluster gain of 1.7% through the second quarter of 2018 while various international indices are firmly negative for the year.
Rising Tides Have Not Lifted All Boats
In addition to high crests and low troughs for the market overall, there has also been a wide gulf in performance between the winning and losing sectors for the first half of 2018. If it weren’t for two sectors, Technology and Consumer Discretionary which are both up double digits for this year, the S&P 500 would actually be in negative territory, or down 2.5%. Another way to look at it is this: 7 out of the 10 industry sectors in the index were negative for the first six months of the year. The defensive sectors that investors normally treat like life rafts in turbulent waters—such as consumer staples—have been the worst performers: Staples have declined close to 10% through June 30th. While our portfolios have participated well because of our broad diversification, we do see opportunities emerging in these sectors that have been left behind, particularly if volatility continues as we expect it will.
Fixed Income – No Port in the Storm
Bonds have been a rare disappointment as well. As measured by the US Aggregate Bond Index, the fixed income market declined more than 1.7% (on a total return basis) for the first six months, thanks to rising interest rates. Short-term rates have moved up in response to the Federal Reserve Board’s tighter monetary policy, which has resulted in two rate hikes so far this year and the likelihood that two more are still to come. The 10-year Treasury yield has also moved higher, rising from 2.45% at the start of 2018 to 2.93% most recently. If you recall from our previous newsletters, we anticipated this move up in rates by emphasizing bonds with shorter durations, which have less sensitivity to changes in interest rates. Generally speaking, our fixed income portfolios, while down modestly for the year, have held up much better than the broader bond market index has. We have also continued to focus on owning the highest quality bonds as debt levels have increased and ratings have decreased across the sector.
Short Term Tailwinds in the U.S.
Although we expect to see stock markets continue to be more volatile than last year, including the potential for some magnitude of a pullback, there are reasons to be optimistic about the performance for U.S. equities for this year overall:
- The U.S. economy is expected to show that an acceleration occurred in the second quarter Gross Domestic Product (GDP) growth to at least 3.5% from just 2.2% in the first quarter.
- Likewise, corporate earnings are accelerating, thanks in part to tax reform. According to FactSet, Wall Street analysts are expecting second quarter earnings to increase 19% from the prior year, the second highest rate of earnings growth since early 2011.
- Confidence in the U.S. economic outlook is rising. The Conference Board, which measures consumer confidence and the Institute of Supply Management, which takes the pulse of businesses through its regional manufacturing surveys, continue to publish surprising high results.
Europe Enters the Doldrums
Unfortunately, we haven’t witnessed a continuation of the synchronous global economic expansion that was the case in 2017 and helped stocks set new records. Indeed, in Europe, the wind seems to have come out of its economic sails completely. Business confidence is waning, possibly in reaction to the anti-European sentiment that started with Brexit and is building again with the new coalition government in Italy, Europe’s third largest economy and the world’s ninth largest. The heightened level of economic and political uncertainty is reflected in the under performance of developed market stocks as measured by the MSCI All World ex-US Index, which has lost over 5% through June of this year. While we continue to have exposure to these markets in our portfolios, we had reduced our allocation to Europe and Japan in exchange for more exposure to emerging markets, which we believe have very attractive long term growth characteristics.
Choppier Waters Ahead?
Although the economic backdrop for U.S. stocks may be favorable in the near term, we do see risks brewing further out on the horizon:
- Trade issues: Proposed tariffs could hinder global trade and raise costs of production that are then passed through to consumers in the form of higher prices.
- Geopolitical factors could chink away at confidence and impact economic growth — And it could come from any number of places—Italy, Spain (also with a new government), China (as a result of trade issues), Iran, North Korea, just to name a few.
- U.S. unemployment, at 3.9%, is at the lowest point in decades. With the labor market this tight, pressure on wages could accelerate, igniting further inflation.
- Regardless, the Federal Reserve seems determined to continue on its path of raising interest rates. This is a headwind that the market needs to digest.
Our approach to navigating what may be more turbulent waters ahead has not changed. As always, we are laser focused on helping you to achieve your goals while paying close attention to risk management. We do this by implementing portfolios that are well diversified across equities and asset classes, and making sure allocations align with your investment objectives and risk tolerance. If we haven’t met with you already to update your client profile, which documents these objectives, we will be doing so soon. It is important that we review this with you annually, or as changes in your situation warrant.
In the meantime, please let us know if there’s anything else we can do to help.
The Cribstone TeamShare