Altair Insight: Choppy But on Course (3Q18) – Quarterly Market Review
The best quarter for U.S. stocks in five years surely did not feel that profitable to those with diversified portfolios – likewise so far for all of 2018. From bonds to international stocks to REITs to commodities, most asset classes have been left on the outside this year while a few American tech giants and other growth stocks divvy up virtually all of what is left of the gains.
A sudden mood shift to start October disrupted even that exclusive U.S. party. Fears that global deceleration, an entrenched trade war with China, further Federal Reserve tightening and the 10-year Treasury yield’s rise could finally sink the bull market wiped out much of the year’s gains for U.S. stocks and pushed other categories further into the red.
After a calm third quarter, did the latest bout of volatility presage an inflection point for markets or perhaps an upcoming recession?
While the question is fair to ask, we do not see a fundamental shift in the markets or the end of the business cycle approaching given how well the U.S. economy continues to perform.
Even with the World Series under way, it is impossible to tell whether this cycle is in the seventh, eighth, ninth or extra innings. But we are confident there is still game to be played. As we continue to monitor economic indicators and financial conditions for signs of change, we do not currently recommend any changes to clients’ target asset allocations.
Another area we are keeping an eye on is any meaningful impact on markets from the midterm elections. While historical trends are not always a reliable guideline, the Standard & Poor’s 500 Index has never had a negative return over the 12 months following a midterm election in the post-World War II era – regardless of which political party controls the House or Senate.
Our commentary continues with a deeper look at the markets through the lens of five defining themes.
1. U.S. growth stocks have dominated a narrow global market by an unusually wide margin, a spread we believe is unlikely to last.
For believers in diversification, 2018 has not been a great year. While U.S. growth stocks have “partied,” at least through three quarters, the rest of the world and investment categories have disappointed. International stocks have joined bonds and commodities in negative results that have hampered balanced portfolios.
The unusually large gap of about 14 percentage points between U.S. and non-U.S. stocks so far in 2018 – a 5 percent gain for the S&P 500 through the first three weeks of October and a 9 percent loss for the All-Country World ex-U.S. Index – has been caused by a combination of factors that we do not expect to persist.
The fiscal stimulus provided by the Tax Cuts and Jobs Act, while expected to continue for awhile, is at a peak and has helped corporate earnings remain buoyant. S&P 500 firms have brought back at least $465 billion from abroad and benefited by another $40 billion to $45 billion from the lower corporate tax rate, according to Strategas Research. As a result, they have been able to invest in share buybacks at a pace projected to exceed the previous record of $589 billion in 2007 by some 30 percent.
The stimulus also has fueled investors’ appetite for risk, favoring growth over value. A few giant growth stocks have carved out much of the gains in a narrow market this year. Through three quarters, Netflix was up 95 percent, Amazon 71 percent and Mastercard 48 percent.
What tipped overseas markets in the opposite direction has been trade tariffs, faltering currencies, slowing global growth and, more recently, concerns about a Brexit deadlock and swelling Italian debt. The dollar’s more than 3 percent rise against a basket of currencies this year has worsened the outlook for emerging markets, adding millions to their dollar-denominated foreign debt.
The eurozone economy has decelerated in part due to U.S. tariffs and reduced demand from China, and European bank stocks have fallen as Italy’s first-year government assumes heavy new debt. Japan’s promising economic recovery has lifted its shares, but growth in much of the rest of the world has eased back from last year’s heights.
The outlook for both domestic and foreign markets can change quickly, however, as the October turbulence has shown.
U.S. stocks should continue to benefit from a stimulus tailwind into next year. We remain positive in our outlook amid solid economic data and earnings results that show little sign yet of fading.
We expect international stocks to narrow if not fully close the gap on their U.S. peers in the mid-term future, based on several factors.
Eventual resolution of the trade war would likely weaken the dollar and bring immediate relief to emerging markets and depressed commodity prices, as well as international developed stocks. The European Central Bank remains accommodative and appears committed to following the Fed’s blueprint of gradual tapering, staying supportive of markets. History suggests overseas stocks will ultimately begin their own cycle of outperformance against the U.S. market.
The reasonable valuations of non-U.S. stocks, too, provide a compelling reason not to give up on the category. International shares trade at their greatest discounts to domestic stocks in years. The forward price-to-earnings ratio of the MSCI EAFE Index, which measures stocks in developed markets outside the United States and Canada, is currently 20 percent below the S&P 500, compared with a historical average of roughly 10 percent.
For all these reasons, we do not view this extreme dominance of U.S. stocks (growth in particular) over the rest of the investment categories as sustainable
2. Solid and improving U.S. economic indicators suggest a recession remains far off.
The current economic expansion is on track to turn the ripe old age of 10 in 2018 and can surpass the 1990s growth cycle as the longest expansion in U.S. history next summer. We think it has a good chance to get there – there is little evidence that old means tired in this case.
Corporate profits are one key area we analyze for hints of weakness. A U.S. recession has never occurred when earnings are increasing, and the current year-long streak of strongly improving profits is in no immediate jeopardy based on what we see in October earnings reports. Fiscal stimulus and regulatory easing continue to lift bottom lines. The fourth-quarter outlook also remains strong, with analysts surveyed by FactSet estimating growth of 17 percent from a year earlier.
Earnings growth can only be fueled further if companies continue to invest and become more productive. This year’s blowout earnings could make it difficult for profits to rise further in 2019, too. But as warnings of “peak earnings” begin to surface, it is worth keeping in mind that earnings on an absolute basis are forecast to continue rising next year even as year-over-year growth comparisons become more challenging following such strong performance.
Another significant gauge is the Conference Board Leading Economic Indicators, which is at an all-time high. Its 10 components include measures of manufacturing, building permits, consumer expectations and unemployment insurance claims.
Other data points we watch closely are mostly positive at the moment aside from auto sales and the housing market:
- U.S. GDP growth for 2018 is now pegged at 3.1 percent by the Fed, which raised it from 2.8 percent this fall.
- Consumer confidence is at an 18-year high, lifted by rising employment and wage growth that has edged up to the highest pace since 2009.
- Retail sales in September were up 4.7 percent from a year ago and have remained consistently strong, reflecting a continued boost to incomes from the tax cut.
- Small-business optimism as measured by the National Federation of Independent Business was recently the third-highest in the survey’s 45-year history.
- Initial jobless claims are the lowest since 1969 and the unemployment rate is down to 3.7 percent, also a 49-year low.
- Job openings reached a record high of 7.1 million in August in the Job Openings and Labor Turnover (JOLTS) report.
- Capital spending growth by companies was higher for a fifth straight quarter from July through September and is on pace for a 25-year high in 2018.
- Manufacturing: The manufacturing purchasing managers index reached a four-month high in September; the Institute for Supply Management manufacturing index fell slightly but is at a level that still indicates expansion.
- Services: The U.S. services sector expanded in September at the fastest pace in the 10-year history of the ISM non-manufacturing index.
- Inflation is rising but remains around the 2 percent level targeted by the Fed.
- Housing: Existing and pending home sales as well as housing starts have all fallen well off their peaks of a year ago due to rising interest rates and a drop in mortgage refinancing.
- Auto sales by major manufacturers fell 4 percent in the third quarter amid increased interest rates and trade concerns.
The arrow continues to point up on most data. However, caution is merited given the possibility of an escalation of the trade war or one too many interest-rate hikes that could weaken this expansion’s staying power.
3. The risks of a trade war persist, though we are not at the danger threshold yet.
Tariffs appear unlikely to derail the U.S. expansion in the near future. The levies implemented so far by the United States and China are characterized by economists as a comparative drop in the bucket for the world’s largest two economies. The longer the stand-off goes, however, the more dangerous it becomes for the global economy and markets.
We still believe financial and political pressures will force the two countries to settle their differences before lasting damage is done to either side. A heightened, extended trade war would have major financial consequences that both Washington and Beijing have every reason to want to avoid.
But the rally in U.S. stocks in the third quarter suggests investors may have overlooked the real risk that tariffs and tensions could escalate for months longer.
Already, the International Monetary Fund in October reduced its estimate of global expansion to 3.7 percent this year and next because of mounting trade tensions, down from 3.9 percent in its July forecast. It left unchanged its projection for U.S. growth in 2018 but cut next year’s by 0.2 percentage point to 2.5 percent. IMF chief economist Maurice Obstfeld referred to “clouds on the horizon” created by the trade conflict.
How near that horizon may be was underscored this fall when President Trump imposed 10 percent tariffs on an additional $200 billion worth of Chinese products while threatening to add another $267 billion worth of imports to the growing list. He put off the worst of the latest announced tariffs’ impact until after the December holiday season that is all-important for American retailers. But the pain that is beginning to be felt in some industries will increase in 2019 without a resolution that halts Chinese retaliatory measures.
So far, most manufacturers using steel or aluminum face higher input costs and farmers whose access to the Chinese market has been restricted are losing profits. Ramping up the total U.S. tariffs with a threatened new round, assuming another tit-for-tat response from Beijing, would likely hit consumer prices and spending.
Settling trade spats with Mexico and Canada in the not-quite-NAFTA accord called USMCA – United States-Mexico-Canada Agreement – bodes well for prospects of an eventual deal with China, though not necessarily soon. We think it is unlikely that President Trump would make tariffs on Chinese goods permanent.
Still, there is a good chance that the levies are raised to increase pressure before attempting to make a deal. We agree with the assessment of U.S. Chamber of Commerce President Tom Donohue that the possibility of a full-blown global trade war remains the single biggest threat facing the economy today. Ultimately, we still hope and believe it will be resolved.
4. Emerging-market stocks are potentially more attractive once key impediments lessen.
No category has been more challenged in this year of global trade conflict than emerging-market stocks. Perennially finishing near or at the top or bottom of asset classes by performance, they are bringing up the rear in 2018 after falling as much as 25 percent from their January peak by mid-October.
We believe they have a chance to be next year’s recovery story. For now, however, developing markets remain fragile as trade tensions linger.
The key to this year’s decline as well as a recovery is China, by far the largest component of the iShares MSCI Emerging Markets Index at 31 percent. Investors clearly are wary of the potential harm from a trade war with the United States; the Shanghai Composite Index was down 25 percent for the year at a four-year low after the global sell-off in early October.
Still, Beijing has weathered the challenge without apparent crisis so far and its economy continues to grow at a reported rate of 6.5 percent. China’s central bank has freed up more than $100 billion for commercial banks and loosened its monetary policy in moves to shore up growth amid the trade battle.
In a worst case, according to an IMF analysis, ongoing trade tensions could knock 1.6 percentage points off China’s economic growth over a two-year period. But the Chinese government’s policies to stimulate the economy are expected to soften much of that impact.
This year’s emerging-markets rout has extended far beyond China, triggered by trade pressures and the dollar’s rise that have punished countries with huge dollar-denominated debts, especially Turkey and Argentina. Investors’ pessimism has deepened amid fears these countries’ troubles could worsen and spread to developed international markets.
We believe the sell-off has been overdone. The most beaten-up markets comprise only a small percentage of global GDP, thus concerns about contagion are overblown. Their economic fundamentals are sound for the most part, and they are reducing spending and raising interest rates in efforts to contain the market turmoil. China still has levers it can pull to absorb some of the pressures on its economy. And if the trade war is settled within months rather than years, as we believe, pressures will subside.
Valuations have become much more attractive as a result of the market turmoil. Emerging-market stocks now trade at about a 50 percent discount to U.S. stocks, twice the historical norm. Their price-to-book value is 1.65, compelling from a historical perspective.
The volatile nature of emerging markets is such that they could still decline substantially more. Cheap prices cannot be the only reason to buy. However, based on the current outlook we are more apt to recommend adding to rather than subtracting from emerging-market stock allocations when fundamental conditions strengthen, including a lessening of global trade tensions. We believe their long-term growth prospects remain strong.
5. A few more gradual rate hikes should not overly disrupt markets as long as the Fed pauses on signs of a softening economy.
A vibrant economy can cause short-term market trouble, as the latest October scare reminded us.
A series of upbeat economic reports – private payroll gains, a new high for the service economy index and unemployment sinking to 1969 levels – counterintuitively helped send markets into a tizzy. Federal Reserve Chairman Jerome Powell praised the “extraordinary” economy, traders assumed that meant more monetary tightening is coming and stocks tumbled. The 10-year Treasury yield spiked to a seven-year high of 3.26 percent.
To our minds, the longer-term takeaway from all the data got buried in the rush to sell.
Certainly, there can be downsides for investors in the near term. Rising yields make borrowing more expensive, which is a potential drag on growth and thus on stocks. Bond investors, too, have felt the sting of this year’s climb in yields, since bond prices fall when yields rise. With 10 weeks left in 2018, the best-known bond benchmark is on track for its fourth negative calendar-year return since the inception of the Barclays Aggregate Bond index in 1976. (It fell 2.9 percent in 1994, 0.8 percent in 1999 and 2.0 percent in 2013.)
However, higher yields resulting from steady economic growth is a positive development. Economic growth has been boosted this year by lower tax and regulatory burdens for businesses combined with strong financial conditions. Full-year real GDP growth has a chance to top 3 percent for the first time in a decade after a 4.2 percent jump in the second quarter. Yields also surged in tandem with GDP after the 2003 tax cut, without derailing markets.
The Fed has been raising interest rates gradually to keep the economy from overheating, a strategy that so far is working. Inflation remains near the 2 percent target and longer-term expectations as measured by the 10-year breakeven inflation rate are under 2.2 percent at this writing. It also is unwinding the balance sheet – reducing the once $4.5 trillion portfolio of Treasury and mortgage-backed securities to below $4 trillion this fall for the first time in more than four years, which likely is contributing to the rise in rates.
Bond prices are not likely to match the lofty gains of years past during this rate-hike cycle. But ultimately a strong economy benefits investors in bonds as well as stocks. Higher interest rates are actually good for long-term bond holders because they mean higher income. They also allow reinvestment at a higher rate.
We believe the Fed is on the right course with its measured pace of small rate hikes, including a ninth increase expected in December. More data-dependent than ever, its steady, predictable path and transparency have added to the market’s stability, October turbulence notwithstanding. The Fed must hit the brakes, however, on its three planned increases next year if data suggest that growth is weakening.
Overtightening would risk an inversion of the yield curve – when short-term rates rise above longer-term ones. We will continue to watch the yield curve closely, as we hope the Fed also is doing, since an inversion is a reliable indicator that a recession is coming. We are not concerned about a flattening curve unless it inverts.
We believe rates may drift higher, just at a less abrupt rate than we saw in early October. With positive macroeconomic data, tame inflation and strong earnings, the economy and the markets can handle it.
Despite the recent choppiness of the market, we see little evidence that this business cycle will halt any time soon. Lasting downturns tend to coincide with recessions, and the probability of the U.S. economy falling into recession within the next year appears low.
Interest rates are rising because of the robust economy and that bodes well for markets in the longer term – short-term volatility notwithstanding. We believe the economy can handle further increases as long as macroeconomic data and company earnings remain strong.
The U.S.-China trade war remains a significant market risk. Ultimately we believe the dispute will be settled before it is allowed to inflict serious damage on the economy or on markets.
International stocks continue to disappoint with returns significantly trailing those of U.S. stocks. We do not believe this extreme disparity will last, however, based on historical performance, increasingly attractive non-U.S. valuations and the potential for a bounceback when trade tensions eventually ease.
The Federal Reserve remains on a prudent course with its steady but gradual interest-rate increases, given continuing strong economic data. We remain watchful of the possibility of it overtightening and inverting the yield curve, which could hasten a recession.
Bonds have had an unusually weak year but we recommend clients maintain target allocations. Generally they have low correlations to stocks, providing diversification benefits in periods of market volatility. Long-term investors also benefit from higher rates as the income rises.
The U.S. stock market defied concerns about a spreading global trade war in the summer and early fall, if not ignoring them altogether. Investors focused on strong corporate earnings and upbeat economic data while taking a benign view of ongoing risks from tariffs and rising interest rates. The result was the strongest quarter for the Standard & Poor’s 500 since the fourth quarter of 2013.
An investable benchmark for the broad U.S. index, the iShares S&P 500 ETF rose 7.7 percent and was up 9.9 percent for the year. A relative handful of large stocks including Netflix (price up 95 percent through three quarters of 2018), Amazon (up 71 percent), Mastercard (up 48 percent) and Apple (up 33 percent) continued to play a disproportionate role in overall market gains.
The U.S.-centric performance extended well beyond technology stocks, which as a sector rose 8.8 percent in the quarter. Health care stocks climbed 14.5 percent, industrials gained 9.9 percent and all 11 S&P sectors were positive.
Smaller stocks posted another solid quarter but slowed their advance and lagged large caps. The iShares Russell 2000 ETF, a proxy for U.S. small caps, returned 3.3 percent from July through September and was up 11.2 percent for the year to date.
Growth stocks continued their dominance over value stocks at every market-cap level. The iShares Russell 1000 Growth ETF posted an 8.8 percent return in the quarter to nearly double its value counterpart (4.9 percent). For the year to date, it was up 16.5 percent while the iShares Russell 1000 Value ETF trailed with a 3.0 percent return.
The enthusiasm that investors showed for U.S. stocks did not extend to overseas markets. The U.S.-China trade war and fears of its consequences contributed to a mixed quarter for global stocks. The strong dollar and varied economic concerns kept international returns well below those of their U.S. counterparts for a fourth straight quarter.
Some indexes edged higher, reflecting pockets of encouraging developments. The iShares MSCI All-Country World ex-US ETF, a benchmark for both developed and emerging markets, advanced 0.9 percent to reduce its year-to-date decline to 3.0 percent. Returns in Europe moved mostly sideways under the shadow of both difficult UK negotiations to exit the European Union and the new Italian government’s heavy deficit spending.
Developed-world stocks did get a significant lift from Japan, where the benchmark Nikkei 225 index rose 8.1 percent to finally return to 1991 levels on the strength of improving corporate earnings, a healthier economy and a weaker yen. The iShares MSCI EAFE ETF, encompassing developed markets in Europe, Australasia and the Far East, returned 1.5 percent while remaining down 1.3 percent for the year. Excluding the impact of translating returns into a robust dollar, the index gained 2.4 percent in local currency to turn positive for the year at 1.8 percent.
Emerging-market stocks suffered through a second consecutive down quarter amid trade uncertainty, rising rates and falling currencies in politically troubled Turkey and Argentina. China’s Shanghai Composite Index gave back 0.9 percent and was down 15 percent this year. The iShares MSCI Emerging Markets shed another 0.9 percent on top of a nearly 10 percent loss in the second quarter and was down 8.3 percent in 2018 through September.
The Vanguard REIT Index Fund inched into positive territory for the year with a 0.5 percent quarterly gain that put it narrowly on track for a 10th straight calendar year without a loss. Returns were modest, especially compared with U.S. stocks, as real estate investors remained wary with the Fed raising interest rates for a third time in 2018.
Within U.S. REITs, the lodging and resorts sector registered some of the highest returns with a nearly 10 percent gain year-to-date, attributed to strong corporate earnings that helped drive an increase in business travel. REITs can be sensitive to rates, as higher rates and yields sometimes make alternative investments seem more attractive. Economic growth ultimately powers the real estate sector, however.
Internationally, the Vanguard Global ex-U.S. Real Estate Fund fell 2.7 percent and was down 5.5 percent through three quarters.
Concerns over international trade weighed on raw materials prices again in the third quarter.
The iPath Bloomberg Commodity Total Return ETN, which tracks returns for 22 components, had a negative return of 2.4 percent to extend its 2018 loss to 2.7 percent. The index’s three consecutive quarterly losses represent the index’s longest slump since the first quarter of 2015, interrupting a period of gradually improving returns for commodities
Precious metals were among the biggest losers. Gold has fallen for six consecutive months, the longest losing streak since 1997, and investors’ continued bullishness on stocks has kept gold from benefiting as a safe haven during the U.S.-China trade war.
Copper prices, often viewed as a reflection of global growth activity, fell 5 percent in the quarter and were down 15 percent for the year. Crude oil was down 0.9 percent, but natural gas climbed 2.9 percent on unusually low inventories for the time of year. Soybeans suffered a second consecutive quarterly loss as buyers looked for other sources of supply as the tariffs battle between the United States and China weighed on demand.
Hedge funds declined slightly in the quarter amid rising interest rates as strategies failed to capture the gains registered by U.S. stocks.
The HFRX Global Index, which tracks the universe of hedge-fund strategies, fell 0.4 percent and was down 1.2 percent for the first nine months of 2018. The HFRX Equity Hedge Index, a measure of long and short equity-related strategies, was down 1.1 percent for the quarter and 0.9 percent for the year.
Hedge funds last year had their best performance in a rising market since 2013, with returns of 6 percent and 10 percent, respectively, for the two benchmarks. This year, strategies have struggled to break even amid the market uncertainty surrounding tariffs and rate increases. Funds that tried to get ahead of political and other broad trends, or so-called macroeconomic funds, were flat in the first nine months. Relative-value hedge funds and event-driven funds were the best performers.
Taxable and tax-exempt bond prices were narrowly mixed in the third quarter.
Investors’ willingness to take on more risk sent stock indexes to record highs, reducing demand for safe-haven assets during the burgeoning trade war. Yet the 10-year U.S. Treasury yield, while rising above 3 percent late in the quarter, remained on a gradual upward path, keeping prices stable. Bond prices move inversely to yields.
The Vanguard Total Bond Market ETF was down 1.7 percent for the year through September after a 0.1 percent quarterly return. If it finishes negative for 2018, it would be only the fourth down year for the bond market benchmark in its five-decade history.
Altair’s investable measure of the muni market, a blend of the Market Vectors’ short and intermediate ETFs, retreated 0.3 percent and was down 0.1 percent for 2018. No material impact to the muni market was expected as a result of damage caused by Hurricane Florence to the Carolinas, based on the absence of long-term impact from prior U.S. storms.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.