Altair Insight: Yo-Yo Market (1Q18) – Quarterly Market Review
The volatility that has turned markets topsy-turvy at times in 2018 should be recognizable to anyone who has followed them for longer than the past couple of years. Call it the old normal. As a century-old adage ever reminds us, the stock market will fluctuate.
What normally does not happen is stocks and bonds losing ground at the same time, as they did in the first quarter by modest amounts. The last time that occurred was the third quarter of 2008. Any similarity to the financial crisis era ends there, however. Most economic indicators we monitor are sturdy, signaling little chance of a recession in the next six months.
The ups and downs of risk assets have dominated financial headlines. The fastest 10 percent pullback of the postwar era took the Standard & Poor’s 500 Index from all-time high in late January to market correction in less than two weeks. After a recovery that erased most of the loss, there was another drop of 8 percent and another partial recovery.
But the small net change from January 1st until now tells us that much of that movement was excessive. Wall Street’s fears about the potential for higher inflation, a trade war, a less market-friendly Federal Reserve and increased regulation on big technology companies have yet to be fully realized.
We have tried to block out the noise surrounding these new threats and focus on the fundamentals.
U.S.-China trade tariffs and growing geopolitical tension in the Middle East leave the near term clouded by uncertainty. We also are concerned by the shrinking difference between short- and long-term bond yields. The yield curve is the flattest it has been in 11 years, which signals that the bond market is not ready to assume materially higher growth or inflation.
Yet the global and U.S. economies are sound, corporate profit growth is picking up and the recent U.S. tax cuts should also help revitalize all-important consumer spending as workers benefit from higher paychecks. The International Monetary Fund has just upheld its strong outlook for the world economy and raised its forecast for U.S. growth this year because of the expected tailwind from tax relief.
The commotion that has rattled markets this year has not caused us to alter either our outlook or the target allocations we recommend for clients in higher-, medium- or lower-risk assets.
Even after a stormy quarter, major stock indexes were still up double-digit percentages year over year, all other major asset classes aside from U.S. REITs were positive over that period and economists’ outlooks remain mostly positive. So does ours.
We remain watchful on the status of import and export tariffs and are looking for any sign of meaningfully higher inflation, which could prompt the Fed to raise interest rates more aggressively.
More on these issues in our quarterly discussion of topics of relevance for the markets:
1. The return of volatility has been the market’s dominant theme in 2018, but it has not changed our overall outlook.
Fasten your seatbelts. It’s going to be a bumpy night.” – Bette Davis, All About Eve
This year’s turmoil in stocks has prompted a few financial commentators to resurrect that famous movie line from 1950. We share the sentiment, but we think another classic Hollywood quote may be equally appropriate since it accounts for what has happened to the market since the biggest pullback in two years:
I’ll be back.” – Arnold Schwarzenegger, The Terminator
In short, after multiple swings, stocks are close to where they began the year. So are our views of the markets’ fundamental strengths that have enabled them to be resilient in the face of trade skirmishes, monetary tightening and other risks.
All the volatility has certainly been noteworthy, reflecting almost daily momentum changes in the tug-of-war between the bulls and bears. The Standard & Poor’s 500 Index has closed at least 1 percent higher or lower 31 times this year – 16 up and 15 down – after doing so on only eight days in all of 2017. The CBOE Volatility Index, a gauge of market turbulence, surged 81 percent in the first quarter, one of its biggest jumps ever.
Volatility itself, however, is no bull-market terminator. It is important to remember that last year’s extreme calm was the aberration, not the rocky start to 2018.
A correction of 10 percent or more occurs every one to two years on average. Yet the market has still historically delivered positive returns in a majority of those years – 14 of the past 22 years that experienced corrections in the S&P 500, according to FactSet Research.
We anticipate that market volatility is here to stay in 2018. Trade issues are not going away any time soon, the Federal Reserve is expected to make two or three more interest-rate hikes this year and a midterm election looms in the second half. Geopolitical risks involving North Korea, Iran, Syria and elsewhere are substantial and hard to predict. Tech stocks including Facebook, Google parent Alphabet and Amazon may continue to be whipsawed, and they carry disproportionate and growing market clout. The FAANG stocks, which include those three companies plus Apple and Netflix, now comprise a nearly 12 percent weight of the S&P 500 – close to double the amount of four years ago.
We remain confident in stocks’ ability to withstand or bounce back from selling pressures in the near to medium term. Any further global tilt toward increased protectionism or a policy mistake by the Fed, however, would make our outlook more pessimistic.
2. Although a full-blown trade war is unlikely, ongoing U.S.-China skirmishes are a near-term overhang for markets.
President Trump fired the first volley in the developing trade battle between the United States and China in March by introducing steel and aluminum tariffs. That was followed successively by tariffs on $50 billion in Chinese goods, a tit-for-tat Chinese move and the threat of additional U.S. levies on another $100 billion or more.
Whether this develops into a long-running conflict remains unclear. Negotiations and a dampening of the initial global tension suggest it will not.
Intellectual property theft is a longstanding issue that many administrations have unsuccessfully attempted to fight. We expect that the current president, with his long history of deal-making, has set out to combat the problem by first laying out some of the harshest terms possible and then will gradually negotiate the Chinese down. After all, Rule No. 1 of his 11 rules in “The Art of the Deal” was Think big and No. 3 was Maximize the options, in which he noted that “I never get too attached to one deal or one approach” given that “most deals fall out.”
Neither China nor the United States wants to jeopardize economic growth to try to win a trade war. But President Trump did warn in a tweet in April that the markets could face additional “pain” from tariffs.
The damage will extend far beyond Wall Street if the stand-off degenerates into a full-on trade war. The International Monetary Fund’s chief economist, Maurice Obstfeld, says the global trading system “is in danger of being torn apart” if the tariffs are enacted and made permanent.
We have reviewed the track record of protectionism and it is checkered at best. Most recently, trade disruptions and thousands of lost jobs accompanied U.S. steel tariffs that were in place for 21 months in 2002-03. Most economists believe that imposing tariffs to address trade grievances only invites retaliation, ultimately raising costs and consumer prices while slowing growth.
Even a temporary trade conflict would likely extract at least a short-term price. Since Chinese products account for over 20 percent of U.S. imports, broad tariffs stand to raise prices and hurt consumer and business spending. Companies like Apple, Boeing and General Motors that do big business in China would face a hit to sales.
We agree with the IMF and others who believe that multilateral negotiations can head off a global trade conflict and the U.S. and China will resolve their differences. In the long run, the benefits of tax cuts, deregulation and repatriation of $500 billion or more of companies’ foreign cash should have a bigger impact in the mar-kets’ favor than the costs of tariffs. Nonetheless, these skirmishes pose a challenge for risk assets until the showdown ends. Clients should anticipate more out-breaks of volatility in the meantime.
3. An acceleration in earnings should help boost the market for the rest of 2018.
So far this year, expectations for improved corporate profits because of the new tax law have been enough to stabilize stock prices in the face of numerous pres-sures. Now we are about to learn if a continued strong outlook can push prices higher.
While earnings are still being reported for the most re-cent quarter, it appears 2018 profits may be even stron-ger than were anticipated coming into the year. S&P 500 companies so far have been beating first-quarter earnings estimates by the widest margins in years en route to what is projected to be the largest quarterly growth since 2011. Profits for the full year are expected to rise by a similar amount. The six biggest U.S. banks just reported their best quarter since the global financial crisis, with a collective increase in net profit of over $5 billion.
Markets have had a chance to factor in forecasts that first-quarter profit growth will prove to be the highest in seven years, thanks largely to corporate tax cuts. Even so, we see room for further upward movement. Most notably, as mentioned, the half-trillion or more dollars anticipated to be brought back to the United States by multinational corporations should provide solid support for stocks through increased share buybacks and dividends that are being announced at a record pace this year.
Internationally, too, earnings growth has improved. One area of note has been emerging markets, where profitability has strengthened and companies and economies appear to be less reliant on commodities than before.
An upside for U.S. investors from higher profits is that valuations have come down somewhat from earlier in the year. More importantly, earnings strength is what has kept the bull market going at nine years and counting.
The improvement in earnings may not directly or immediately boost economic growth. But higher earnings are expected to boost companies’ capital expenditures, which will increase productivity and lead to higher wages. That may contribute to GDP growth down the road.
First-quarter economic signs have been mostly positive in a year the IMF projects U.S. gross domestic product to rise to 2.9 percent from 2.3 percent last year (see chart on page 7). Employment growth remains robust and the labor market is the tightest it has been in decades. Retail sales should increasingly benefit from higher paychecks that were adjusted starting in mid-February for the lower tax rates.
We think the projected pickup in earnings can help supply momentum to the stock market for the duration of the year.
4. REITs have disappointed, but their fundamentals are sound and the early 2018 sell-off was overdone.
Real estate investment trusts often – not always – come under temporary pressure from rising interest rates. That underperformance has been evident during the Federal Reserve’s current rate-hike cycle, with the Vanguard REIT ETF returning only a cumulative 6.5 percent since December 2015 compared with 32.9 percent for U.S. stocks. U.S. REITs were the laggards during the market-wide decline in the first quarter with an 8.1 percent drop.
Fears of more aggressive interest-rate increases under the new Fed leadership have weighed on REITs. The market has not yet given this asset class any boost because of tax reform, either. REITS are pass-through entities and do not pay corporate taxes. Holders of REITs, however, may benefit from the new tax law, as the pass-through income may be taxed at favorable rates.
It is impossible to predict when REITs will return to outperforming stocks, as they have in six of the past nine years. However, we believe several factors justify retaining our target weighting to this category.
Perhaps most notably, fundamentals in this sector are generally healthy and should provide support for prices. REITs continue to generate higher earnings growth. Jobs and wage growth, a backbone of the real estate market, are solid. Improving economic conditions should boost demand for office space and housing. In a related vein, REITs can serve as a hedge against higher inflation because rents and real estate values generally climb as prices rise.
Dividend yields, of primary appeal to REIT investors, have risen to 4.8 percent from 4.2 percent at the end of last year, due mainly to falling prices. Dividend gains complement advances from the rise in shares, which have increased for nine consecutive years.
Valuations have fallen more than those of other asset classes with the recent sell-off, and they trade in line with the S&P 500. REITs are now trading at around the largest discount levels to their net asset values since the financial crisis.
Low correlation with the broad stock market can result in significant underperformance, as in the past two years. But it also provides diversification and a potential dampening of losses in a sell-off of stocks. This was the case in March, when the S&P 500 fell 2.5 percent for the month and REITs gained 3.8 percent.
REITs’ current discount to net asset value (see chart on page 8) make them more attractive than in the recent past. For long-term investors, we believe REITs still merit their current allocation in portfolios.
We remain cautiously optimistic for the next six months. Higher volatility will likely continue as markets frenetically respond to the uncertainty of trade tensions and rising interest rates as well as to the positive influences of U.S. fiscal stimulus and global economic strength.
The fiscal stimulus provided by corporate tax relief and increased government spending, along with accelerating corporate earnings, currently outweigh the potential negative impacts of the trade disputes and geopolitical uncertainty.
We do not believe a full-blown trade war will develop. Both the United States and China have shown interest in a negotiated resolution and have little to gain from an extended stand-off.
Inflation indicators continue to move toward the Federal Reserve’s 2 percent target. But inflation remains low by historical standards and we see little evidence of it rising to a level that would impede economic growth in the near to mid-term.
We remain committed to our existing bond allocation despite the recent upward pressure on interest rates because we still do not believe a sustainable surge in either inflation or yields is on the horizon.
The stock market had a Jekyll-and-Hyde beginning to 2018 en route to just its second down quarter in the last five years. Momentum from the new tax law helped launch the Standard & Poor’s 500 Index 8 percent higher by January 26th following the fastest-ever start to a year. From that point on, long-absent bouts of volatility dominated the market.
Investor worries about the consequences of rising rates, trade tariffs and tech troubles sent markets on a lurching course through February and March. Despite the turbulence, the iShares S&P 500 ETF ultimately pulled back by just 0.8 percent during the quarter.
While a backlash against several technology companies broke the momentum of the market-leading FAANG stocks – Facebook, Apple, Amazon, Netflix and Google parent Alphabet – the tech-dominated Nasdaq Stock Market still managed to finish with its seventh straight quarterly gain (2.3 percent). And technology (up 2.8 percent) was one of two sectors along with consumer discretionary (up 3.1 percent) with positive returns. Telecom (-7.2 percent) and consumer staples (-6.9 percent) stocks were the biggest losers.
Smaller-company stocks, which had trailed large caps in 2017, edged them in the first quarter while finishing essentially flat. The iShares Russell 2000 ended 0.2 percent lower.
Growth maintained its performance advantage over value as an investing style for the quarter – a dominance that has been almost uninterrupted since 2016 and stretches over most of the nine-year bull market. The iShares Russell 1000 Growth ETF added 1.3 percent compared with a 3.0 percent decline for value stocks in the same size category. The growth-over-value gap was even larger among mid- and small-cap stocks.
Some of the same pressures that dragged down U.S. stocks from their January all-time highs also weighed on stocks abroad. The biggest impact, along with higher interest rates, came from U.S. import tariffs that were aimed largely at China but could have a broad global impact if fully enacted as proposed.
The iShares MSCI EAFE ETF, an international benchmark tracking developed-market stocks in Europe, Australasia and the Far East, fell 0.9 percent for the quarter despite a 5.0 percent return in January. The dollar’s ongoing decline provided a significant cushion for international stocks measured in dollars.
Measured in local currency, the EAFE was down 4.2 percent, with much of the decline traceable to off quarters for the largest stocks in Asia and Europe. Japan’s Nikkei 225 Index dropped by 5.8 percent while the Stoxx Europe 600 Index shed 4.7 percent – again, both in local currency.
Emerging market stocks again were the strongest global performer, led by Latin America with an 8.5 percent return. The iShares MSCI Emerging Markets ETF reached the quarter mark with a 2.5 percent gain for 2018 and an impressive 25.0 percent one-year return to lead all asset classes.
The iShares MSCI All-Country World ex-US ETF, which tracks both developed and emerging markets, ended March down 0.5 percent year-to-date. Canada was the worst-performing country with a 6.5 percent loss.
U.S. real estate investment trusts began the year significantly lower, putting their streak of nine consecutive calendar years without a loss in early jeopardy. The Vanguard REIT Index Fund fell as much as 12 percent in the first two months before trimming its first-quarter loss to 8.1 percent.
REITs’ performance typically hinges on the strength of the underlying economy, but they also tend to be yield-sensitive in the short term. REITs’ sharp decline during the quarter occurred while the benchmark 10-year U.S. Treasury yield was climbing by half a percentage point through much of the quarter. They rallied when modest inflation and economic data seemed to ease the pressure on the Fed to more aggressively raise rates and the 10-year yield pulled back.
Internationally, the Vanguard Global ex-U.S. Real Estate Fund eked out a 0.4 percent gain.
Coming off back-to-back positive years, the iPath Bloomberg Commodity Total Return ETN fell into negative territory for 2018 during the broad sell-off in the second half of March to end the quarter down 0.2 percent. A strong worldwide economy and a weak U.S. dollar continued to underpin prices, which are generally denominated in dollars, but trade tensions and a slight ebbing of global momentum appeared to weigh on a number of the 24 commodities tracked by the index.
Gainers still slightly outnumbered decliners. Cocoa led the way with a 35 percent rise on production issues in West Africa. Grain prices also rose, led by a 7 percent increase for soybeans. Gold and oil advanced modestly. Cattle and hog prices were among the biggest losers in the quarter, while base metals such as copper and aluminum also retreated.
Hedge funds stumbled following a strong January like most other asset classes, ending the quarter with mixed returns. Returns for the two investable indexes widely used as industry benchmarks finished on opposite sides of the breakeven point.
The HFRX Global Index, a broad measure of all hedge fund strategies, declined by 1.0 percent. The HFRX Equity Hedge Index, a gauge of strategies that maintain long and short positions in primarily equity and equity derivative securities, advanced by 1.2 percent. Both had posted their best returns in four years in 2017 – up 6 percent and 10 percent, respectively.
Prices of both taxable and tax-exempt bonds declined as the benchmark 10-year U.S. Treasury yield rose to a four-year intraday high of 2.95 percent in February. Both categories then benefited from investors’ flight to safety in March to trim their losses during a down quarter.
The Vanguard Total Bond Market ETF ended the quarter with a return of negative 1.6 percent after having sunk as low as 2.5 percent the day the 10-year yield hit its highest level since 2014.
Munis fared somewhat better but still gave ground due in part to the new tax law reducing their attractiveness for some institutional buyers. The lower corporate tax rate provided less incentive for banks and property and casualty companies, which traditionally hold a large amount of the nation’s municipal debt, to buy tax-exempt munis. But munis rebounded in March with their best month since October. Altair’s proxy for the muni market, a blend of the Market Vectors’ short and intermediate ETFs, declined by 0.5 percent.
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.