Investment Commentary - Third Quarter 2018

Written by dwilson on October 10, 2018
  • Solid U.S. economic growth leading to tight labor market
  • U.S. stocks outpacing international stocks
  • Growth stocks continued to lead value stocks
  • Fed continues raising short-term rates

The third quarter saw a continuation of most of the themes that have been working in the markets.  Stocks are outperforming bonds, the U.S. is outperforming international, and growth is outperforming value.  The U.S. economy is growing steadily.  The Federal Reserve is continuing to raise interest rates.  Inflation has started picking up but remains moderate.  For now, the risks from a trade war with China, of the late cycle U.S. economic expansion subsiding, or inflation rising seem small.  We are now in the longest bull market and second longest economic expansion in history.  Investors should stay disciplined and avoid the temptation of “rearview” investing. 

Stock Market Review & Outlook
After turbulence earlier in the year, the S&P 500 rebounded 7.7% in the third quarter to register a new all-time high.  Small cap stocks gained 3.6%.  U.S. stocks shrugged off concerns over rising trade tensions and benefitted from solid economic growth and strong corporate profit growth.  Corporate profits were boosted by rising oil prices, the corporate tax cut, and stock buybacks that increased earnings per share.  Announced stock buybacks for 2018 are over $700 billion, an all-time high.  Historically, corporations have not been good at buying their shares at low prices, buying far more shares near market peaks than troughs.  With stock indexes near all-time highs, corporations appear to be buying high once again.  The third quarter recovery has major U.S. indexes such as the S&P 500 and Russell 2000 up more than 10% for the year. 

The gap in performance between growth and value stocks continues to widen, with growth stocks easily outpacing value last quarter.  Over the past ten years growth indexes have outperformed value indexes by around 3-4% per year in both the large cap and small cap markets.  These periods of strong outperformance don’t last forever.  The last time growth outperformed value by such wide margins was leading up to the tech bubble in 2000.  When the cycle changed, value stocks held up much better than growth stocks in the years that followed.

U.S. stocks’ outperformance against international stocks is even greater than growth stocks over value the last 10 years.  That continued during the quarter.  The MSCI EAFE which measures developed international stocks gained 1.4% for the quarter but remains down -1.4% YTD.  Emerging market stocks declined -1.1% for the quarter and are down -7.7% YTD.  Slowing growth overseas and concerns over rising trade tensions, along with weaker international currencies have contributed to the weak performance for developed and emerging international stocks.

Given international stocks underperformance versus U.S. stocks, some investors may ask “Why invest in international stocks?”.  The chart below illustrates the relative performance of U.S. stocks versus international stocks.  Since around 2010, international markets have consistently lagged U.S. stocks.  However, prior to this, international stocks outperformed U.S. stocks for most of the previous seven years.  Going further back through the chart you’ll notice these periods of outperformance tend to last multiple years.  Given the long period of outperformance by U.S. stocks, international stocks appear attractively positioned on a risk versus reward basis, even if U.S. stocks continue to outperform in the short-term.  We recommend a continued allocation to international stocks.  With that said, our strategic allocation for our clients’ investments, has a significantly higher allocation to U.S. stocks.

 

Fixed Income & the Federal Reserve
As was widely expected, the Federal Reserve raised short-term interest rates for a third time this year to 2.0% – 2.25%.  The Fed is expected to increase rates again in December and perhaps three more times next year.  This would bring rates to their expected long-term target of 3.25% - 3.50%.  As a result of rising rates, the core U.S. bond market was flat for the quarter and is down -1.6% YTD.  In expectation of rising rates, our dynamic portfolios are positioned with shorter duration than the broad market which has helped it hold up better this year.  While rising interest rates detract from bond returns in the short-term, over time higher interest rates are very beneficial to bond investors.  As the chart below illustrates, 5-year bond returns have strong ties to the starting yield.  As yields increase, it bodes well for bond returns over the next 5 years.

 

Alternative Investments
We follow a number of investing and trading strategies that have historically generated return streams less tied to traditional stocks and bonds.  U.S. real estate continues to benefit from a healthy economy, strong job growth and household formation.  This has led to high occupancy levels and generally increasing rental income.  Infrastructure is likewise benefitting from a healthy economy and increased usage of toll roads, airports and sea ports.  Weaker international currencies have detracted from returns on assets overseas.  During the quarter, merger arbitrage strategies continued to adapt to a more uncertain regulatory environment.  Solid deal volume and rising interest rates led to positive returns for the quarter.  Managed futures, measured by the SG Trend Index, gained 2.0% for the quarter boosted by strong trends in precious metals, agricultural commodities and U.S. stocks.  It was also a good quarter for the defensive equity managers we follow who, despite the headwinds of being value investors, delivered solid gains for the quarter as well. 

Economic Review and Outlook
The current economic expansion is the second longest in history.  It has been a slow but steady expansion and recently growth has picked up.  The U.S. economy grew 4.2% during the second quarter, well above the 2.3% average growth rate during this expansion.  Tax reform, higher government spending, and increased exports helped to boost growth which looks likely to remain above average for the next couple of quarters.  After that, structural limitations including weak productivity and labor force dynamics will likely slow growth to 2% or less.  While there are numerous signs that we are late in the economic cycle, most economists don’t see an imminent threat of recession.  However, economists are notoriously bad at forecasting recessions, so we shouldn’t count on them to predict the next recession!

The labor market continues to be an area of strength for the economy.  The latest unemployment rate is 3.7% and if the economy keeps growing it could reach its lowest level since the 1950s by year end.  The chart below is another way to view the job market.  It compares the ratio of people who are unemployed to job openings.  Currently, the ratio is below one which means there are more job openings than people who are unemployed!  While that may seem hard to imagine, if you have been trying to hire, you can understand how challenging it is. 

The tightening job market is also an indication of being late in the economic cycle.  So far, wage growth has remained muted, but if economic growth remains solid, that could lead to higher wage growth which could reduce corporate profits or lead to higher inflation.

 

Conclusion
As investors review their portfolios, it is tempting to add to the areas that have been doing the best recently, especially U.S. growth stocks, and in turn reduce the areas that are lagging or don’t seem to be doing much.  That’s often an effective strategy in business.  But investing is different.  When one segment of the market is outperforming, it is getting more and more expensive, and future expected returns are going lower and lower.  The lagging segment is getting cheaper and cheaper, and future expected returns are increasing.  There is no way to know when the cycle will turn and when alternatives and bonds will outperform stocks, when international stocks will outperform U.S. stocks, or when value will outperform growth.  Nothing magical happened in March of 2000 that made it obvious the stock market would take seven years to reach new highs, nor will anything special happen when the current bull market eventually hits its peak.  Instead, investors need to recognize that at some point stocks will go down, and certain areas of the market and strategies that have not done as well will likely become outperformers on the downside.  This is exactly how diversification is supposed to work and why it is important to not lose sight of this in a market dominated by high flying U.S. growth stocks.

The statements and opinions expressed herein are subject to change without notice based on market and other conditions.  The information provided is for informational purposes only and should not be construed as investment or legal opinion.  Please consult a tax or financial advisor with questions about your specific situation.