January’s strong global market growth ended abruptly in February as volatility soared and technology stocks, in particular, made hasty retreats from record levels.
An out-of-nowhere new investment risk emerged during the quarter, fueled by headlines of a potential trade war. In an effort to stop product dumping into our economy, President Trump enacted tariffs aimed at China and China retaliated with tariffs on certain U.S. products. The game begins, and it could be a significant, and highly unforeseen, variable in the markets.
The real questions: How will the increased cost(s) of tariffs be borne, and will the demand for our exports of the tariffed products shift? With our ever-increasing manufacturing and supply globalization, a trade war could lead to other countries filling the supply or demand. How these changes would affect growth and the
Interest rates, as well, continue to be a driving factor in the economy and the bond and stock markets. The Federal Reserve Bank raised key interest rates again in
Q1 2018 DRIVING FACTORS
The Federal Reserve Bank, once again, met expectations by increasing key interest rates one-quarter of a percent (0.25%) during its March meeting1. The path for future rate hikes is paved: a minimum of two more increases in 2018, with the likelihood of one additional wildcard increase. The Fed is watching inflation closely. A continued reading above 2% will provide ammunition for successive rate hikes in June, September, and December. Increasing interest rates will create economic drag by increasing the money cost for businesses and consumers. The reaction in the bond market is important and will be discussed below.
Our strong economic growth continued in Q1 and likely will not miss a stride for the remainder of the year. The keys to calculating the end of this economic expansion, which began in 2009, are corporate earnings, global growth, and inflation. Consumer spending and borrowing, both back to pre-recession levels, can push growth for quite some time, as can the new tax law, assuming all its benefits aren’t used by public companies to buy back shares in a short-term effort to boost stock prices.
EFFECTS ON ASSET CLASSES
Finally, we saw the end of the Goldilocks run in stock prices. After another record month in January, volatility returned with a vengeance in a February correction. Major tech companies like Facebook and Tesla saw large stock-price declines and averages moved wildly in February and March.
Large-cap fund returns2 were mixed, with growth funds up between 1% and 7% and value funds down 2.5-5.0%. Mid-cap funds were similarly mixed, with growth gaining 1.0-2.0% and value losing an average 4.5%. Small-cap growth funds saw slight gains and value funds were widely dispersed between -3.0 and +2.0%. Foreign stocks also saw losses with core funds losing 2.0-3.0% and emerging markets, faring better, with less-than-average losses of 1.0%.
Natural resources were extremely volatile with core stock funds losing near 8.0% and master limited partnership (MLP) funds losing 12%. The MLP declines may be related to extra taxes assessed by a regulatory agency. The actual amounts have not yet been billed, so much speculation is made about the net effect after the tax cut recently enacted by Congress. REITs fell again, by 6.6%, from interest-rate fears continuing to loom over the real estate market. Dividend yields in REITs and MLPs remain much higher than average at the current prices.
Bond markets reacted negatively to February’s increased stock volatility. The Fed’s rate increases continue to have a minimal effect on many of the bond funds that are designed for
Let’s review recent performance by asset class: Short-term bonds finished near even with minor losses (less than 1.0%). Mid-long positions, including mortgage-backed and corporate positions, ended with small losses (less than 2.0%). Foreign bonds posted losses of 2.0%, while high-yield municipal bonds moved lower by 1.3%. Corporate high yields suffered a 1.5-2.0% loss. Preferred stocks had one of the worst quarters since 2008, with losses of 2% on most preferred stock funds and 7% on real estate-based preferred.
In the past, bonds have provided a stable income source and a buffer against equity volatility. Interest rates have bottomed out and are on the way up, creating downward pressure on bond prices. This could lead to more volatility in bonds than we have seen in the past three decades. Care must be taken to manage the risk in bonds and the risk in stocks during this unusual period of rising rates at the end of a long, bull bond market.
The need for income to support
Economic expansion continues in the United States and most of the developed world. The U.S. often leads the world into recoveries and recessions, so we expect foreign economic growth to continue until the end of the current U.S. economic cycle. The threat of a trade war could reduce both our exports and imports. In 1930, the Smoot-Hawley tariffs were passed as a protectionist measure to support the farmers and manufacturers in the U.S. This led to retaliation from countries around the world, including Canada, which raised tariffs on 16 key products that represented 30% of U.S. exports to that country. Canada then forged a better trade relationship with the United Kingdom to work around the problem tariffs. U.S. exports and imports fell dramatically during that time, and experts believe the tariffs not only failed to deliver the benefit promised to voters, but, more importantly, exacerbated the Great Depression. Today, the world is more connected by trade than during the 1930s. It is highly likely trade partners will look for workarounds, as Canada did, to avoid extra tariff costs. A trade war may stop or slow China from product dumping (e.g., solar) and stealing technology (e.g., computer chips), but it may come at a great cost. We consider this a new risk to the equity markets that could hasten the next recession or at least slow the rate of growth later this year and into 2019.
Our outlook for equities remains positive, albeit with an allowance for more volatility than we have seen in the last five years. Growth in foreign economies plus a possible reduction in U.S. growth from tariffs should lead to foreign equities outperforming in the near term. Our views on equity returns are dependent on the strength of the U.S. economy and lack of significant inflation, which create an ideal environment for stocks. Corporate earnings (a key indicator) continue to grow. We will watch for a slowdown in earnings, along with other key indicators to assess the continued strength of this cycle.
Rate hikes, rate hikes, rate hikes. All eyes are on the Fed for the next few quarters. We believe the Fed’s current rate-increase plan—slow and steady—will not derail the bond market. Any inflation signals would spark the Fed to take more action, while signs of an economic slowdown would lead to less action. The trade war and demand are bullish for bonds, but inflation and a tight labor market are bearish.
Our world is increasing in complexity and transparency. Between tweets, screenshots, YouTube, headlines, and viral video, there is no shortage of information. Distilling the data and focusing on the relevant, important, and useful is the most important part of financial planning.
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We publish these insights quarterly for our clients, with further detail on specific asset classes. Our personalized investment management strategy is built around each client’s personal Financial Plan and Investment Policy Statement. We review both as we make changes to each client’s portfolio, working to ensure their investments match their personal risk tolerance, return goals, and tax picture.
We welcome the opportunity to talk about how we might help you plan, build, preserve your wealth.
From left, our Investment Committee members include:
Earl Knecht, CFP®, Portfolio Manager
Kelly Crane, CFP®, CFA, CLU, MBA, Chief Investment Officer
Robert Lance, Director of Operations
Categories: Market Commentary, Market Forecast
1 The Federal Reserve raised key interest rates by 0.25%. Reported on https://www.cnbc.com/2018/03/21/fed-hikes-rates-by-a-quarter-point-at-chair-
2 All asset-class quarterly data pulled from Barron's Lipper Quarterly Performance Report, dated 4/3/2018.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline.
Stock investing involves risk including loss of principal.