Following are our analyses of the second quarter's key driving forces, including the impact of interest rates and tariffs on equity and bond asset classes.
We also look forward into Q3. We're in the late stages of one of the longest economic-expansion periods in our history, we're inching out of a 35-year bond bull run, and trade wars are escalating. How might this impact markets?
After the first quarter’s rough end, Q2 launched with market turmoil, volatility, and changing interest rates. The markets questioned the growing economy after political risks escalated, with tit-for-tat tariffs proposed by the U.S., China, and other global trading partners. Though intended to resolve unfair trade practices, tariffs act like a tax and are a lose-lose economic plan. The Federal Reserve raised interest rates during the quarter, in June, as expected1. Though key indicators are bullish on U.S. economic growth for the year, but the probability of future rate hikes may diminish if the trade war heats up.
Below, we assess recent factors and examine how they may shape the economy and markets.
Q2 DRIVING FACTORS
Crude oil prices rose during Q2, from roughly $64 to over $73.50, and energy (oil) stocks benefited greatly. In contrast, the Federal Energy Regulatory Commission (FERC) passed a tax on interstate partnerships that run oil and gas transmission pipelines. This tax may cost the industry nearly 5% of revenue. Some companies are structured to avoid the tax, but master limited partnership (MLP) prices plunged nearly 20%. Many have recovered substantially, and we expect continued economic expansion to drive demand and overrule the tax's negative effect.
The Fed increased key interest rates 0.25% in June and telegraphed a plan for future rate hikes: one in September and possibly another in December, for a total of four this year. December is more tenuous, pending the trade war. It’s worth noting: The Fed desires to raise rates as long as possible to help ensure maximum effect when lowering rates in the next recession. Bond prices reflect expectations.
Strong U.S. economic growth continued in the second quarter. Real GDP finally broke through its 2.7% average, held since the late 1960s. We will be watching inflation, growth, and earnings closely this fall to assess if tariffs are reducing demand and driving key indicators. Positive boosts from tax cuts are just now kicking in and may dampen the trade-war effect until 2019. Corporate and consumer balance sheets remain strong and debt levels don’t appear over-extended. We may be in the seventh or eigth inning of this baseball game in the economy and equity market.
EFFECTS ON ASSET CLASSES
After substantial 2017 gains, volatility in 2018 has shaped modest year-to-date returns. Here are the asset-class results2: Large-cap returns were mixed, with growth funds up 5% to 7% and value up 0.5% to 2%. Tech stocks helped drive returns. Mid-cap funds also were mixed. Growth gained just over 4% and value 2%, on average. Small companies continued to outperform: Small-cap growth funds gained 6% to 9% and values were up 4% to 5%. Foreign stocks continued to struggle, with core funds changing -2% to 3% and emerging markets dropping 4% to 11%. Natural resources rallied, apart from gold, which lost 5%. Oil-stock funds gained more than 10% while MLP funds were up 9% to 13%. REITs rallied nicely, up 3% to 8%, depending on property type. REITs and MLPs will remain out of favor until interest rates plateau or a recession looms. At current prices, REIT and MLP dividend yields remain much higher than average. This will be a key factor when stock-price growth slows.
Despite a Q2 rate hike and stock-market noise, bond markets remained relatively stable. The rate increase mostly was absorbed by a small price dip. Here is the quarter’s asset-class performance: Short-term bonds ended near even with small gains (less than 1%). Mid-long positions finished mixed with small losses or gains (less than 1%) in mortgage-backed and corporate positions. Preferred positions also were mixed—some down 2%, some up 2%. Foreign bonds posted losses near 5% in emerging markets, while high-yield, municipal bonds grew by 1.3% to 2.0%. Corporate high-yield recovered and posted a gain of less than 1%.
We’re in the late stages of one of the longest economic-expansion periods in our history. A trade war could be its end. The time for negotiation is now—and it’s running out quickly. The situation is complex, and recent talks have yielded little fruit. Consequences could manifest in our economy as early as this fall, followed soon by the markets. The tax cuts already in place will boost our economy short term and counter the trade war. Consumer reinvestment and spending are key to watch in this late-stage growth cycle. We depend heavily on consumers to create demand that spurs growth, spending on investment, and hiring (or pay increases) in the work force.
As this market cycle matures, we remain cautiously positive about stocks. Macroeconomic issues, such as the trade war, and key indicators, such as earnings, will provide the greatest clues to the cycle’s end. Corporate-earnings growth has been strong and driven by cost cutting and conservative investment. If the trade war creates a need for multinational companies to develop alternative production and shipping plans, investment may continue to drive earnings.
Our focus remains on Fed rate hikes and bond-market direction as predictors of future hikes and bond performance. (Read: Bond Strategies When Interest Rates Rise.) Eventually, we’ll see more inflation or an economic slowdown signal, and either will provide a clue. As we inch out of a 35-year declining-rates era, current rates are still very low. Today’s CD and fixed rates are much too low to support income and return needs of retirees and pension plans. Continued economic growth can support slightly higher rates in this economy and bond market.
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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 M. Lance, Director of Operations
Categories: Market Commentary, Market Forecast
1Reported on http://www.businessinsider.com/federal-reserve-fomc-statement-and-interest-rate-decision-june-2018-2018-6.
2Asset-class data source: Wall Street Journal: http://www.wsj.com/mdc/public/page/2_3061-mfq18_2_results.html, dated 7/6/18.
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.