Analysis of Q3 2018 Market & Economic Performance
Editor’s Note: Volatility reared its head in October, shortly after this writing. Read for our analysis of mid-October market conditions here.
Little volatility during the third quarter allowed U.S. equity markets and the economy to remain strong. While progress on trade deals with Europe and Mexico boosted confidence that tariffs won’t derail the global economy, there’s still much work to be done in striking a deal with China, and U.S. political turmoil constantly distracts.
As we write this during the first week of October, the job market and economy aren’t slowing and, in fact, may be heating up. Unemployment has hit a 49-year low, and wage growth, though still below the 50-year average, finally began to catch up from its nine-year drag. Renewed wage growth, one of the last key indicators to recover since 2009, signaled a spark in inflation and drove volatility in the stock and bond markets—something we haven’t seen in six months. Improved wages also confirm our economic strength, which will continue to drive the markets and fuel global expansion for the coming quarters.
Q3 DRIVING FACTORS
Crude oil prices fell in July and early August, then climbed steadily to close at $75.54 on September 30. Watching commodity prices, including energy, is an important key indicator of possible inflation.
As expected, the Federal Reserve Bank raised key interest rates in September one quarter of a percent1. At the risk of sounding like a broken record, the speed of rate increases has the greatest effect on the bond markets and economy. It’s nearly certain the Fed will increase rates again in December and into next year. It’s a delicate balancing act—fighting inflation with higher rates without exacerbating the inevitable economic slowdown.
Inflation discussions have returned as the strong U.S. economy coupled with new wage growth and low unemployment could kickstart price increases. Though current GDP numbers remain robust (only a slight decrease due to hurricane and other weather issues), most economists are voicing the chance of an economic slowdown toward 2019’s end. The effects of tariffs and a trade war with Asia could accelerate the slowdown, likely slowing imports and exports first, followed by reduced revenue in domestic companies and the service industry. The dollar’s strength also will reduce exports and have a more profound effect on global trade.
EFFECTS ON ASSET CLASSES
Stock prices rebounded sharply in Q3. Returns for various equity classes are as follows2: Large-cap fund returns were mixed, with growth funds up 6-8% and value funds up 3-6%. Once again, tech stocks helped drive returns. Mid-cap funds rose nicely during the quarter; growth gained 5-7% and value 2.5-4.0%. We continue to see outperformance with small companies. Small-cap growth funds gained 5.0-7.5% and value funds were up 1-4%. Foreign stocks continue to have a tough time, with core funds moving upward by 0-3% and emerging markets suffering losses between 1-3%.
The bond markets were stable until the first week of October, when inflation fears spiked the largest single-day change in the 10-year Treasury since 2013.
During the past quarter, bond returns were decent, with gains across most classes in line with expectation and undamaged by the September rate hike. Here is a sample of performance by asset class for bonds: Short-term bonds finished near-even, with small gains (less than 1.0%). Mid-long positions finished with gains of 0.5-1.5% in mortgage-backed and corporate positions. Preferred positions had a nice quarter, with gains of nearly 2%. Some companies are issuing variable-rate preferreds, which may do well in this increasing rate environment. Foreign bonds returned between -2% and +2% in emerging market positions, while high-yield municipal bonds moved higher by almost 1%. Corporate high-yield advanced again with gains of more than 2%.
The popular financial press has attacked bonds as a sound investment since 2010, but history has proven them wrong. During the same period, bonds provided an excellent source of income and stability and complemented stocks in a balanced portfolio. With the new environment of rising rates and inflation, it’s important to mitigate risk in bond asset-class selection.
Economy: The United States economy is a force, and we expect its current momentum and strength to endure well into 2019 (with adjustments for inflation, trade tariffs, labor shortages, and increasing cost of debt).
Equities: Corporate earnings growth will continue to dominate the investment milieu and any global trade improvement may help extend this historic bull market. The Fed’s actions, too, are important signals, and their rate-increase forecasts continue to be bullish for equities.
Stock market current and future prices will be extremely sensitive to corporate earnings and profit. Any slip in profits, earnings, sales, or increases in cost-of-goods and labor could foreshadow the next correction.
While geopolitical tensions are dominating headlines, they’re having little effect on the equity market. Instead, the longer-term effects of trade deals, taxes, and regulation all create a headwind, or tailwind, for stocks and the economy.
Bonds: It’s all about rate hikes, rates hikes, and more rate hikes! Though rates remain attractive, continued Fed action will eventually negatively impact both investor bond holdings and the economy. Investors who are passively sitting on their existing bond portfolios are experiencing increased risk. Higher rates will damage existing bond portfolios, cutting bond prices and value. In the economy, higher rates will drive up interest expense for both businesses and variable consumer loans. The increased interest cost will effectively pull money out of circulation and slow the economy.
In this environment, it’s vital to make tactical changes to stay in front of the growing rate-and-risk scenario. This will be more important moving into 2019, as volatility in the stock market increases and the market cycle becomes more mature.
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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
1The Federal Reserve raised key interest rates by 0.25%. Reported on https://www.wsj.com/articles/fed-raises-interest-rates-signals-one-more-increase-this-year-1537984955.
2All asset-class quarterly data, dated October 5, 2018, pulled from http://www.wsj.com/mdc/public/page/2_3061-mfq18_3_results.html.
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.