2nd Qtr Portfolio & Market Observations 2018

After a negative first quarter, U.S. equities have officially recovered all of their losses from the market correction earlier this year. The S&P 500 Index, representing large-cap stocks, returned a modest 2.65% for the first half of the year. Its small cap counterparts, being the biggest beneficiary of the new tax bill and less susceptible to trade war headlines due to their domestic emphasis, were up nearly 10%, with most of this return coming during the past quarter. Growth continued to outperform value across the large and midcap spectrum for the latest quarter, outperforming across all capitalization sizes by historical margins in 2017. For the quarter, energy, consumer discretionary and information technology were the strongest performing sectors, while the industrials, financials and consumer staples sectors were the weakest.

Foreign equities were not able to keep pace with U.S. equities, and both the MSCI EAFE Index, representative of the developed non-U.S. equity market, and the MSCI Emerging Markets Index turned negative in Q2 after being in positive territory for the first quarter.

U.S. bond markets weakened in the second quarter, reflecting the improving economy and the Fed’s continuing interest rate normalization program. The 10-year U.S. Treasury note yield broke above 3.0% midway through the quarter, but concerns over the economic impact of rising trade frictions brought the rate back below that key psychological level by the quarter-end. The Bloomberg Barclays U.S. Aggregate Bond Index, which represents investment grade U.S. bonds, lost 0.2%.

The bigger story in the Treasury market may have been the ongoing flattening of the yield curve, which many market participants view as an omen of an economic slowdown. An inverted yield curve, where long term rates fall below short term rates, almost always precedes an economic recession, although one could argue that the quantitative easing, undertaken by central banks, may be placing an artificial upside barrier on yields.

Economic growth appears to be on track to record a stellar performance in the last quarter, fueled by strong business investment, tax cuts, tightening labor market and boosted consumer spending. In May, the unemployment rate hit a new low, and growth in retail sales accelerated as consumer confidence remained near a historic high. Furthermore, housing starts picked up in the same month, helped by rising wages and lower taxes. Survey data for May indicates the private sector has so far been unfazed by current tariff tensions with China and other trade partners. The months ahead might represent a critical junction, as new restrictions on investments between Chinese and American firms were unveiled on June 30th, while reciprocal tariffs with China and retaliatory measures from Canada will take effect in July.

As expected, the Fed continued its tightening campaign, raising interest rates another 25 basis points in June. With broad inflationary pressures largely contained and the yield curve flattening, a number of FOMC members have indicated they may be close to the end of the tightening cycle. However, current consensus forecasts call for two more 25 basis point rate hikes at the September and December meetings.

We are definitely not predicting a flat or boring market. If anything, without the safety net of the Fed’s accommodative monetary policy, the market should be more volatile. A sell-off at some point in the next six months is very possible, with the rising concerns of a trade war being one of the many potential causes. In addition, as rates rise, we also expect investors to reassess the attractiveness of U.S. stocks versus fixed income. Finally, acceleration of wage growth should have a negative effect on profit margins, even as it boosts the economy as a whole.

On the other hand, corporations continue to report record profits and CEOs, while some a little cautious, see the latter half of 2018 as a very good year for business.  While the downside risks are real, the ongoing strength and momentum of the U.S. economy greatly mitigates the obvious negatives.

Dumont & Blake Investment Advisors, LLC
June 30, 2018

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