Global stock and bond markets hit a sustained patch of turbulence during the first half of 2018. After all the bouncing around, major equity indexes had mixed, subdued results with the S&P 500 logging a muted 2.65% total return and the Dow finishing down (0.82%). The All Country World Index (excluding the U.S.) was off (3.77%), and the U.S. bond aggregate fell (1.66%). Overall, most diversified portfolios were relatively flat to slightly down midway through the year.
The primary factors contributing to the current bout of investor angst are higher U.S. interest rates, renewed strength in the U.S. dollar, and an escalation in global trade tensions. Ironically, at the start of the year, it was the nuclear standoff with North Korea that stood as the most significant threat to the global economic expansion. Now, a prospective trade war with our closest economic allies has the markets on edge.
U.S. small cap stocks were the winners in the first half of the year (Russell 2000 rose 7.6%) as investors piled into this asset class believing domestically focused companies are more broadly insulated from rising interest rates and tariffs than large U.S. multinationals. On the other hand, non-U.S. stocks, particularly emerging markets, which significantly outperformed in 2017, got stung in the second quarter by a stronger U.S. dollar and trade war fears.
The back half of the year should offer more clarity on several fronts including global trade, the U.S. midterm elections, and the Fed’s desire to push interest rates higher. Despite strong underlying corporate earnings growth, it is likely the markets will continue to vacillate until after the mid-term elections. Investors should take the current volatility in stride and resist the temptation to do too much tampering with long term strategic allocations and maintain their non-U.S. exposure despite negative headlines.
The Greenback’s Comeback
After losing value against other major currencies for much of 2017, the U.S. dollar staged a partial revival in the first half of 2018 largely as a result of rising U.S. interest rates. Higher relative interest rates in the U.S. as compared to other developed countries creates demand for U.S. dollar-denominated assets and hurts the performance of non-U.S. investments in the short term.
As can be seen from the chart above, the U.S. dollar’s value against its trading partners currencies are highly volatile over time. Moreover, the dollar will likely come under pressure when the Fed signals it’s nearing the end of its rate hiking cycle which may occur later this year, particularly if tariff and trade disruptions start taking a bit out of growth. Longer term, the U.S. dollar could also face pressure from ballooning budget deficits and a normalization of global interest rates, making dollar denominated assets less attractive.
Speculating on short term currency movements is extremely difficult given their historically volatile nature. Therefore, investors are better served by holding some non-U.S. denominated investments that offer both long term growth potential as well as portfolio diversification benefits over time.
Tech Getting Hot Again
Given the continued strength, elevated valuations, and outsized relative performance of large U.S. technology growth companies, some are wondering if there is a “tech bubble 2.0” in the making. Even though many large tech companies are far more profitable than they were in the internet boom in the 90’s, from the chart below, it’s clear that tech’s representation in the S&P 500 has risen materially in the last few years. At current levels, the tech sector accounts for almost 26% of the valuation of all companies in the index. While still some ways off from the approximate 35% level at the peak of the 90’s boom, the unrelenting rise of growth stocks should warrant some caution when deploying new capital to this area of the market.
Furthermore, only five companies (Apple, Microsoft, Google/Alphabet, Amazon, and Facebook) account for roughly 15% of the value of th S&P 500. In turn, these same companies represent over 27% of the red hot large cap growth sector.
While the increase in the value of the tech sector doesn’t necessarily portend an imminent crash or future underperformance it is does suggest that investors whose portfolios are dominated by the S&P 500 and large cap growth indexes are becoming more concentrated and dependent on the future of a rather narrow list of companies.
While the U.S. economy has become more IT oriented as it matures, other sectors of the U.S. economy have become much less significant. Most notably, just five years ago, energy represented over 10% of the S&P 500 (now 6%), and financials were over 16% (now 14%). While there are many factors that impact the performance of certain sectors, over time they tend to go through cycles of growth, maturity, decline, and rebirth. During the growth phase, investors bid up the value of the hot sector while avoiding underperforming, slower growing sectors. At this point in the cycle, investors should consider the merits of rebalancing from large cap growth and into the other underperforming sectors that may offer better value.
While tempting to offload underperforming non-U.S. exposure given indications that trade tensions may linger and even get worse before getting better, doing so would be short-sighted. If the U.S. and North Korea experience serves as any guide as to how trade negotiations may eventually play out, the tough talk from the U.S. and its trading partners will likely give way to reconciliation and compromise since all parties understand that high trade barriers are ultimately harmful to the global economy. Of course, in the meantime, the current lack of clarity will impact certain countries more than others since it’s unclear how long this process may take and what economic damage, if any, will be done over the long term.
With strong earnings growth and the global economy still in expansion mode, albeit at a slower pace than last year, global equities should resume their upward trend. However, there might not be much progress until after the mid-terms. Despite near-term weakness in emerging markets, the asset class remains attractive for long term investors. On a relative basis, the MSCI Emerging Markets Index trades on 11.9x forward price-to-earnings ratio (PER), a discount of close to 25% to the MSCI World Index.
Fixed income investments had a rough first half of the year; however, bonds should make up some lost ground in the back half of the year as the Fed likely signals a slowing of future rates increases. One area offering good yield with reasonable credit and interest rate risk is short duration preferred stock. Given the most recent favorable results of bank examinations by the regulators, short duration preferred stocks (mostly issued by financial institutions) are appealing given their relatively high yields and relatively low credit and interest rate risk. Otherwise, focusing on high quality, diversified income sources with limited term duration remains an appealing way to generate income as well as mitigate equity risk.