The third quarter of 2018 was a strong showing for U.S. equities, but a soft performance for most other markets and asset classes. Despite significantly discounted valuations and economies that are in earlier stages of recovery than the U.S., non-U.S. developed, and emerging market stocks failed to rally along with U.S. equities due to heightened trade tensions and a resurgent U.S. dollar.
The S&P 500 finished the quarter with an impressive 7.79% return while the All-Country-World-Index (excluding the U.S.) returned just 0.71%. The total return for the bond aggregate index was essentially unchanged in the quarter as a slight rise in interest rates (which pressured bond prices) offset income. The tech sector and small caps continue to lead the U.S. market higher this year as investors expect robust future profits from these areas and believe them to be reasonably well-insulated from tariffs, at least for the time being.
Fourth quarters are usually seasonally strong for the equity markets; however, with the uncertainty of mid-term elections looming, rising interest rates, and ongoing trade tensions with China, there will likely be additional volatility and a possible pullback at some point during the last few months of the year.
Corporate profits are on course to register stellar growth this year (largely thanks to corporate tax cuts) and expected to grow at a single-digit rate next year, helping provide an environment where the bull market in U.S. equities can still run further. However, with this year’s stock gains largely driven by a surge higher in the tech sector, investors should be mindful of the tech sector’s constitution in their portfolios and potentially rebalance to value and non-U.S. stocks in the event of a future momentum shift. Furthermore, as short-term interest rates climb, bonds and cash equivalents offer an appealing alternative to some low-volatility alternative equity strategies.
Fed in Action
A growing U.S. economy, tax cuts, increased government spending, and surging corporate profits (benefitting from the reduction in the corporate tax rate from 35% to 21%) have provided solid cover for the Federal Reserve to remove liquidity from the economy. Since late 2015, the Fed has raised the Fed-funds rate 8 times from 0% to its current target of 2%-2.25% and since the start of 2017, the Fed has reduced the amount of securities held on its balance sheet from roughly $4.5 trillion to below $4.2 trillion as shown on the chart below.
The combined effects of these actions should work to slow growth over time as higher interest rates raise borrowing costs for businesses and consumers and the reduction of the Fed’s balance sheet withdraws liquidity as investors use cash to purchase the securities that the Fed is selling. Thus far, the only major casualty of the Fed’s liquidity-sapping actions appears to be emerging market economies that are heavily financed by U.S. dollar-denominated debt (i.e. Turkey).
The big question is how much further the Fed can continue these initiatives without putting a dent in the second longest expansion in U.S. history? Unless there is no longer such a thing as a business cycle, at some point, higher interest rates will choke off consumer credit, leading to a contraction in corporate profits, and a recession. Of course, no one knows exactly when this will happen, but it is likely that it will occur sometime within the next few years. With that being said, the Fed is keenly aware of their propensity to induce recessions and will likely slow the pace of interest rate hikes so as to not invert the yield curve (situation where short-term rates are higher than long-term rates). An inverted curve is often a condition that induces a credit contraction and recession.
Growth vs. Value
As seen from the chart below, there is no denying that growth stocks have been the place to be the last several years as large IT/tech related companies (which comprise almost half of the Russell 1000 Growth Index) continue to attract investor capital. Investors are clearly extrapolating historically strong earnings growth well into the future and driving stock prices up in the process.
The current environment is reminiscent of the late 1990’s when the tech sector outperformed the broader markets for several years before falling hard in the ensuing recession. Of course, today’s technology companies are far more profitable than those from that era. While the growth trend may very well continue for quite some time, you can see from the chart below that since 1980 the dot.com era was the only other time that growth stocks have had a greater level of sustained out performance. Again, this does not mean a change is imminent only that it is an abnormally large performance gap that is likely to revert over time.
With the economy 10 years into an expansion mode, it’s no wonder that consumers are feeling pretty darn good about the economy. In fact, according to the Consumer Confidence Index seen below, consumers haven’t felt this good about the economy since 2000.
The bad news, as also observed from the chart, is that consumers tend to feel the best about the economy near economic peaks or end of the economic cycle and feel the worst at the bottom of an economic contraction. While it is possible it’s different this time, if history is any guide, the current level of high confidence may not last all that much longer.
With short-term bonds yielding almost as much as long-term bonds, investors can minimize interest rate sensitivity and still generate decent yield by gravitating towards short-intermediate term, high quality fixed income holdings. Junk and high yield bonds have performed well this year but are not providing meaningful compensation for taking quasi-equity like risk.
Moreover, despite this year’s poor performance for emerging markets, investors should stick with a minor allocation to both stocks and bonds from developing countries given the attractive risk/return profile and long-term growth prospects. As evidenced by the current trade deal with Mexico and Canada, it is likely the administration comes to terms with China at some point which will relieve a significant overhang.