Quarterly Investment Commentary
MARKET RETURNS: The third quarter provided U.S. stock investors another period of solid results. The U.S. economy’s forecasted growth rate of 3.8% for the third quarter, although lower than the second quarter’s 4.2%, is still a strong showing. The impact from tax cuts was expected to diminish by the mid-point of the year, but earnings growth has been very strong, with forecasts suggesting year-over-year percentage gains in the high teens – a little lower than the 25% earnings growth in the second quarter, but still strong. Non-U.S. developed market investors have had to contend with lower growth relative to the U.S., combined with concerns from current and future increases in the value of the U.S. Dollar, which negatively impacted some emerging market borrowers and certain large European banks that are holders of this debt. While international developed stocks generated positive returns last quarter, emerging market stock investors had mild losses partly due to movement in the Dollar. As expected, the Fed lifted the Federal funds rate 0.25% in late September, but U.S. bond returns were flat on the quarter, as the higher yields provided by bonds today were better able to absorb the rise in shorter-term interest rates. International bonds lost ground on the quarter, as investors considered the possibility of an uptick in the pace of tightening interest rates abroad. Cash returns benefitted from the Fed increasing short-term interest rates, with 12-month returns above 1.5 percent.
|9 months ending Q3||12 Months ending Q3|
|US Large Cap Equities||S&P 500 Index||7.71%||10.56%||17.91%|
|Int’l Developed Equities||MSCI EAFE Index||1.35%||-1.43%||2.74%|
|Emerging Market Equities||MSCI Emerging Equities Index||-1.09%||-7.68%||-0.81%|
|Fixed Income||Bloomberg Aggregate Bond Index||0.02%||-1.60%||-1.22%|
|Cash||US Treasury Bill 1-month average||0.48%||1.28%||1.57%|
Non-U.S. Markets: While developed non-U.S. stocks generated mildly positive returns last quarter, returns were slightly negative for emerging market investments over this period. The strength in the U.S. Dollar (assisted by the Fed’s steady increase in short-term rates) has been challenging for emerging market countries with large debts denominated in U.S. Dollars or large trade deficits. Countries with both of these issues (e.g. Turkey and Argentina) can find it difficult to service debt when the value of the debt is rising as a result of a rising U.S. Dollar and high inflation in the country’s own currency. Our portfolios have very little exposure to either Turkey or Argentina. However, concerns regarding this risk spreading to other emerging market countries, as well as the impact to holders of potentially troubled debt (particularly large European banks) sent prices across emerging markets and in certain developed market segments lower. Recently, both Turkey and Argentina took good steps by raising their own interest rates to stabilize their currencies. The worries around a global trade war have also added to market concerns, but the recent agreement by the U.S., Canada, and Mexico on a revised trade deal may moderate that concern. Finally, the U.S. Dollar is fundamentally overvalued, and while this can persist in the short-run, expectations are that the U.S. Dollar will eventually weaken, helping to relieve some of this pressure. Our overall allocation to emerging markets is small, but we still believe that it provides good long-term value for clients. We also believe that European stocks are a better value as compared to U.S. stocks currently which can show up as better performance over time.
Mid-term Elections: As of this writing, the possibility of a divided government (one where the U.S. Congress and the White House are not united under the same party) has increased with the upcoming elections in November. Naturally, a common question is: “Under what scenario has the stock market or the economy done better – a government under Republican or Democratic control, or a divided government?” The table to the left, which uses data as far back as 1947, suggests that the stock market has done better under Republican control, while the economy has done better under control by the Democrats. What stands out is that the country has experienced a divided government a majority of the time (61%) with both the market and economy faring well. However, research by Goldman Sachs, which looked at stock market performance under these and other scenarios, concluded that the performance differences were not statistically significant; in other words these differences could have occurred by pure chance. So, even if the Democrats take over either the House or the Senate, or even both chambers, it does not necessarily mean bad news for the market or the economy.
October 2018 Volatility: We want to address the recent slide in stock prices that occurred on October 10th and 11th as of this writing. A jump in long-term interest rates at the beginning of the month increased investor concerns around the pace of rising interest rates. Over the last nine years, the economic expansion and gains in the stock market have been under a low interest rate regime, and investors have become accustomed to these rates and the nice upward glide in stock prices that have resulted. While interest rates have been rising, they are still quite low from a historical standpoint. However, the Fed’s steady and deliberate increasing of the funds rate has begun to change the mindset of investors: as bond yields rise, taking excess risk is no longer required in order to earn a reasonable return. With the higher interest rates that have occurred, and even potentially higher rates to come in the future, it is not a surprise that some investors have rotated away from stocks. We understand that the volatility produced by this move is uncomfortable, however. Investors have grown accustomed to a rather steady increase in stock prices over the last several years. J.P. Morgan calculates that as of September 30, 2018, the average intra-year drop in the S&P 500 Index since 1980 was 13.8%, but the last year where investors actually experienced an intra-year drop that exceeded this level was seven years ago, in 2011. Since 1980, the S&P 500 Index produced positive returns in 29 out of 38 years (76% of the time), even in some years when intra-year declines exceeded the 13.8% average. This serves as a reminder that while stock market volatility is uncomfortable, it is also normal. As mentioned previously, growth in U.S. GDP and corporate earnings have been quite good, and unemployment is close to a 50-year low–the U.S. economy is in good shape. The Fed understands this and feels the economy can handle higher rates.
Conclusion: We’ve thought volatility would rise at some point, and have been moderating portfolio risk slowly for some time. The outcome of the mid-term elections, in the event of the Democrats winning back control of either the House or the Senate, could also increase volatility in U.S. markets if the risk of potential gridlock is perceived to be a negative with investors. On the other hand, the U.S. economy is in good shape, with Europe also showing signs of improvement, which is supportive for global stock returns. We pay close attention to the markets and your investments, and will write you again if markets continue retrenching.
Enjoy the rest of the year and have a happy holiday season!
Please note that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk. Therefore, it should not be assumed that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended and/or undertaken by Opes Wealth Management) will be profitable.
 Guide to the Markets, September 30, 2018, pg. 14, J.P. Morgan Asset Management