Markets Position Themselves for Risk of Trade War

Q2 2018 Market Commentary

Plum Street Advisors
Q2 2018 Market Commentary – July 11, 2018

The US Economy continues to show strong growth, as the second longest expansion since World War II shows no signs of letting up any time soon.  Economists are projecting GDP growth of over 3% in the second quarter, and corporate earnings are on pace to grow over 20% year over year.

During the second quarter of 2018, markets became increasingly focused on the risk of a trade war being initiated by the United States.  Starting with more limited tariffs in the first quarter, the risk of a broader trade war heated up in the second quarter. The United States imposed tariffs on $34 billion in Chinese goods on July 6th, while the Chinese government responded with a similar list of their own.  The fear is that the trade war spreads from here, and President Trump is not playing down these concerns as he threatens further tariffs ranging from a 20% duty on imported cars to tariffs on $200 billion of additional Chinese goods. Economists warn that a global increase in tariffs could create higher inflation and slow economic growth.

The markets clearly positioned themselves for the possibility of increased trade barriers as the risks increased.  In the US, small cap stocks (with less exposure to foreign revenue) strongly outperformed large cap stocks during the quarter.  From a sector perspective, sectors with significant foreign exposure underperformed, and industrials were the worst-performing sector for the quarter and for the month of June.  More domestically-oriented sectors such as utilities, telecom, and real estate outperformed, especially in June as trade war rhetoric heated up. Globally, emerging markets were the most negatively impacted as trade concerns, which significantly impact export-led markets, combined with debt concerns and currency weakness against the dollar. For example, the MSCI China A Onshore index of shares traded on the Shanghai and Shenzhen exchanges was down net -13.1% in US dollar terms year to date through June.  

Despite global trade risks, continued strong earnings and sanguine domestic news helped stocks overall post positive returns across the developed markets. In the US, the broad Russell 3000 index returned 3.9%.  International stock returns were positive in local markets, but the strengthening US Dollar (up 5% during the quarter against a basket of developed market currencies) meant that EAFE returns in US Dollar terms were -1.2% (net).  

The Economy

The US economy is currently enjoying strong growth, as deficit-financed tax cuts and increased government spending are propelling GDP growth for the coming years.  While GDP growth weakened from 2.9% in the fourth quarter to 2% in the first quarter, it was set to rebound in the second quarter. The biggest cause for the dip in the first quarter was consumer spending, which increased just 0.9%.  Overall, the US economy saw broad increases across most sectors of the economy.

Corporate earnings continued to show strong year-over-year strength, rising 26.6% in the first quarter – propelled by lower taxes. Unemployment has remained around 4.0%.  Low unemployment rates have created a tight labor market with some upward pressure on wages, although these are being contained for now by workers re-entering the workforce.

Currencies

The US Dollar rallied strongly in the second quarter, depressing international market returns in US Dollar terms, and particularly hurting commodity and emerging market returns.  Dollar strength has been supported by rising interest rates in the US (which draws foreign money into US markets) and stronger economic growth in the US compared to international markets.

Emerging markets have been particularly hard hit.  It has made it more expensive for countries with dollar-denominated loans to pay interest and principal, and the currencies of several emerging markets fell sharply versus the US Dollar.

If the dollar remains strong, it is likely to hurt profits of multinational companies as a rising dollar will make products less competitive abroad.  It also makes commodities like gold, silver, and copper (which are are denominated in the US Dollar) more expensive for foreign investors.

Equities

US Stocks performed well in the second quarter, with small-cap indexes leading the way. The Russell 2000 small cap index returned 7.8%, while the Russell 1000 large cap index returned 3.6%. On a year to date basis, growth stocks have outperformed value stocks in both large cap and small cap indexes by significant margins (7.3% to -1.7% in the Russell 1000 growth and value indexes and 9.7% to 5.4% in the Russell 2000 growth and value indexes).

In the international markets, developed countries strongly outperformed emerging economies.  The MSCI EAFE index of developed country markets declined -1.2% in US Dollar terms (although it was positive 3.5% in local market terms).  The MSCI Emerging Market index fell by net -8.0% in USD terms and was also negative in local currency terms, declining net -3.5%.

Fixed Income

During the second quarter, US interest rates continued to increase, but at a slower rate. Overall, interest rates still remain low by historical standards. Rates for short-term U.S. Treasury securities increased in the second quarter (June 13), in concert with the Fed’s second interest rate hike of 2018. The Federal Reserve has indicated that two more 0.25% increases may be expected this year.

The yield on the 10-year U.S. Treasury note rose only slightly compared to its yield at the end of the first quarter, with concern mounting over a flattening yield curve (yields on short term bonds increasing more than long term bonds). The yield on the 3-month U.S. Treasury bill increased to 1.9% by quarter-end, up 0.2% from prior quarter-end, while the 10-year U.S. Treasury note yield ended the second quarter at 2.9% vs. 2.7% on March 31st.

For the second quarter, the Bloomberg Barclays U.S. Aggregate Bond Index (representing investment grade U.S. bonds) held up fairly well amid rising rates and geopolitical tensions, returning -0.2%, while the shorter duration Bloomberg Barclays U.S. 1-5 Year Government/Credit Index returned a positive 0.2%.

Commodities

The Bloomberg commodity index rose from April to mid-June, but then fell to where it started in the last couple weeks of June.  Despite the volatility, the index value changed only 0.4% over the quarter. The price of oil increased from $65 per barrel for WTI crude at the start of the quarter to $74 per barrel by the end.  Precious metals did less well, with gold losing 6.45% over the quarter.

Summary

The slow and steady recovery, now in its ninth year, keeps steadily puttering along, and that’s how we should like it.  GDP is growing between 1.5% and 3% per year, inflation is staying in check, unemployment is low but not too low, the Federal Reserve has been able to slowly bring interest rates back toward normal levels, and market volatility – all things considered – continues to be reasonable.

Any near-term risks to the US Economy would seem to come more from a potential external shock to the system than from internal cyclical causes.  A trade war is certainly on the radar at this point, but so are geopolitical concerns and a domino effect from troubles elsewhere, such as emerging market debt issues (possibly spurred by continued dollar appreciation).  We will be keeping a close eye on how these risk factors evolve.