Plum Street Advisors
Q3 2018 Market Commentary – October 11, 2018
The dichotomy in economic momentum between the U.S. and much of the rest of the world widened this past quarter, and stock market returns followed along. Strong U.S. growth is expected to continue, although increasing tariffs and rising interest rates present both near-term headwinds and long-term risk factors.
Trade frictions heated up during the quarter, although at the end of the quarter a new NAFTA agreement was reached which caused some to hope that the Trump administration’s higher tariffs are just a temporary posturing position. However, an agreement with China will be far more complex and difficult to reach, and some damage will likely be done to both sides before the spat with China is over.
For now, things have rarely looked better for the U.S. consumer. Taxes were cut for this year, the unemployment rate is solidly below 4%, wages are starting to rise, the stock market is up, and growth is surging ahead. As a result, consumer confidence is approaching peak levels, and consumer spending is solid, having risen for six months in a row.
Corporate earnings have also been terrific. In the second quarter, year-over-year growth in corporate earnings was 25% according to Factset, and in the third quarter they are projected to grow 19%. These numbers were significantly impacted by the tax cuts, but even so, corporate earnings are expected to grow more than 10% in 2019.
As a result of the strong consumer and corporate numbers, U.S. real GDP growth was an extraordinarily high 4.2% in the second quarter, and Moody’s economics is projecting continued above-average growth of 3.2% in the third quarter. The third quarter estimate would have been even higher if it wasn’t for the mounting negative effect of lower exports due to increasing trade barriers.
Outside the U.S., growth has been more challenged. For example, the overall real GDP growth of the 19 countries that make up the Eurozone rose only 1.5%. There are significant concerns about high levels of debt and rising rates in several parts of the world. Not only are there alarm bells ringing in emerging markets like Turkey, but even in Italy bond rates have jumped as concern has grown about an increasing government budget deficit. The U.S. looks well positioned to withstand these pressures in the near term, but if the contagion spreads, the U.S. economy will not be immune.
U.S. equity markets had an upbeat third quarter. The broad market Russell 3000 increased 7.1% amid rising economic indicators and growth in corporate earnings. By contrast, emerging markets as measured by the MSCI Emerging Markets index (net total return, USD) declined by 1.1% as concern grew about the impact of trade barriers, local currency weakness, and debt levels. Developed market stocks rose, but only by 1.35% (EAFE index, net total return, USD), partly due to the strengthening US Dollar.
In the U.S., large company stocks as measured by the Russell 1000 led the way, although for the year-to-date period smaller company stocks (Russell 2000) still had a slight lead. For the quarter, the Russell 1000 total return was 7.4% compared to the Russell 2000’s total return of 3.6%. Growth stocks led value stocks, as technology stocks like chip-maker Advanced Micro Devices posted significant increases in their stock price.
The US Dollar continued to strengthen in the third quarter, and the impact was felt most strongly by emerging market countries with significant dollar-denominated debt. Turkey was an extreme example, but its currency crisis was helped along by US sanctions over the detention of an American pastor. Still, there were red flags for the currencies of other emerging countries like Argentina, India, South Africa, Russia, and Brazil.
The rising dollar and increasing interest rates have made it more expensive for countries with dollar-denominated loans to pay interest and principal on their US Dollar debt. Emerging market bonds and stocks have declined this year as their fiscal health has deteriorated. Emerging market currency declines are nothing new, however, and it is as yet unclear whether the current signs imply a more serious emerging market crisis.
US interest rates continued marching upward in the third quarter, and both long and short term bonds increased. The Federal Reserve raised its benchmark federal funds rate for the third time this year, to a range of 2.00% to 2.25%, and may well raise it one more time in December. Meanwhile, the yield on the 10-year U.S. Treasury note rose 0.20% compared to its yield at the end of the first quarter, from 2.85% to 3.05%.
For the third quarter, the Bloomberg Barclays U.S. Aggregate Bond Index (representing investment grade U.S. bonds) held up fairly well amid rising rates, remaining essentially flat, while the shorter duration Bloomberg Barclays U.S. 1-5 Year Government/Credit Index returned a positive 0.3%.
The Bloomberg commodity index declined 2.5% during the quarter, amid a stronger US Dollar, increasing trade friction, and concerns about Chinese demand. Oil was a rare bright spot for commodity investors, as prices rose due to concern about new Iran sanctions scheduled for November. Gold had its sixth straight monthly decline in September, and fell 5.1% for the quarter.
U.S. stock markets have soundly beaten international markets this year. While it’s hard to say when exactly this will change, it will not continue indefinitely because the relative price of U.S. stock markets has gotten much more expensive than that of international markets.
The U.S. large company Russell 1000 benchmark is trading at over 18 times forward earnings, while the international ACWI ex-US benchmark is trading at just over 13 times forward earnings. This is a reflection of the stronger growth expected in the U.S., and may well be justified, but it’s important to keep in mind that the favorable position of the U.S. economy right now has been reflected in the stock prices already.
We continue to believe strongly in keeping a diversified portfolio, and remind our readers that relative country outperformance changes significantly from year to year. While international stocks may not have risen as strongly as a U.S. stocks recently, in the long run we feel confident that there will be tangible benefits from owning a broad mix of country stocks and bonds. That has certainly been the case over time.