QUARTER 2 2018 COMMENTARY
Global capital markets were fixated on the impact of escalating trade tariffs and the Italian elections
The Fed continued to hike interest rates and reduce its balance sheet.
Emerging markets endured the brunt of U.S. monetary and trade policy decisions, further pressuring Turkey, Brazil and China deeper into bear market territory.
Strong headline economic activity and corporate earnings buffered U.S. markets from volatility.
U.S. equity returns suggest concerns about peaking economic growth and accelerating inflation.
Markets were once again on a rollercoaster due to tumultuous headlines, including escalating trade tariffs, an anti-establishment electoral win in Italy, and higher U.S. interest rates. China, Canada and the European Union all took steps to retaliate against U.S. tariffs. Concerns over the Italian election outcome caused Italian 10-year bond yields to jump 130 basis points to 3.0% in less than a month. Stateside, the Federal Reserve raised interest rates in June while signaling two more hikes in 2018. Meanwhile, gyrations in emerging markets were amplified as a potential dollar funding crisis gathered momentum. This comes as emerging market’s share of global GDP is at an all-time high more than 40% (versus 20% in the crisis of the late 1990s). Due to his concerns about U.S. monetary policy, Urjit Patel, the governor of the Reserve Bank of India, wrote an open letter to the Federal Reserve in the Financial Times in early June. In the letter, Patel describes the “double-whammy” caused by the Fed’s balance sheet shrinking as U.S. Treasury issuance rises dramatically (nearly $800 billion more in 2018 because of tax cuts):
“Dollar funding has evaporated, notably from sovereign debt markets. Emerging markets have witnessed a sharp reversal of foreign capital flows over the past six weeks, often exceeding $5bn a week. As a result, emerging market bonds and currencies have fallen in value.”
In June the Federal Open Market Committee (FOMC) raised interest rates by 25 basis points, as anticipated, from 1.75% to 2.00%, its seventh raise of this hiking cycle. The FOMC released updated economic and monetary policy projections, indicating that there would likely be two additional rate hikes in the second half of 2018. Unfortunately for emerging markets, accelerating U.S. economic activity and looming signs of inflation have boxed-in the FOMC, so continued tightening is likely. Quarterly growth has been accelerating for a record eight consecutive quarters, and CPI is now higher than every observation but one since February 2012. Even the FOMC’s slower moving and preferred inflation metric, Core Personal Consumption Expenditures (PCE) price index, exceeded its long-run target of 2.3%.
Two important dynamics of inflation and consumer spending came to light at the end of the quarter. The energy commodity component of CPI was up 22%, and at the end of June, real personal consumption expenditures decelerated from 2.6% to 2.3% year-over-year (slowest since February 2014). If these trends continue, the Fed could find itself in the awkward position of having created a potential environment for stagflation. Non-farm payrolls remained robust with a three-month average of 179,000. The unemployment rate dropped to 3.8%, the lowest since April 2000.
U.S. equity markets were unable to deliver strong returns, despite the backdrop of growing corporate earnings from the first quarter. S&P 500 operating earnings were up 27% when compared to a year earlier—the biggest such increase since exiting the depressed levels of the credit crisis in 2010 and the second consecutive quarter of +20% growth. However, markets are forward looking, and since the start of fourth quarter earnings announcements in mid-January, the S&P 500 is lower by roughly 2%. The reaction of the U.S. Treasury market to seemingly better economic data and hotter inflation was also notable. The 10-year U.S. Treasury note yield rose modestly by 12 basis points to 2.86% while the spread between the 10-year and 2-year Treasury yields dropped precipitously to 33 basis points—a new low for this cycle and a level last experienced in August 2017.
Small cap stocks continued to outperform large caps as trade tensions and the strong dollar have hurt returns of multi-national companies. Within the small cap sector, the Russell 2000 Value Index has increased 5.4% for the year, while the Russell 2000 Growth Index gained 9.7%. In the large cap space, the Russell 1000 Growth Index is up 7.3% in 2018. The Russell 1000 Value Index remains negative for the year at -1.7%. The Russell Micro Cap Index was up 10% after being up less than 1% to start the year.
Energy was by far the best performing sector in the S&P 500. It increased almost 14% for the quarter, bringing its year-to-date return to approximately 7%. WTI crude oil gained 13%, rising to over $74 per barrel. The entire return for oil was made in the last two weeks of June, following OPEC’s announcement of smaller-than-expected output increases, which lifted the cloud of uncertainty over global production.
The energy sector once again led the S&P 500 in earnings, increasing 62% from a year earlier. Yet, technology’s 49% increase had the largest impact on the index, given its 26% weight. Earnings growth was broad-based and robust, and every sector but real estate (+9%) experienced double-digit increases. Expectations for full-year 2018 S&P 500 Index earnings were raised slightly to $158 per share, which would put year-over-year earnings growth at 27%. Given the move in earnings relative to stock prices, the S&P 500 now trades at 20.5 times trailing twelve-month operating earnings, which represents a 70 basis points drop from last quarter’s reading. Operating margins hit a new record of 11.4%, wiping out the old record from the previous quarter by 113 basis points. Margins in all but three sectors (technology, consumer staples and consumer discretionary) increased.
Bonds delivered mixed results in the quarter. Credit-sensitive sectors outperformed safer alternatives. High-yield gained 1.0%, according to the Bloomberg BarCap High Yield Corporate Index. Municipal bonds, as measured by the S&P National Municipal Bond Index, gained 0.8%. The Bloomberg BarCap U.S. Aggregate Bond Index was lower by -0.2%.
Emerging markets struggled. The headliner was China, given its importance to the global economy. After peaking in late January, the Shanghai Composite Index dropped 20% and into a technical bear market, setting it back to levels last experienced in February 2016. Selling accelerated in mid-June after the U.S. announced 25% tariffs on $50 billion of Chinese goods. The tariff, which goes into effect July 6, kicked off another round of equity selling, which left the Chinese market down -8% in the last two weeks of June. China has vowed to retaliate and may already have begun to do so indirectly. The Yuan has depreciated by 7% over the last several weeks, the most since the first half of 2015. Other countries that endured significantly lower equity returns were Turkey, which returned -26%. The Turkish Lira has depreciated more than 20% against the dollar due to continued double-digit inflation and the re-election of President Recep Tayyip Erdogan. Brazil returned -26%, amidst rumors of another political scandal, this time involving current President Michel Temer (Dilma Rousseff’s vice president), in addition to high unemployment and poor economic activity.
The MSCI Emerging Markets Index ended the quarter lower by -8.0%, returning -6.7% for the year. Italian equities were down -7.3% as the anti-establishment Five Star Movement took the Italian election. For the year, the MSCI EAFE Index is lower by -2.8% in dollar terms.
The outcome of U.S. midterm elections will significantly affect the Trump agenda, particularly an infrastructure spending bill that could extend an already aging economic expansion and further increase deficits. Such a spurt of growth in an economy with little spare capacity will have consequences for inflation, which is already running above FOMC long-run targets. Political posturing around the inflation narrative has already begun. President Trump showed concern over consumer sentiment and the fact that higher inflation might create a more hawkish Federal Reserve. He lobbied (tweeted) OPEC to lower oil prices through production increases.
“Oil prices are too high, OPEC is at it again. Not good!”
He didn’t stop there.
“Hope OPEC will increase output substantially. Need to keep prices down!”
Noticeable weakness within global financial companies also bears close monitoring. The sector, proxied by the iShares Global Financials exchange-traded fund, has fallen nearly 14% since the beginning of February, and its poor performance cannot be blamed entirely on Deutsche Bank (which is down nearly 50% from its peak earlier this year). U.S. large cap financial stocks are off 12% from their highs in January and currently sit barely off their lows for the year. The sector ended the quarter down thirteen of the last fourteen trading days.
A common thread among actions by governments and central banks in the first half of the year was protectionism and insularity—a stark departure from the open trade and coordinated global action that pulled capital markets and economies out of the depths of the credit crisis. These themes will likely persist into the third quarter. The carousel of tariff announcements, elections, and critical central bank decisions will continue amidst slowing growth and rising inflation. That puts a lot of pressure on companies trying to maintain above-average earnings growth and on U.S. consumers trying to navigate an inflation and interest rate environment they haven’t experienced in more than 10 years.