QUARTER 3 2018 COMMENTARY
Full Steam Ahead
During the third quarter, growth again outperformed value and emerging markets continued to lag developed markets.
U.S. equities had their best quarterly result in nearly five years as corporations continued to generate strong earnings and pursue vigorous stock buyback programs.
The Federal Reserve continued tightening monetary policy while also reducing the size of its balance sheet.
U.S. budget deficit projections have surpassed $1 trillion this year and are expected to increase. Markets will watch the growth of these deficits closely.
Fueled by tax cuts, U.S. corporate earnings growth and stock buybacks maintained their torrid pace, while growth stocks widened their performance lead over value stocks. The malaise mounted for emerging market countries such as Turkey and Argentina as political and economic issues dragged on from earlier in the year. All these trends are influenced by the intensifying tightening the Federal Reserve has placed on monetary policy while the U.S. budget deficit continues to widen.
As expected, late in September, the Federal Open Market Committee (FOMC) raised interest rates by 25 basis points from 2.00% to 2.25%, its eighth increase in this cycle. In addition, the program to reduce the Fed’s balance sheet, known as quantitative tightening, was increased to a $50 billion per month pace, up $10 billion from the previous quarter. Solid growth and persistent inflation suggest a ninth interest rate increase is possible at the FOMC’s meeting in December. The most recent reading for the Consumer Price Index (CPI) was 2.7% on a year-over-year basis. Meanwhile, the FOMC’s slower moving and preferred inflation metric, the Core Personal Consumption Expenditures (PCE) price index, appears to have settled above the FOMC’s long-run target of 2.0% with monthly readings averaging 2.3% in the quarter.
Real personal consumption expenditures, a broad measure of consumer spending, increased to 3.0% on a year-over-year basis which is the highest growth rate since early 2016. Non-farm payrolls remained robust with a three-month average of xxx,000. The unemployment rate dropped to 3.x%, the lowest since April 2000.
Not all the news related to tax cuts was positive – the Congressional Budget Office (CBO) released a report in September that estimated the budget deficit for the 2018 fiscal year at nearly $1 trillion, a $200 billion increase from their previous estimate in April. Deficit expectations for the 2019 fiscal year are more than $1.2 trillion and the CBO now estimates the budget deficit will remain above 4% of gross domestic product (GDP) each year for the next decade, which is as far into the future they will attempt to go.
U.S. equity markets delivered impressive returns – indeed the best quarter for large caps in almost five years – as earnings growth lived up to lofty expectations. For the third consecutive quarter, the energy sector once again led the S&P 500 in earnings, increasing 142% from a year earlier. Except for health care, every sector in the S&P 500 posted double-digit earnings growth. Interest-rate sensitive sectors such as real estate investment trusts, utilities and consumer staples also posted double-digit earnings growth, albeit at a slower clip than other more service-oriented sectors.
Third quarter S&P 500 operating earnings are expected to post 28% year-over-year growth, which would be the third consecutive quarter of +20% earnings growth. Operating margins hit a new record high of 11.5%, although with just a 0.15% increase over the previous quarter, margin improvements are now decelerating. Expectations for 2018 full-year earnings were unchanged at $157 per share, which would put year-over-year earnings growth at 26%. In addition to strong fundamental results, S&P 500 companies have spent $380 billion in stock buybacks in 2018. This represents a staggering 50% increase relative to 2017. Technology companies were the big spenders, accounting for roughly 40% of aggregate buybacks.
From a performance perspective, the health care and industrial sectors led the way posting double-digit returns. Energy, materials and real estate all lagged and were all up by less than 1%. In September, Standard and Poor’s created a new sector titled communication services. This new sector replaces telecommunication services and includes several large companies that are currently housed in technology and consumer discretionary. Media companies, such as Walt Disney and Netflix, will no longer be included in consumer discretionary while internet companies, such as Facebook and Alphabet, will be moved from technology to communication services. Former telecom companies including AT&T and Verizon are now part of the communication services sector.
Large cap stocks outperformed their small cap counterparts while growth continued to outperform value. Within the large company universe, the Russell 1000 Growth Index increased by 9.2%, leaving it up 17.1% for the year. The Russell 1000 Value Index gained 5.7% which pulled it into positive territory for the year at 3.9%. Within the small cap space, the Russell 2000 Growth Index rose 5.5%, leaving it higher by 15.8% for the year. The Russell 2000 Value Index returned 1.6% and is now up 7.1% in 2018.
The Alerian MLP Index was higher by nearly 7%. Building on positive returns from previous quarters, WTI crude oil gained 7% as it rose into the mid-$70s per barrel. This occurred even with the U.S. reaching record oil production in September of 11.1 million barrels per day.
The 10-year U.S. Treasury note yield rose modestly by 19 basis points to 3.05% while the spread between 10-year and 2-year Treasury yields dropped precipitously throughout the quarter to 24 basis points—a new low for this cycle. Accordingly, long term rates are sluggish to move higher despite the FOMC raising short term rates.
Credit sectors delivered mixed results in the quarter as lower-rated securities once again outperformed safer alternatives. High-yield bonds gained 2.4% and are now up 2.6% for the year. Municipal bonds lost 0.2%, leaving them down 0.6% for the year. The Bloomberg BarCap U.S. Aggregate Bond Index was flat, leaving it down by 1.6% so far this year. Leveraged loans continue to be the darling of the credit space, returning 1.8% in the quarter (4.0% for the year). Loans as an asset class also reached the milestone of $1 trillion in outstanding value, nearly double that of 2013 levels.
Headline emerging market returns suggested benign economic conditions, but beneath the surface several countries continued to struggle. In dollar terms, the MSCI Emerging Markets Index was lower by 1.1%.
China, which entered a technical bear market during the second quarter, fell another 8% as trade war rhetoric became reality in July. Shortly thereafter, the U.S. threatened that an additional $200 billion of goods that could be tariffed. This pushed China’s stock market down even further, now at -9% for the year. Turkey’s stock market declined an additional 21% in the third quarter (-47% in the previous six months). Among other issues, Turkish markets reacted negatively to the news that recently re-elected President Erdogan had appointed his son-in-law as Treasury and Finance Minister. Adding to negative sentiment, the newly appointed minister declined to raise interest rates - a move many felt would help reign in soaring inflation and a collapsing currency. Argentina’s fiscal situation reached a critical point ultimately necessitating a $50 billion bailout pledge from the IMF. This comes as the country’s current account deficit reached 6% of GDP and the peso lost 30% relative to the dollar.
For the year, the MSCI Emerging Markets Index is lower by 7.7% and the MSCI EAFE Index is lower by 1.4%. This highlights the weakness in all areas of international investing.
U.S. mid-term elections have the potential to ratify or derail the current direction of government policy. The economic recovery that started in 2009 has been highly dependent on government intervention through bailouts, spending programs and tax cuts. After the 2016 Presidential election, the economy received an additional and unprecedented boost in the form of structural tax changes. A continuation of the Republican agenda could provide a further sugar high to the current economic expansion and capital market cycle. Given the minimal levels of spare capacity in the economy, this could bring inflation to the forefront and ultimately force even tighter monetary policy. This, in turn, would shift the investment regime for allocators of capital.
According to RealClear Politics (RCP), there are nine seats in the Senate considered toss ups on November 6th. In the House of Representatives, RCP views forty seats as toss ups. Another popular forecaster, Fivethirtyeight.com currently predicts the odds Republicans will maintain control of the House of Representatives are 23%. While projecting a 72% chance the Republican party will maintain control of the Senate. Regardless of the outcome, it has become clear that fiscal prudence exists in rhetoric only and that budget deficits are going much higher.