US Market Viewpoints: Second Quarter 2018Submitted by Castlebar Asset Management on July 6th, 2018
Markets balanced strong economic growth in the US against global trade tensions this quarter. Despite the escalating trade rhetoric, stocks ended the quarter higher and are once again positive for the year. The S&P 500 is still about 4.5% off from the all-time highs reached in January of this year. The second quarter is shaping up to be one of the strongest for economic growth since the global financial crisis. The early data being released has shown a strong performance after a lackluster first quarter. This is not too bad considering we are 10 years into this economic expansion.
Trade tensions were the focal point for investors. The US has placed tariffs on about $50 billion in goods from China and is threatening to slap another $200 billion in tariffs on July 6th. The initial set of tariffs by the US and counter tariffs by China have been largely political and symbolic. The escalating tensions are troubling and have dictated a lot of the market sentiment. The main event is between the US and China but the US is also taking part in an undercard with our North American neighbors, Europe and Japan. The Trump Administration has taken an aggressive posture at the beginning of each action only to soften their stance as their default negotiation tactic. We will see if they continue to use this strategy or are willing to push forward to a full trade war. A global trade war would be a negative for stocks and in general no one wins in a trade war.
Small cap stocks had a fantastic quarter more than quadrupling the performance of the S&P 500. Smaller companies rallied because their businesses are insulated from much of the trade war impacts. These companies tend to earn less than 20% of their revenues from overseas where the average S&P 500 company earns close to 40% of their revenues globally. The top performing sectors were energy and technology. Energy shares jumped over 12% in the quarter as crude prices have steadily risen this quarter. You probably have seen your gas prices tick higher each week at the gas pump now that crude prices are steadily over $70 a barrel. This was the best quarter for energy stocks since 2011. Tech continues to be a market darling with investors buying more this quarter. The tech sector rose 6.2% in the quarter. Investors are drawn to the earnings growth offered by the tech sector. The five largest companies by market cap are all in the technology sector (Apple, Amazon, Alphabet, Microsoft and Facebook in order if you were wondering). Industrials and financials underperformed in the quarter falling each about 3.5%.
We remain optimistic that stocks will perform well over the next 12 to 18 months. The near term, through the end of the year, could be choppy as the market digests trade talks and the upcoming midterm US Elections. As we discussed above – no one wins in a trade war. If this continues to escalate our optimistic outlook could sour. We have written in the past that midterm elections years tend to have poor performance in the summer and early fall months. With a contentious election season expected, we anticipate that there will be increased volatility heading into the November elections.
We are keeping our optimistic stance in place because the corporate earnings outlook is strong, leading economic indicators are stable or trending higher, mergers and acquisition activity is picking up and the Federal Reserve (Fed) is tightening monetary policy in market favorable manner. Companies earnings have picked up this year on both economic expansion, as well as, from tax cuts. Growth rates for full year 2018 should be in the high teens and earnings are expected to grow in the low teens next year. There are no signs from the early warning indicators that there might be a recession on the immediate horizon. Business confidence remains strong and the difference between long term interest rates and short term interest rates (referred to as the yield curve) is still positive. They are two of the more reliable signals that recession risks are increasing and neither show any signs of rolling over. Corporate merger and acquisition activity is heating up which bodes well for performance over the next year.
The Fed did raise interest rates again this quarter. The Fed Fund Rate stands in a range between 1.5% and 1.75%. The market is expecting the Fed to raise rates two additional times this year. This pace is still favorable for stocks. The Fed will eventually overcorrect and raise rates either too quickly or to a level that discourages economic growth. This is not a concern this year, but it is something we’ll continue to watch in 2019.
Valuations for stocks are somewhere between fair value and slightingly expensive. The S&P 500 is trading at 16.2x forward 12 months earnings. This is in line with long term averages. The reason we believe stocks are in the fair value to a slightly expensive range is profit margins are at record levels. This leaves little room for improvement moving forward. Market valuation is more attractive today than a year age based on earnings growth. Stocks are still an attractive option for investors. We prefer stocks over bonds, but think cash is more attractive than bonds in the near term. As interest rates rise you’ll see bond prices weaken but interest rates in money markets and savings accounts should tick higher.
You can read our 2018 First Quarter US Market Viewpoints here.
Please contact me at 913-660-0708 or by email to discuss your financial planning and investment management needs. You can sign up for our monthly newsletter here. Follow me on Twitter @CastlebarAM.
Disclaimer: The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.