US Market Viewpoints: Third Quarter 2018Submitted by Castlebar Asset Management on October 5th, 2018
The US markets are entering the final quarter of the year in a strong position. The S&P 500 had its best quarterly performance since 2013, hitting fresh all-time highs again this quarter. Other milestones were reached as Apple and Amazon became the first companies in the US to reach a $1 trillion market value. The economic outlook remains bright with growth rates exceeding expectations, unemployment at generational lows and inflation in check. Investors largely shrugged off concerns over trade tensions and rising interest rates during the quarter. All of this is setting up for favorable environment as we wrap up 2018.
The rundown for this quarter is pretty similar to the 2nd quarter. Large cap companies (S&P 500) significantly outpaced smaller companies in the US, bonds and international stocks. Instead of rehashing the similar points from our previous Viewpoints, I think it is important to take a moment to revisit the topic of diversification. With the S&P 500 grabbing headlines this has a lot of people wondering why their portfolios are not keeping up with the S&P 500. The simple answer is diversification is a buzz kill. When you own a diversified portfolio, you will always perform worse than the best performing asset class. Since the S&P 500 is often thought of as the market, many investors feel like their portfolio is missing out. Your portfolio is probably performing in line with expectations. A diversified portfolio also means you will always own something that is out of favor (like international stocks!). Human nature draws us toward wanting more of the best performing investments. Owning a diversified portfolio will prevent us from getting too much of one hot performing investment class when the inevitable pull back happens. This is the reason we set investment allocations and rebalance to our targets twice a year. This gives us a target to help you reach your goals and prevents us from being too influenced by what is performing best at the moment.
Stocks across all sectors did well this quarter. No sector had a negative performance in the period. The top performing sectors were healthcare, industrials and technology. Healthcare stocks jumped 15.0% as investors returned in droves to this sector. The group checks a lot of different boxes. Some healthcare stocks are undervalued, others offer some growth but the whole sector has been out of favor with investors this year. Industrials rebounded this quarter adding 11.0%. Despite concerns around trade wars and tariffs, industrials performed well on the back of a strong economy in the US. Tech shares did perform well in the quarter (+9.0%) but gave back some of their gains in September. There was a shift in the quarter away from technology stocks as concerns over valuations and some profit taking weighed on the sector. The laggards were real estate (+0.4%), materials (+1.8%) and energy (+2.1%).
We remain positive on stocks over the next 12 months but do not expect the road ahead to be as easy for investors. The environment remains favorable given the high level of business confidence, easier regulatory environment, solid earnings growth and relatively low level of interest rates. We expect things to get harder because year over year comparable numbers will be more difficult to reach for both companies and economic data. The reason we feel comfortable for the next year is there is no evidence that a recession is on the horizon. The early warning signals of a recession are showing no indication we should be worried.
The Federal Reserve (Fed) raised rates by 0.25% in September. The Fed Fund rate now stands at 2.25%. This is still historically low, but it is the first time that interest rates have been above the inflation rate. The Fed is expected to raise rates one more time this year. The pace of increases has been favorable to stocks since they have not raised in consecutive meetings. We expected the pace of rate increases to slow next year. It takes a quarter or two for an interest rate increase to have an impact on the economy. Given the Fed’s actions over the last two years we expect them to take a patient approach and closely watch what is happening. This should offer a reprieve for bonds which have not performed well because of rising rates. Savers can also start to smile because banks and money market funds are paying modest interest rates again. One thing that could cause the Fed to raise rates at a quicker pace would be if inflation starts to pick up.
While we are positive on stocks and the economy it is helpful to ask, is this as good as it gets? This is an exercise we ask ourselves to take the pulse of the current environment several times each year. Things are very good in the US and this could ultimately cause the economy to slow in the coming 12 to 18 months. Unemployment is at a generational low at 3.9%. I was at a meeting with Esther George, the President of the Federal Reserve Bank of Kansas City, and she had a few notes about the employment environment. She commented that the labor market is so constrained she is hearing from businesses that they are rehiring employees they had fired because it is hard to find people to work. Also, the biggest burden for companies in her district is they are unable to expand at the rate they would like to because of the lack of job candidates with the skills needed to fill open positions. She also feels that the unemployment level would continue to move lower across the country. Small business optimism is at the highest recorded level since this survey was started back in 1973 and consumer confidence is at levels not seen since 2000. There could be continued improvements in all of these measures, but the case is building that things might be reaching a peak in the near term.
Midterm elections are about six weeks away. The odds are there will likely be some shift in power in Washington. Typically, midterm elections years are more volatile with lower returns. This year has bucked that trend. After the last election cycle, we are out of the election prediction business!
I heard someone use the saying “it is hard to predict, so we must prepare” in an interview recently. This is an appropriate way to look at the current investment environment. Let’s enjoy the favorable investment climate while we have it and remain disciplined, so we are prepared for any unexpected events ahead.
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.