Halfway through the year, 2018 is making records for attention-grabbing headlines. How this constant barrage of news affects the greater economy and the implications for investable assets requires consideration of many factors and how they interact with each other.
Foremost, we are in the latter stages of an economic expansion, in which signs of strength or weakness are difficult to discern. While we continue to hold an optimistic outlook for the remainder of the year, we must emphasize that each investor’s goals and objectives should be the primary driver for portfolio positioning; the outlook for the economy and the markets should be a secondary consideration.
It is our view that equities will continue to provide attractive returns, relative to fixed income and cash, but we recognize that markets can turn quickly. Further, given that investment portfolios become more sensitive to market declines when investors rely on them for income, we urge our clients who are now taking income or close to taking income to meet with their advisors and think about a more cautious approach at this stage of the cycle.
Currently, the U.S. economy appears to be rather strong, continuing on its second longest expansion in the country’s history. Unemployment is low, consumer and business confidence are high, and the recent tax cuts should boost consumer and corporate spending going forward. Reinforcing the economy’s solid footing and continued strength are a series of leading economic indicators that show signs of the economy picking-up, rather than leveling off.
However, there are factors that can threaten the prospects of continued economic growth, including, but not limited to, the following:
Escalating Global Trade Tensions, Especially with China
Because the U.S. and China represent the world’s largest economies, the recent volley of retaliatory tariffs heightens concern of a significant trade war. President Trump’s plans to levy tariffs on more than $200 billion of Chinese imports reinforces his campaign promises to get tough on China and “level the playing field for U.S. workers and businesses.” However, it is currently unknown if the president will follow through on all of his proposals, or if he is merely using the threat of tariffs as leverage against a somewhat weakened Chinese economy. The fact is that China is more dependent on exports than the U.S., and it would suffer a bigger blow should the tit-for-tat threat of tariffs become a reality.
|Export to the other (Billion $)¹||Exports as a % of GDP²|
|Figures above as of 2017|
While China has other tools at its disposal to counter U.S. tariffs, such as currency devaluation or unloading its large positions in U.S. treasuries, we believe that cooler heads will prevail. It is nonetheless an ongoing development, and something we will continue to monitor closely.
The Federal Reserve and Other Central Banks Raising Rates and Unwinding Balance Sheets
After more than 10 years of an accommodative monetary policy to help the U.S. climb out of the recession and strengthen the economy, the Federal Reserve continues to raise interest rates and unwind its balance sheet. At the same time, global central banks have remained somewhat accommodative which, to some extent, mutes the Fed’s actions to normalize policy. With the Fed continuing to raise rates and unwind its balance sheet, and other central banks expected to reverse course in the next year or so, there will be a point in which monetary policy can become a hindrance on economic growth.
We do not believe that this will happen anytime soon. Rather, it is our opinion that the Fed will remain cautious, as doing so gives it a longer runway and more tools to deal with the next downturn.
One concern that could cause the Fed to raise interest rates faster than planned is higher-than-expected inflation. Despite recent signs indicating that inflation is starting to pick up, we believe inflation will remain at its current modest level. We base our rationale on several factors, including the following:
To gauge equity returns going forward, we must look at how long the economy can continue to expand. We must also recognize that although returns at the end of the cycle can be strong, they can change direction quickly as soon as signs of a potential recession become evident. The table below, which shows returns leading up to and during the past six recessions, puts this concept into perspective.
|Returns 18 to 6 Months Before the start of a Recession³||Returns 6 Months Before the start of a Recession³||Returns During Recession⁴|
Considering how fast equity markets changed direction leading up to past recessions, it is no wonder market volatility has picked up during the first half of 2018 as investors look for clues and digest information on the state of the economy. Despite this volatility, U.S. stocks, as measured by the S&P 500, did manage to squeeze out a positive return of 2.65 percent for the first half of 2018, outperforming bonds, which were actually down -1.62 percent over the same period. In addition, a decline in equity valuations to more modest levels from those at the start of the year provides another potential bright spot in our outlook
To try and gauge where returns will be going forward, we believe two factors will play a major role:
As of this writing, the expected year-over-year, second-quarter earnings growth for the S&P 500 is 21.3 percent, which would be a solid follow-up to a strong first-quarter performance of 24.8 percent growth⁵. While earnings growth is unlikely to continue at this pace, we believe that further economic expansion would lead to further earnings growth, albeit at a lower level than what we have experienced recently. With valuations declining slightly year-to-date, continued earnings growth can justify higher stock prices.
On some level, stocks and bonds are substitutes with one another. Higher bond yields can be a threat to higher equity returns. Historically, this point has come when the yield on the 10-year treasury reached 5 percent, as shown in the chart below⁶.
While we are a long way from a 5 percent yield, one can argue that the inflection point is lower today, given the current low-interest rate regime. Further, with the Fed unwinding its balance sheet, an expected rise in the issuance of treasury bonds to fund budget shortfalls resulting from the tax cuts, and inflationary pressures starting to pick up, there will be pressure on rates to move higher. This relationship will play out over the coming months and years, and there will be a point when the risk/reward dynamics may shift in favor of bonds. However, in the near term, we believe equities remain compelling and will continue to offer returns above that of fixed income and cash.
To date, interest rates have moved higher across the yield curve, with short-term rates moving more so, and the yield curve flattening. In addition, credit spreads, which are the additional yield that lower-quality bonds pay above higher-quality bonds to compensate for the additional risk, tend to widen as the economy approaches a recession, and historically precede selloffs in the equity market. While fixed income will remain a critical component of a well-diversified portfolio, returns will likely be muted going forward. Recognizing that each investor’s goals and objectives are unique, we believe a short-term higher-quality portfolio makes sense in this environment.
We are in the latter stages of an economic expansion, for which a precise ending is challenging to predict. As investors look for clues to narrow in on this timeline, we expect the market to be choppy. However, we also believe that the current expansion has more room to run, and equities will continue to produce returns above alternatives, such as fixed income and cash. Investors must temper this optimistic view with their own unique goals, objectives and time horizons, which will always take priority over market outlooks.
About the Author: Joseph Karl, CFA, is head of research and senior portfolio manager with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors and Accountants, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email email@example.com.
Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.
Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/deal and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.
The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.