The April-June quarter saw mixed returns from financial-market investments. Large-company U.S. stock benchmarks gained 1-3%, while small-caps advanced more briskly. Overseas stocks were weak, especially after translating returns into appreciating U.S. dollars: developed-market indices were off around 2%, while emerging- and frontier-markets fell nearly 10%. Real-estate- and commodity-related investments were mostly firm; crude oil gained almost 15%, although the price of gold fell. After spiking to a multi-year high in mid-May, bond yields eased during the last six weeks and finished only slightly higher (the 10-year Treasury yield rose to 2.85%, from 2.74% at the end of March). Investment-grade bonds notched modest gains, though slightly wider credit spreads resulted in flat-to-modestly-negative results in the high-yield sector.

Among large-company U.S. stocks, relatively good three-month results came from the Consumer Cyclicals, Energy, Technology and Utilities sectors; lagging groups included Basic Materials, Capital Goods, Financials and Health Care. The large-cap growth index outperformed its value counterpart by four-to-one (+5.2% to +1.3%); the mega-cap FAANG stocks (Facebook, Amazon, Apple, Netflix and Google parent Alphabet) gained more than 16%, on average.

Benchmark Performance – Equities
Second Quarter 2018 Last Twelve Months
S&P 500 Index +3.4% +14.4%
Large-Cap. Core Mutual Fund Avg. (Morningstar) +1.1% +7.6%
Small-Cap Stocks (Russell 2000) +7.8% +17.6%
Non-U.S. Stocks – Developed (MSCI EAFE) -1.2% +6.8%
Non-U.S. Stocks – Emerging (MSCI EM) -8.0% +8.2%

Benchmark Performance – Fixed Income
Second Quarter 2018 Last Twelve Months
Barclays Intermediate Gov’t/Credit Index (taxable) +0.01% -0.6%
Intermediate Municipal Mutual Fund Avg. (Morningstar) +0.8% +1.1%

Review

Following the first-quarter’s heightened volatility, financial markets were relatively calm in the April-June period, though rising trade-related tensions provided some late fireworks. Domestic large-cap and overseas developed-market stocks followed a two-steps-forward-one-step-back path: steady gains through early-June, back-sliding into quarter-end. Though major U.S. benchmarks remained below their late-January all-time highs, the S&P 500’s cumulative advance/decline tally registered multiple new highs and the Russell 2000 small-cap index easily eclipsed its previous peak – encouraging signs that gains were not entirely concentrated among the FAANG stocks. Emerging- and frontier-market equities, hit by a combination of escalating trade tensions, global growth worries, and a rebounding U.S. currency, declined more than 10% in the final eight weeks of the quarter. Chinese stocks were among the biggest losers, with both on-shore and Hong-Kong listed indices falling more than 20% from their first-quarter highs.

Data released during the period indicated global economic activity had eased somewhat from the robust pace seen around the turn of the year. First-quarter GDP slowed in all major developed-market regions, though growth held steady or increased in most emerging markets – including China. More timely reports indicated the U.S. economy was reaccelerating, with estimates of second-quarter growth running between 3% and 4% – nearly twice the first-quarter’s +2.0% pace. Relative weakness persisted in both Europe and Japan. Chinese data ticked up early in the period, but a range of the most recent reports hinted a weaker pattern may have set in. Inflation gauges continued to inch higher, particularly in the U.S., where both headline and core rates climbed above 2% for the first time in years.

With growth accelerating in the U.S. but flagging elsewhere, central bank monetary policies diverged, stoking currency volatility. The U.S. Federal Reserve surprised no one by raising its short-term interest rate target in June – to a near-ten-year high of 1.75-2.00%. Post-meeting communications indicated two additional hikes were likely before yearend, a slightly more ‘hawkish’ stance than previously telegraphed. Meanwhile, the European Central Bank continued to prepare markets for the end of its quantitative-easing (bond-buying) program, but investors judged its latest pronouncements marginally ‘dovish,’ reflecting slowing growth and stubbornly low inflation. The Bank of Japan signaled anew its reluctance to tighten policy, abandoning the goal of hitting its long-held 2% inflation target within the next year. And as the quarter ended, the People’s Bank of China in effect eased policy by cutting bank reserve requirements and allowing the yuan to depreciate. Reflecting these developments, the trade-weighted foreign-exchange value of the U.S. dollar gained more than 6% from its late-March low, quickly reversing roughly half of its 2017 descent.

What’s Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1) Dividend Income (for three months this is the annual yield divided by four)
2) +/- Change in Earnings per Share* (average for S&P 500 companies)
3) +/- Change in Valuation (Price/Earnings Ratio)
= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to give us the +3.4% S&P 500 total return?

Second Quarter (April-June) 2018
Dividend Income +0.5% +3.4%
+ Change in Earnings +3.6%
+ Change in Valuation -0.7%
= Total Return +3.4%

Our read: Forward earnings again outpaced rising prices (albeit marginally). Valuation remains elevated, but is gradually improving.
Profits reported during the period by U.S. publicly owned companies (generally covering the first three months of the year) were the best in more than 20 years. The cumulative total for the S&P 500 came in 27% above the year-ago period; moreover, nearly 80% of companies exceeded analyst expectations for earnings, and only a slightly smaller proportion beat on the revenue line. Although managements’ second-quarter guidance was relatively restrained, Wall Street consensus still envisions gains in the mid-20% range through the remainder of the year.

Outlook

Though a sound American economy and robust profits should remain supportive for some months (at least), the financial markets face mounting headwinds in the form of slowing global growth, ebbing policy accommodation, escalating trade frictions, and broadening political risk. Investor perceptions of these threats are evolving and subject to frequent revision – which seems likely to result in renewed volatility in the months ahead.

The U.S. economy enters the year’s second half in rude health. Both consumer and business confidence are buoyant; unemployment is low and falling; wage gains are gradually accelerating (albeit from a disappointing base); and real-estate markets are healthy. Last year’s tax cuts and spending bills will continue to support growth into 2019, and forward-looking indicators hold scant evidence of an impending downturn. The situation abroad is less reassuring. Decelerating economic activity and the recent break in emerging-market stocks have coincided with widening credit spreads in Europe and a growing – though still miniscule – incidence of corporate defaults in China. In the context of last year’s broad-based growth, and the continuing willingness of central banks to provide monetary accommodation as needed, we currently judge these developments to be mid-cycle hiccups rather than something more ominous. That said, recent data and financial-market reactions suggest increasing fragility.

The emerging-markets (EM) sell-off, which accelerated as the quarter progressed, has investors questioning the durability of the asset class’s impressive albeit brief period of outperformance (as a group, EM equities outpaced large-cap domestic stocks +39% to +21% over the five quarters through March). The turbulence to date seems largely attributable to the recent appreciation of the U.S. dollar; since 2011, four similar-magnitude swoons – declines ranging from 5% to 17% – were associated with periods of dollar strength. More broadly, however, investors fear the Chinese economy – remarkably steady for the past two years – is beginning to labor under a regime of tightening credit and coerced deleveraging. This is more troubling, as the worst EM bear-market of recent years – a 35% decline from April 2015 through January 2016 – coincided with a Chinese ‘hard-landing’ scare. Investors will likely continue to shun EM stocks as long as the dollar is appreciating and/or the Chinese economy is perceived to be underperforming. But unless incoming data signal a major downshift in China – which we do not expect – near-term volatility may be an opportunity to build lower-cost positions in this important long-term-growth asset category.

Evolving monetary policy – dubbed ‘quantitative tightening’ by one clever observer –continues to warrant caution. With the Fed in the vanguard, global central banks have begun to reverse the unprecedented accommodation in place since the global financial crisis. Although bond yields have recently eased in response to trade tensions and volatile stock prices, the trend is clearly up: the April-June quarter was the third consecutive period, and fifth of the past eight, to see higher U.S. yields. And while inflation has so far been remarkably well behaved, near-record-low unemployment combined with the solid growth expected in coming months creates a distinct risk of overheating – which could prompt a strong and unwelcome Fed response. We noted in our April letter that, largely thanks to the Fed, the era of TINA (‘There Is No Alternative’ to owning stocks) may be ending, as high-quality, short-maturity investments once again carry meaningful yields. While higher yields are good news for long-term investors who hold balanced portfolios, an unanticipated spike could entail (possibly substantial) short-term pain.

The growing prospect of a ‘global trade war’ is clearly the greatest risk looming over financial markets. (Bespoke Investment Group recently noted that news reports of rising trade tensions were linked to seven of the eight worst daily-opening declines for U.S stocks this year.) While the highest-profile drama has been the escalating tit-for-tat between the U.S. and Chinese governments, measures taken and contemplated by the U.S. also affect trade with Canada, Mexico, Japan, Europe and…. well, essentially, the rest of the world. Though the direct, easily tallied costs of protectionism might be relatively modest (not least because the U.S. economy is not very reliant on international trade), the second-order effects on business confidence and investment are sure to be larger, as the viability of global manufacturing value chains created over four decades is called into question. While Harley-Davidson’s decision to shift export production abroad was politically naïve, economically it was eminently rational. Thousands of firms – in all the affected countries – could face similar dilemmas in the months ahead.

More broadly, we fear the nationalist instincts that motivate U.S. trade policy also augur a more fundamental risk. Taken too far, such instincts threaten to undermine the coalition of ‘like-minded’ (i.e., democratic, free-market) nations – the U.S., U.K., the core European Union members plus Japan – that together built and sustained an international system that has been immensely beneficial to the global economy over the past seven decades. There is no guarantee that what comes next will represent an improvement.

The first half of 2018 played out much as we suspected it might: investors entered the year extrapolating the unusually supportive conditions that underpinned widespread gains in 2017; the likelihood of disappointment seemed relatively high. Subsequent developments have been mixed: U.S. economy and corporate profits – strong; overseas growth – less so; bond yields – rising; populist, market-unfriendly policies – on the march. As a result, financial investments have mostly provided weakly positive or negative returns. The less-rosy news flow and disappointing market results of the past five months have likely deflated investor expectations somewhat, while surging profits have resulted in improved valuation – salutary developments both. Nevertheless, we believe risks are rising while stock-market prices remain demanding – and rising short-term yields mean the likely ‘opportunity cost’ of holding relatively safe, non-stock investments continues to fall.

We hope you are enjoying the summer; please call (or email) anytime with comments, questions and suggestions.

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Milwaukee, WI 53202  |  414-221-0081
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