U.S. small cap stocks outpaced other equity classes in the first half of 2018, in large part due to their relative insulation from global trade turmoil that sapped strength from overseas markets. European shares were also hurt by a GDP growth slowdown. The S&P 500 finished the half slightly positive amid significantly higher volatility.
Rising interest rates took a toll on bond prices (prices move inverse to yields) and credit spreads widened a bit though they remain tight by historical measures. Emerging market debt faced pressure from the trade dispute, higher rates and a stronger U.S. dollar.
Actions in the last few weeks of the second quarter could have a sizable impact on markets in the final six months of 2018 and beyond.
In mid-June, the Federal Reserve raised short-term interest rates for the second time in 2018 and signaled that it may accelerate its monetary tightening – instead of one more rate bump before year-end, there could be two. As rationale, the Fed pointed to a strengthening U.S. economy and some early flickers of inflation.
Some market watchers have proclaimed a newfound hawkishness at the Fed, but such a view is justifiable only by the meek standards of the current tightening cycle.
Figure 2 below shows the Fed’s rate path during this monetary tightening cycle. Over the past 11 quarters, current short-term rates have meandered up from near zero to about 2%. Compare that gradual climb to the steep moves in the 1990s and early 2000s that lifted rates much faster and higher over the same number of quarters (in 1995, rates dipped briefly before rising again).
In our view, the difference between three and four rate hikes in 2018 is a minor issue for markets. More important for investors is that the Fed is working to be more transparent in order to reduce the occasional volatile guessing game about its intentions. The central bank has made clear that it intends to maintain a slow upward tempo on rates, and will tolerate inflation a bit above its 2% target rather than disrupt economic growth.
Markets should view the Fed’s stance of measured rate hikes as a positive. After nearly 10 years of expansion and with sub-4% unemployment, we are likely in a later stage of the economic cycle where some caution on rates isn’t a bad idea. Furthermore, moving too quickly on rates could add more strength to the U.S. dollar (+6% in the second quarter), to the detriment of American exporters.
Non-U.S. developed and emerging economies experienced a slight dip in their growth trend in the first half of 2018, but the outlook is solid for the year as a whole and 2019 (Figure 3). The rough patch in the euro area, for instance, appears to be due to short-term capacity constraints when demand picked up in 2017.
We think Europe will eventually be able to resolve the capacity issues, but decided to reduce our exposure until we see more improvement. We are more optimistic on emerging markets, which have been disproportionately punished due to trade debates. China specifically is intentionally slowing growth in a healthy way in order to manage excess supply and environmental concerns.
There are a couple of other variables in play that could pose headwinds for the global economy and asset markets in the months ahead.
The first is a large-scale trade war, the likelihood of which increased in late June when the White House pushed broader sanctions against China and Beijing promised to retaliate. While the trade-related rhetoric has been sharp, actions so far have been limited – this suggests we may actually be witnessing sharp-elbowed negotiations that end short of an all-out trade war, which would almost certainly hurt all parties.
Another big variable is the price of oil, where inadequate output concerns caused by supplier issues in Venezuela and sanctions against Iran led to oil prices hitting levels last seen in 2014. If oil rises much higher, it could put pressure on consumers and slow down the global growth trend that’s fueling new demand.
In the second quarter, USAA Managed Portfolios (UMP) revised tactical allocations to include U.S. stocks in order to reduce exposure to trade wars, but held on to some emerging market stocks as the risk/reward balance is still advantageous. These allocations are based on momentum trends, as well as a qualitative assessment of fundamentals, valuations and macro conditions.
2Q portfolio performance for UMP was helped most by positive results posted by U.S. large- and small-cap stocks. Our exposure to overseas equities, hindered by a rising U.S. dollar and slower GDP growth, detracted from performance during the quarter. Fixed income finished largely flat for the period despite interest-rate volatility, though our allocation did provide some downside protection when trade-related market turbulence occurred.
Our key themes:
U.S. EQUITIES: Expectations for Standard & Poor’s 500 earnings and revenue growth were buoyant coming into 2018, and they have steadily climbed from there. The consensus full-year forecast is now 20% earnings growth and close to 8% revenue growth. Share prices have also been supported by widening profit margins. These factors have contributed to the bull market for stocks extending into a 10th year. Small-cap shares have been helped by federal tax cuts and trade-war rumblings, and could appreciate more if global commerce is impeded.
EMERGING MARKETS: After a stellar 2017, emerging market stocks have struggled in the first half of 2018. In the short term, EMs are exposed to negative impacts from trade barriers and higher commodity prices, and they also face a considerable threat if the U.S. dollar continues to gain strength. The longer-term story is better – we believe EMs offer more attractive relative valuations compared to developed markets, along with strong earnings growth potential and a longer runway given their earlier stage in the economic cycle.
U.S. CORPORATE BONDS: With the various uncertainties now facing the global economy and asset markets, we believe it’s appropriate to play a little defense by taking some risk off the table. We like short-term, investment-grade credit for both its diversification benefits and the yield pick-up compared to Treasuries with similar maturities. While short-term corporate bonds cannot match the safety of Treasuries, they have a track record of generating higher returns with only slightly more volatility and have less price sensitivity to higher interest rates.
As always, our suggestion to members is to remain focused on the long-term investment plan that you have put so much thought into. For those USAA Managed Portfolio shareholders who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.