Countervailing forces created plenty of volatility in the second quarter, as investors veered from applauding the strength of the US economy to bemoaning the threat of heightened trade conflicts. US equities (S&P 500) posted a gain of 3.3% in the quarter but remain more than 5% below the high set in late January. Yields on the bellwether 10-year US Treasury bond rose from 2.74% at the start of quarter to a high of 3.12%, only to fall back to 2.86% at quarter-end. For the first half of 2018, the S&P 500 returned 2.7%, while the broad bond market index1 posted a negative return of -1.6%.
Surging earnings growth from US corporations, stemming in part from tax reform, had investors reducing their international holdings in favor of domestic assets in 2018’s first half. The MSCI EAFE Index of developed international equities slipped 2.7% in the first half of this year while emerging market equities (MSCI EM) fell 6.7%. The strong US economy, coupled with high relative interest rates (versus foreign government bonds) led to increased demand for US assets and a 5% rally in the value of the US dollar during the quarter. A strong dollar exacerbates the losses for domestic investors in international markets, and makes it harder for foreign borrowers to repay their dollar-denominated debts.
Oil prices continued their steady march upward. US crude was priced at just over $74 per barrel at the end of June, up from $59 at the start of the year. Strong global economic growth and OPEC-induced production quotas fueled the price rise, despite increasing production from US sources. The US is producing more oil today than it did in 2008 – with half the number of operating rigs. Higher oil prices operate as a tax on consumers and businesses, offsetting some of the benefits of the lower tax rates enacted at the start of the year.
Outlook and Strategy
With the expansion entering its tenth year and already the second longest in US history, investors are becoming increasingly concerned about when the next recession will start. Yet economic growth has been accelerating over the last several quarters, and few economists foresee any significant clouds on the immediate horizon. We agree and expect economic growth to remain solid for at least the next four quarters. With equity valuation levels at or below long-term averages in most regions, the outlook for risk assets (such as stocks) remains positive.
Beyond that, we see two important risks to the medium-term outlook. One is the waning influence of the stimulus from recent tax reform. Since the substantial cuts in tax rates were not accompanied by commensurate spending reductions, only a dramatic increase in sustained economic growth will prevent a large increase in the federal debt. Indeed, the Congressional Budget Office forecasts an increase in the federal debt as a percentage of GDP to rise from 76.5% in 2017 to 96.2% in 2027. Larger deficits will likely lead to higher interest rates and cutbacks in federal spending, as more federal dollars are shifted toward interest expense.
The other medium-term concern is the Federal Reserve’s efforts to prevent the economy from overheating by raising short-term interest rates and trimming its balance sheet. The Fed’s official long-run US real GDP forecast is only 1.8% and the US is running substantially above that now. As a result, expect the Fed to continue to steadily raise the federal funds rate over the next several quarters in order to constrain inflation around its 2% target. At the same time, the Fed is unwinding its massive holdings of Treasury bonds accumulated during its Quantitative Easing (QE) period. The absence of a large buyer on the bond market like the Fed is likely to put further upward pressure on rates. Eventually, higher rates will crimp demand and entice investors to shift holdings from stocks into bonds.
In the near term, the escalating rhetoric over trade policy between the US and its trading partners threatens to raise costs for consumers, postpone important investment decisions, and disrupt longstanding supply chains and business relationships. As of this writing, conditions appear to be deteriorating, but we remain hopeful that negotiations will end favorably.
Although the onset of the next recession is nearly impossible to predict, its inevitability is a near certainty. In our view, however, the next recession in the US is likely to be far milder than the last two and the commensurate impact to asset prices likely to be much less. The slow and steady US expansion of the last nine years has prevented the normal excesses that would typically accumulate during a faster expansion. Rather than fear its arrival, we encourage investors to remain broadly diversified across a range of asset classes that will respond differently in the next downturn.
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