US equities continued their steady rise in the third quarter of 2018, further distancing themselves from equity markets in other parts of the world. The substantial reduction in corporate tax rates enacted at the start of the year is paying big dividends in the form of sharply higher earnings growth from US companies. Year-on-year earnings growth is running north of 20% this year, and this trend is expected to continue for the remainder of 2018. Beyond the tax cuts, stock prices are being supported by strong revenue growth, modest inflation, and high levels of consumer and business confidence. The S&P 500 rose 7.7% in the third quarter, bringing its 2018 return to 10.6%.
Overseas, the story is different. In Europe, investors remain concerned about sluggish economic growth, the final structure of the Brexit deal, and the new Italian government’s plans to expand the welfare state by dramatically increasing federal spending. The MSCI EAFE Index of developed international stocks rose 1.4% in the quarter, but is down by 1% year-to date.
Emerging market equities have been under severe pressure in 2018, weighed down by the new tariffs imposed on US imports, the strong US dollar, and persistent (yet so far unfounded) concerns about an economic collapse in China. Notwithstanding all the celebrations about consecutive quarters of US GDP growth above 4%, China’s growth rate remains about 50% higher than the US. The MSCI Emerging Markets Index posted only a small loss in Q3, but the index is down 7.5% in 2018, with many Asian-focused funds performing substantially worse.
The Federal Reserve’s gradual but steady lifting of short-term interest rates has increased income yields, but has depressed returns in the bond market this year. (Returns include both the effect of income and price change on bonds). Broad measures of investment grade US fixed income securities declined anywhere from ½ to 2 percent so far this year, while lower-quality bonds posted modest positive returns. Floating-rate funds, largely immune from price declines stemming from higher rates, delivered gains from 2 to 4 percent year-to-date. Municipal bonds were essentially flat, as income receipts offset higher rates. Other interest-sensitive sectors such as real estate also struggled in the face of higher rates, but firming oil prices helped energy partnerships recover some of the steep losses experienced in 2017.
Outlook and Strategy
The consistent pattern of higher US equity prices through the first three quarters of 2018 was dramatically punctured in the first week of October. Investors finally acknowledged the high valuations of the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), the apparent lack of progress on China-US trade talks, and the recent sharp rise in interest rates by decisively marking down equities during a two-day selloff in early October. The panic selling drove the S&P 500 down by nearly 5 percent; other equity markets fell, but the losses were less severe. Bond prices rose, but not nearly as much as expected in a typical “flight-to-quality” rotation.
While it would be tempting to cite this recent turbulence as the beginning of the end of the nine-year upward trajectory of US stock prices, the fundamentals argue for a different conclusion. As noted earlier, earnings growth is exceptionally strong, and while the pace is expected to slow in 2019, gains of approximately 10 percent over 2018 remain the consensus forecast. US economic growth should continue at an above-average pace through at least the first two quarters of 2019, when the stimulus effects of tax reform and increased federal spending start to wear off. The recent pullback has sliced the S&P 500’s year-to-date return to approximately 5% and has reduced the price/earnings ratio to attractive levels.
Most of the danger to equity prices in coming quarters is likely to be self-inflicted. The first is a continued or escalating trade war with our major trading partners. So far, markets seem to be concluding that the economic damage arising from a protracted trade war is likely to be more severe among those countries that rely on exports to the US rather than the reverse. However, the threat of a 25 percent tariff on most Chinese imports on January 1 is likely to directly impact the competitiveness of US companies that rely on manufacturing or assembly in China (e.g. technology). A successful compromise should result in a strong rally in Asian stocks.
Another trend to be mindful of is the upward pressure on interest rates. The Fed is predicted to move toward “normalization” of the fed funds rate to approximately 3.50-3.75% versus the current 2.0-2.25%. Their goal is to foster stable growth and maximum employment while keeping inflation under control; threading the needle in this way without sending the economy into a tailspin is no easy job. The expanding federal deficit, up 32% in the first 11 months of fiscal 2018 vs. the prior year, should continue to rise as a result of recent tax reform and increased federal spending. More federal borrowing puts upward pressure on interest rates, slowing the economy and drawing money out of stocks.
We turned more cautious on US stocks earlier in the year as these negative forces were gaining strength. Still, US stocks powered higher. We believe we are approaching an inflection point in which international stocks (in particular, emerging market stocks) are likely to reassert their leadership role over the US. We are attracted by low valuations, low expectations, forecasts for a weaker dollar, and a possible resolution of the trade negotiations that have negatively impacted stock prices all year. The upward pressure on interest rates should keep fixed income returns muted, but valuable as a hedge in the event that the global economy encounters unexpected headwinds. Real assets, valued for their inflation-protection attributes, should continue to play a role in a diversified portfolio.
Learn more about our Director of Research, Bruce Simon.
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