Through the first half of the year, US stocks are mostly positive and are easily outpacing their international counterparts. This is a reversal of last year’s trend, which saw international and emerging markets outperform the US by a fairly wide margin. Part of the reason for this year’s divergence has been a stronger US dollar, which tends to favor domestic-focused small companies and hurt emerging market economies. Since it is unclear if the dollar will be able to continue its recent run against other currencies, and since many areas outside the US are at more attractive valuations, we continue to prefer global diversification.
Perhaps the biggest theme for investors so far in 2018 has been the return of volatility. Over a period of about nine weeks, the S&P 500 declined 10% from its peak in late January. By historical standards, this was a perfectly normal correction. But the response from many investors was to run for the hills. In February alone, investors pulled over $26 billion from US equity funds – the largest monthly withdrawal since the depths of the Financial Crisis. Perhaps they forgot that temporary corrections (defined as a 10% decline from recent highs) are a normal part of the investing landscape. Or perhaps 2017’s fabulous 20% return with hardly any downside caused them to believe in a “new normal”. In either case, they likely missed the market’s quick recovery. As of this writing, the S&P 500 is less than 1% away from all-time highs and stands positive for the year. (This speaks to a fundamental belief that you’ll hear often going forward: the primary determinant of investment success is investor behavior).
On the economy, things are pretty good. Industrial production is at an all-time high, as are corporate revenues and earnings. Household net worth is at a record high, consumers are less leveraged than they’ve been in decades, and confidence remains elevated. Second quarter GDP growth was 4.2%, the highest pace in nearly four years. Given that we are coming off of a very strong quarter, I find it surprising to see so much talk from the financial media about recessions. These discussions are typically centered on the shape of the yield curve—the difference between short-term rates and long-term rates—as the shape of the yield curve is considered to be an indicator of future economic activity. While the spread has narrowed to a level not seen in years, it shouldn’t distract us from the fact that many leading economic indicators are trending higher. Take truck tonnage for example. Trucks carry 70% of the freight in this country, so when demand falls off it’s usually a harbinger of slowing growth. But truck tonnage is up almost 8% this year to an all-time high. This is not recessionary. Fears of an impending recession seem quite unfounded at this time.
While there are a lot of bright spots in the economy and markets, there are still a number of persistent headwinds. Chief among them would be the possibility of a deepening trade war with China and other nations. Although there is no resolution yet to the US/China trade dispute, the market is showing some resilience in the face of the headlines, and for good reason. While China is our largest trading partner, total exports to China account for less than 1% of our economy. So if all of China stopped buying US goods in retaliation to our tariffs, it wouldn’t throw us into an economic tailspin, although some industries would suffer (grains, soybeans, aircraft manufacturers). No economist in their right mind would advocate for tariffs. I certainly don’t. But if the Trump administration succeeds in getting other nations to lower or drop their tariffs, then perhaps Trump is a better deal maker than first assumed. As long as the result is more open markets and freer trade, the near-term costs may be justified. But much remains to be seen.
On an administrative note, our long-term allocations have not changed meaningfully since last quarter, so aside from managing cash flow activity, clients should not expect to see major changes. If you have questions or comments, please let us hear from you.
Ashley Vice, CFA, CFP®
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