The months ahead promise investors a challenging balance of rewards and risks. In September, U.S. markets are poised to set the record for the longest bull market in history after another quarter of tax reform aided earnings growth. Tax reform benefits could be increasingly challenged as trade tensions weigh on business confidence. The Fed is looking beyond headline risks such as a flattening yield curve with two more rate hikes likely in 2018. Anticipated midterm election outcomes remain a close call. In this edition of Market Monthly we consider all these items and focus on what to expect for the rest of 2018.
Yield Curve Flattening/Inversion
Frequent chatter calling for predictions of an inverted yield curve and corresponding 2020 recession are overhyped. Inverted yield curves do not cause recessions, but they are often symptomatic of an overly aggressive Fed. This is not yet the case. In fact, rates remain low enough and fiscal policy remains loose enough that financial conditions remain easy, not tight. While it would be a mistake to dismiss concerns about a flattening yield curve as a sign of future trouble, it would also be a mistake to overlay flat yield curves of the past over today’s economic environment and forecast a recession.
The chart below illustrates that historically, when 10- and 2-year Treasury notes offer equivalent yields that recessions (in gray) have often followed within 12 months.
Takeaway: The greater near-term risk is not yield curve inversion, but rising long bond yields. Fed rate projections may be too steep out to 2020, but bond market pricing may be too pessimistic given underlying economic strength. A flat yield curve with meaningfully higher credit spreads would sound the alarms, but not yet.
Trade, a “Rising Chorus of Concern”: Fed chairman Jerome Powell characterized the recent escalation of trade rhetoric as a “rising chorus of concern” in his recent testimony before the Senate Banking Committee on July 18. These conclusions were likely drawn from the recent Federal Reserve Beige Book released on the same day. The “Fed Beige Book” is a “boots on the ground” analysis that takes the pulse of U.S. business decision-makers in each of the Fed’s 12 regions. The most recent report on business conditions cites:
- Concerns about trade policy
- Expanding manufacturing in all 12 districts
- Tight labor conditions across many sectors with moderate wage inflation
- Growth in consumer spending
- Rising input and raw material prices beginning to shrink profit margins
Takeaway: The Fed’s path toward “normalization” marches on with supporting economic results. The markets will tell us when the Fed crosses the line of normalization into perceived tightening territory, which is at least two hikes away. Odds for September and December rate hikes now stand at 89% and 63% respectively.
U.S. and China trade talks remain at a standstill with new potential tariffs kicking in on Aug. 31. Recent talks between the U.S. and Europe have been productive but inconclusive. NAFTA remains the highest near-term probability for a trade win for President Trump. Potential trade wins in Europe and NAFTA are leverage points for Chinese negotiations.
The U.S. has targeted Chinese tariffs in those areas that impede successful implementation of China’s “Made in China 2025” initiative. A goal of this initiative is for China’s industry to become independent or even lead in areas of technology, automation, transportation, aerospace, health care and agriculture. The U.S. would like to slow that progress. The chart below shows those broad categories most impacted by U.S. tariffs on Chinese goods. Intermediate goods (manufacturing inputs) represent almost half of the targeted tariffs.
Takeaway: In a nutshell, the U.S. seeks to broadly open China’s markets whereas China seeks to expand its current base. China represents just 8% of U.S. exports whereas the U.S. represents 18% of Chinese exports. If tariffs are fully implemented, winners and losers will quickly emerge.
Washington: The Midterms Are Coming!
Midterm elections have historically low voter turnout. Voter enthusiasm will be a lightning rod and renewed volatility could rear its ugly head. As the chart below shows, recent polling in a generic ballot of Democrats and Republicans give Democrats a seven-point lead. As always, political predictions are highly entertaining but inherently unreliable.
The chart below offers average monthly S&P 500 returns for every midterm election since 1962. With only midterm election history as a guide, it suggests markets perform better once there is more clarity around an election outcome.
Takeaway: As October approaches, we will see competition heat up with the U.S. House up for grabs. Key Senate races in states like Florida, Arizona, Tennessee, Nevada and Indiana could make Nov. 6 a very long night regardless of party affiliation between close races and seats flipping. Market impact should be kept in check.
Second quarter S&P 500 earnings season is nearing completion with another outstanding quarter underway. Below are a few highlights with context.
- 21.3% year-over-year earnings growth and 9% revenue growth
- 83% are beating their earnings estimates/73% are beating their sales estimates
- All 11 S&P 500 sectors are reporting year-over-year earnings and revenue growth
- 44% of companies have cited tariffs in their earnings announcement. Of those:
- 61% say tariffs are having no impact on results
- 27% have seen a negative impact while others are concerned about future impact
- Tax reform accounts for 2/3 of incremental earnings growth
- S&P 500 profit margins at 11.6% a cycle high
Takeaway: These results highlight broad-based participation. The thrust from tax reform will continue to fade in subsequent quarters leaving organic earnings growth expectations in the 7%-9% range. Prolonged trade tensions pose a threat to profit margins for large U.S. multinationals who sell abroad and U.S. manufacturers who depend on international supply chain inputs for production. This is where the first warning signs of earnings downgrades will be found.
Market and Earnings Breadth Send Mixed Signals
Amazon and Microsoft combined for 27% of the year-to-date (YTD) S&P 500 return. The top 10 performing stocks in the S&P 500 have accounted for 62% of the S&P 500 YTD return and comprise 18% of the market cap of the entire index. Such narrow market breadth has historically signaled a warning. Fundamentals continue to be supported by broad-based earnings growth we highlighted in the previous section yet the median stock in the S&P 500 remains roughly 5% below its 52-week high. YTD Index performance has been driven by these top-10 performers shown below.
Takeaway: Continued strength in economic and earnings results combined with easing trade tensions could increase market breadth for a healthier S&P 500 advance by year-end. Confidence eroding trade tensions and continued narrow market breadth remain primary market risks.
Facebook Getting a Facelift
In 2017, Standard & Poors and MSCI index providers undertook an effort to reclassify companies according to where they derived their primary revenue source. Effective Sept. 28, the old Telecom sector is being retired in favor of the newly created Communications Services sector that encompasses Telecom, Media, Entertainment and Interactive Media and Services. Facebook, Google, Twitter are moving from the Technology Sector to the newly created Communication Services Sector. Netflix, Disney and Comcast are three of the larger Consumer Discretionary stocks being reclassified into the new Communications Services sector. AT&T and Verizon will be the other major components.
The chart below reflects the anticipated changes for the three impacted sectors and represent little more than a change of address within the S&P sector schematic. Below are implications from the change:
- Sector exchange-traded funds (ETFs) managed by State Street and Vanguard will rebalance automatically, but investors who own Tech ETFs may no longer own Google or Facebook in those portfolios
- Google and Facebook will represent 47% of the Communication Services sector market cap
- Active fund managers must reevaluate their preferred sectors for any impacted holdings
- Broad Index ETFs will self-adjust
- Lines of distinction between value and growth styles will become even more blurred
Takeaway: This was the right move at the right time and is a more accurate classification system that is not expected to have meaningful market implications. Lumping Google, Facebook, Disney and Netflix in the same sector as AT&T and Verizon is very new dynamic for sector investors.
Our earlier discussion of a flattening yield curve has direct implications for bond positioning. In this flattening yield curve environment, investors are not being compensated to place money into long-term bonds. Our base case continues to call for a year-end 10-year note of 3.25% supported by sustained economic growth and a resolute Fed. Between now and the end of the year, interest rates on 10- and 2-year Treasury notes may very well follow a parallel path rising equally. In 2019, spreads may tighten even further but not invert without disinflation or significant gross domestic product contraction. The current case may best be compared to 1998 when 10-2 spreads threatened to flatten and then muddled through the next year and a half.
For now, bond investors would be best suited to keep it simple. Credit spreads are more likely to widen than shrink. The yield curve is not expected to adequately reward investors to extend the maturity of their bond portfolio. This leaves a high quality short-duration portfolio as a relatively safer destination. Soft inflation data would threaten this outlook.
The chart below highlights performance for stocks, bonds and nonfinancial assets through July 31, 2018. Stocks continue to be led by U.S. growth and small-cap companies. Bonds continue to be led by short-term T-Bills that are less interest rate sensitive, high yield and municipals. International stocks (developed and emerging) have been negatively impacted by the modest appreciation in the U.S. dollar. A recent uptick in global economic strength and new Chinese fiscal stimulus could add second half support to international stocks.
August officially ties the mark for longest bull market on record set back in the dot-com era at 113 months. But bull markets don’t just die of old age.
Rising echoes calling yield-curve inversions and resulting recessions in 2020 have been overdone while recent GDP growth of 4.1% and earnings growth of over 20% remain unsung heroes. We don’t dismiss potential risks; however, we can’t deny that late cycle recoveries have historically rewarded investors who stand their ground. The age old trick is how to reconcile between these concerns about risk and reward. We suggest a three-step approach to asset allocation.
Step 1: Rebalance
Portfolio rebalancing is a regular and routine way to work with your portfolio manager to objectively reevaluate your current investment objectives and rebalance your portfolio in any market environment. This is ongoing.
Step 2: Reduce Market Risk Within Your Existing Asset Allocation
Your objectives may remain the same but sometimes market conditions do not. Under some scenarios with rising risks, it may be best to maintain your asset allocation objectives tactically adjusting risk within that objective. For example, reducing bond portfolio durations or becoming more defensive within existing equity allocations is one way to remain committed to your objectives but with less market sensitivity.
Step 3: Tactically Reduce Risk of Your Asset Allocation
During times of high conviction market stress, modestly reducing exposure to riskier asset classes and reallocating to lower risk asset classes can help reduce portfolio drawdowns. Knee-jerk reactions to market volatility are ill advised, but market or personal circumstances sometimes warrant that capital preservation takes on an elevated short-term role.
Active asset allocation remains the primary tool to manage portfolio risk in any market environment in an opportunistic way. Current economic strength and corporate performance suggests investors stick to their current plan to invest and rebalance. As we inch closer to 2019, it may be more appropriate to move to Step 2 as the cycle matures.
- Modestly rising yields toward 3.25% on 10-year Notes remain our base case
- Yield curve flattening likely to persist with no near-term case for inversion
- Monetary policy is tighter but not tight, two more hikes in 2018
- Trade tensions beginning to impact sentiment
- Watch Q3, Q4 earnings for tariff-related downgrades
- Midterm elections promise tight races with seats to be flipped
- Organic earnings growth of 7%-9% to persist into 2019
- S&P sector reclassification may effect dialogues but not portfolios
- Widening market breadth is necessary for U.S. stocks to break trading ranges
- Earnings and sales results remain robust through 2018 with help from tax cuts
- Asset allocation gains importance as risks rise
This piece is produced by BB&T’s Wealth Portfolio Management Team.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.