Following a period of elevated volatility earlier in the year, the second quarter saw the market return to a much more stable and positive pattern, with each month posting a positive return. However, despite the positive returns, the year-to-date gain of 2.7% for the S&P 500 falls well short of the 9.3% gain for the first half of last year.
The most significant factor affecting the market this year has been numerous policy announcements relating to tariffs and trade restrictions. The U.S. has proposed changes against some of our largest international trading partners. In most cases the countries affected (China, Canada, Mexico, etc.) have responded in kind, with their own retaliatory tariffs and trade restrictions. Economists estimate the potential economic impact of these proposed tariffs on U.S. GDP growth could range from -0.1% to -1.8% over the next two years. Additionally, many of the proposed tariffs are expected to lead to higher prices for consumers and reduced international trade. Given that the most recent measure of U.S. GDP growth was 2.0%, the effects of the proposed tariffs could range from fairly benign to severe, depending on how trade negotiations develop in the coming months.
The threat of a “trade war” has had far reaching consequences. Notably, international stocks have fallen this year following a very strong performance last year. The MSCI EAFE, which measures international stocks for developed countries, has slipped –2.4% this year, compared to a 25.6% gain for 2017. Emerging markets stocks have performed even worse, falling –6.5% this year, compared to a 31.0% gain last year. Additionally, the U.S. dollar has strengthened, causing foreign investments held by U.S. investors to become less valuable when denominated in U.S. dollars.
However, despite the distraction of ongoing international trade disputes, the U.S. economy continues to push ahead, helped a great deal by the tax legislation which was passed at the end of 2017. According to economists, U.S. GDP is expected to grow by as much as 2%-3% over the next two years. Wall street analysts expect corporate earnings to grow by more than 25% this year, which is largely attributable to lower corporate tax rates. Unemployment has fallen to a multi-decade low of 4.0% with an estimated 1.3 million jobs added so far this year. There have been concerns that inflation may begin to accelerate, but the most recent CPI reading was up only 2.9%, which remains well below the long-term average of 4.0%. To most economists, the U.S. economy remains strong and is likely to continue to grow.
The Federal Reserve has added to investor anxiety by raising their benchmark Fed Funds rate twice this year to a target of 1.75%- 2.0%. The rate increases have impacted short-term interest rates as the 2-Year T-Bill rate has increased to 2.5% from 1.9% at the beginning of the year. The benchmark 10-Year Treasury Bond rate has also risen to 2.8% versus 2.4% at the end of 2017. With short-term rates rising faster than long-term rates, there has been an increased focus on the yield curve, which is the difference between the 10-Year Treasury rate and the 2-Year T-Bill rate. The yield curve currently stands at 0.3%, versus 0.5% at the beginning of the year. If the yield curve continues to drop, it could become inverted, a scenario where short-term rates are higher than long-term rates. Historically, an inverted yield curve has been a reliable indicator that an economic recession may be approaching.
In addition to the effects on the yield curve mentioned above, rising interest rates have also negatively impacted bond prices, with the Bloomberg Barclays Aggregate Bond Index declining -1.6% so far this year. Expectations are that interest rates will continue to climb this year and beyond, causing many investors to question whether or not they should be invested in the bond market. But, a bad year in the bond market is not nearly as damaging as a bad year in the stock market. For example, since 1975 the bond market, as measured by the Bloomberg Barclays Aggregate, has not declined more than –2.9% in a single year, and there has not been an instance of back-to-back annual declines.
In recent months, an increasing number of market observers have raised concerns that a recession may be on the horizon. There is a growing sense of disbelief that the economy can continue to grow as it has for the past nine years, especially with growing trade tensions and rising interest rates. Much of the recent acceleration in the economy has been attributable to the stimulus provided by the yearend tax reform legislation. The immediate benefits of the tax cuts are expected to run their course by mid-2019. From there, many expect economic growth could slow down. But a deceleration does not necessarily result in a recession, and in most cases, a recession does not create a downturn as severe as the 2008-09 financial crisis.
Temporary setbacks (or even recessions) should be expected along the way, and your portfolio should be positioned in a manner that supports your long-term goals and objectives, regardless of short-term economic developments. Given the mounting concerns of trade wars, rising interest rates, flattening yield curves, and the possibility of a recession, investors have become increasingly anxious. While all of these concerns are worth our attention, we believe that the U.S. economy remains strong and can continue to grow for at least the next year or two. Under any conditions, it is important to remain well diversified and remember that investing is a long-term proposition.
Thank you very much for your continued confidence in our service and advice. If you would like to discuss our opinions, outlook, or your portfolio in greater detail, we would be happy to schedule a meeting or a conference call at your convenience. Lastly, don’t keep us a secret. If you know someone who would like help planning for their financial future, we will be pleased to speak with them to see if we can assist.
Horizon Advisors is a Houston based fee-only wealth management firm. Horizon is a fiduciary advisor. We specialize in helping successful individuals and families understand, organize, and manage their often complex financial situations. Horizon offers integrated financial planning and investment management services.