Stock markets here in the U.S. are traditionally pretty quiet over the summertime. The kids are out of school, the weather is hot, and many financial managers, traders, and practitioners prefer to spend their time on vacation or in the pool.
But like many industries, finance is changing rapidly today, and traditions are being upheld less frequently. This summer, while the markets have more or less adhered to the summertime lull tradition, the financial news has not. Among other topics of note, we have:
- New tariffs on imports here in the U.S., and escalating trade tensions as a result;
- Unceasing & fresh political headlines, and;
- A tightening monetary policy by the Federal Reserve Bank here in the U.S.
In response to all this, markets here in the U.S. haven't blinked. (Or maybe they haven't opened their eyes yet). Volatility continues to be extremely low compared to the last 25 years of returns data. And that includes the returns of bonds and foreign currencies too, not just stocks.
Nevertheless, even if the market doesn't feel that all this news is worth rolling over for, it's important for us to keep an eye on what's going on. Read on for our quarterly update on the global capital markets.
There are a lot of concerns being tossed around in the media about global trade. President Trump has announced tariffs on steel and aluminum, which has domestic companies that rely on these imports scrambling. GM, for example, just announced that they've revised their earnings guidance downward as a result.
The court of public opinion here is very negative. The argument is valid: tariffs are a very protectionist move by Mr. Trump, and one that could significantly harm our economy long term. If our trading partners respond with tariffs of their own, we could continue to volley back and forth, with more and more new taxes on each others' imports.
That said, we need to consider these tariffs in context. I'm all for free and open trade, but our tariff levels here in the U.S. are actually a fraction of our trading partners'. (Check out this post I wrote recently for more background). Put another way, we're taxing goods imported from our friends abroad at far lower rates than they're imposing on imports of ours.
On top of this, I think the risk that tariffs stifle our economic growth significantly is being overblown. At their current levels, total new tariffs represent a very small sliver of our aggregate output as a country. Paraphrasing Vanguard's Chief Global Economist Joseph Davis, import taxes would need to rise significantly in order to be a real threat.
Despite all the focus on escalating trade wars, U.S. market returns were pretty strong in Q2. The Russell 3000 Broad Market Index gained 3.89% on the quarter. What's interesting to me is that growth continues to outperform value. This is contrary to long term data (value tends to do better over longer periods of time), but typical during the later stages of an economic cycle.
Looking at the data, large cap growth gained 5.76% on the quarter, outpacing large cap value's return of 1.18%. Pointing back to the news, this is mainly driven by five massive FAANG stocks:
These four companies make up for about 10% of the S&P 500, and have contributed virtually all the return thus far in the year. At the end of June, the S&P 500 was up 2.6% on the year thus far. Without the FAANG stocks, it would have be negative.
I'm not convinced that this concentration of large corporations presents any new risks to investors. Every bull market has its leaders. The one thing I'd suggest we keep in mind is that over longer time periods (15+ years), value shares do tend to outperform growth. While we can't predict what will happen in the future, don't ditch value stocks because you feel like you're missing out on easy FAANG returns. It won't happen forever.
Elsewhere on the economic front, the Atlanta Fed's forecast for second quarter GDP growth was 4.5% annually. This is very high. And according to the Job Openings and Labor Turnover Survey, the number of available jobs across the country is actually greater than the number of people unemployed. This is the first time that's happened since the data began being collected in 2001. There are caveats here of course (unemployment numbers don't account for discouraged workers, and wage levels are not rising), but that's quite a significant milestone.
Corporate earnings for the second quarter have also come in strong, or at least those that have been reported thus far. From this, one metric that's somewhat useful to track is the "beat rate". Publicly traded companies are required to give earnings estimates, based on their outlook on the economy and their own company. While there is an incentive to sand bag a forecast (executives are often paid more when they exceed expectations), the portion of companies beating their second quarter earnings thus far is 86%. This is also pretty high. Beat rate doesn't always correlate to massive stock gains, but is loose confirmation that the economy is strong and the business environment is generally good.
Looking ahead, all eyes will be on global trade and how rapidly the Federal Reserve Bank decides to raise interest rates. As rates climb, financing costs increase for individuals and companies alike. This tends to dampen corporate earnings and pump the brakes of the business cycle. Decelerating at the appropriate pace is the line that's so challenging to walk successfully.
Equities in developed markets delivered positive returns in their local currencies in the second quarter. But, thanks to a strengthening dollar, returns from developed international markets were actually negative in U.S. dollar terms.
Looking back at last year, developed markets across the world soared, as there was a consistent effort toward unified global growth. Since then there's been more dissonance, which has many investors doubting the global economy's momentum.
A great example of that is how different countries are handling their returns to more normal monetary policies since the financial crisis. Here in the U.S. our economy is humming along pretty well, and the Fed is steadily raising interest rates accordingly. Conversely, the European Central Bank and Bank of Japan are both standing pat on their regimes of ultra-low interest rates.
This makes sense for them, of course. Economic data in both areas is not as strong as what we're seeing here in the U.S. Nevertheless the diverging trends signal less harmonization, and that gives investors pause.
Within the Eurozone, we're also seeing countries struggle to cohere from a political standpoint. If you recall, Italy had a major election back in March. In December of 2017, Italy's president, Sergio Mattarella, essentially dissolved its parliament. The election in March was to establish a new government, which was mandated with creating economic policies and managing the country's relationship with the EU (which is not particularly warm & fuzzy).
The European Union would like to reduce Italy's high debt levels through austerity measures in order to increase stability and competitiveness across the entire Eurozone. Italy's new parliament did not exactly endorse the idea of austerity measures. The group of legislators collectively saw this as a foreigner intruding on their right to spend money, and the rebuke has increased tensions between Italy and other members of the EU. Unsurprisingly, this is a pretty similar situation to what we saw with Greece 8 years ago.
To sum this up, individual countries will always do what they think is right for their own people. While we saw individual countries and regions come together and strive for global growth with unified policies last year, everyone seems to be going their separate way in thus far in 2018. America, of course, is leading the charge in that regard.
Emerging Market Stocks
In the less developed emerging economies, equities fell 8% on the quarter overall. And like sectors here in the U.S. and in more developed international economies, growth outperformed value shares.
This is the sharpest quarterly decline for the asset class we've seen in nearly three years, and it can be attributed to a few different factors:
- Rising global trade tensions
- A strengthening dollar
- Rising U.S. interest rates
The emerging markets are particularly susceptible to fluctuations in the U.S. dollar and rising interest rates. As the world's reserve currency, emerging economies (both governments and companies) tend to borrow U.S. dollars, as it's often easier to obtain financing from lenders around the world. When the dollar appreciates relative to the country's home currency, that makes interest and principal payments more expensive. According to Harding Loevner, in Q2 currency movements accounted for over half of the MSCI Emerging Markets Index's decline.
Drilling down to individual countries, there are some growth concerns coming out of China and Brazil. In China, the government is beginning to clamp down on unregulated lending (AKA "shadow banking"). The fear is that additional restrictions on credit make it more difficult to obtain financing, which tends to inhibit economic growth. And, of course, there are looming international trade pressure building from President Trump's tariff regime.
The story in Brazil also comes down to currency fluctuations, after a 13% plummet in the Brazilian real relative to the U.S. dollar. Brazil is Latin America's largest economy. As oil prices have risen over the last 18 months (and the Brazilian real has declined), local diesel prices have skyrocketed there. In protest, a group of truckers decided to strike and block major roadways for 10 days in May.
The strike and ensuing blockage basically paralyzed the Brazilian economy over the 10 day period. Brazil's president, Michel Temer ended up agreeing to fuel subsidies in order to appease the truckers. While this ended the strike and got Brazil's economy moving again, it raised questions about the government's commitment to fiscal reform and responsibility, adding fuel to Brazil's bad quarter. All in all, Brazil's stock market was down 26% on the quarter relative to the U.S. dollar.
Despite the Fed's trend of interest rate increases with the steadily improving economy, there is concern from several officials (according the minutes of recent meetings) that trade disputes could slow corporate activity and stall the need for future hikes. But even if global trade does slow aggregate GDP growth, inflation has crept back into the picture. Regardless of how the economy is doing, the Fed will be forced to raise rates if that continues. Remember - the primary mandate of the Federal Reserve is to promote the stability of the U.S. dollar. They can't let inflation run out of control.
Looking at the yield curve, the yield on ten-year treasury bonds has risen from a low of 1.35% in mid-2016 to a recent high of 3.12%. Yes, the Federal Reserve will probably continue raising short term rates, but longer term bond yields may be peaking. Looking at the graph below, the difference between short term and long term bond yields is at it's lowest amount in ten years. This is also known as a "flat" yield curve, and is typical in the later stages of business cycles.
While short term interest rates are set by the Federal Reserve, long term rates are more reflective of the market's longer term economic outlook. A flat yield curve suggests that investors are becoming more concerned about our growth outlook and rising inflation risks. This is all congruent with what we're seeing and reading in the media.
While short term rates will probably continue to climb, long term rates appear to be heading in the opposite direction. An inverted yield curve, where long term interest rates are actually lower than short term interest rates, is not at all unlikely.