Quarterly Letter – Second Quarter 2018

The first half of 2018 has sure given investors plenty to digest as market watchers begin to look beyond the impact of tax reform and positive economic conditions to wonder what might be next for the economy and markets.  From our vantage point, we still see plenty of reasons for optimism in the near-term, but there are also mounting concerns on several fronts that bridle our sentiment.  For sure, the economy continues to gallop along, showing little sign of fatigue.  However, this momentum isn’t fully translating into greater market returns as investors assess the gathering clouds of a trade war and ongoing interest rate hikes by the Federal Reserve.

As investors grappled with a number of positive and not-so-positive factors, US equity markets were volatile, but generally moved higher.  The S&P 500 exited the quarter at 2,718, managing to generate a respectable return of 3.43%.  Following a slight negative return in the prior quarter, this places the index at a year-to-date return of 2.65%.  In the US, large-cap stocks were impacted by concerns over mounting tariffs while small-cap stocks, which generate a lesser share of revenue outside the US, were far less impacted.  The Russell 2000 index gained a healthy 7.75% during the second quarter and lifting already above-average valuations in this area of the market.  Another notable trend so far this year has been the strong outperformance of growth stocks relative to value stocks, not an unusual occurrence in the later stages of an economic expansion.  We continue to believe the prospect for positive equity market returns in 2018 may be decided by a tug-of-war between favorable economic conditions and rising corporate profits versus the headwinds of widening trade tariffs, various political risks and rising interest rates. So far, the tit-for-tat trade actions have impacted less than 0.5% of GDP (based on announced tariffs relating to $80B of imported goods) and appear to be more about posturing. However, we’ll see how far policy makers are willing to go and note that tariffs and trade wars are often, at best, a zero sum game.

A rising US dollar combined with trade rhetoric held back international and emerging markets in the second quarter.  The MSCI EAFE index closed down -1.24% and the MSCI Emerging Markets index fell -7.96%. These negative returns mask global economic growth that is largely gaining momentum with approximately 70% of countries in the MSCI ACWI (All Country World Index) experiencing GDP above their long­term averages. Compared to the protracted economic cycle here in the US, one of the longest running expansions since 1900, the cyclical upturns seen outside of the US are in earlier stages and still enjoy supportive monetary policies. As inflation and interest rates tick higher here at home, we continue to have a positive outlook regarding international developed and emerging markets, which sport cheaper relative valuations, supportive monetary policies, and rising growth rates. Of course, these positive features could lose much of their luster if global markets become ensnared in protectionism and an expanding trade war.

Percolating inflation and a strong jobs market are giving the Federal Reserve ample clearance to continue hiking interest rates and the Fed delivered its second quarter-point rate hike of the year in June.  Short-term rates and yields have been most impacted by these moves with intermediate-term and long-term rates impacted to a lesser degree. This has resulted in a flattening yield curve and reflects market expectations that a rising interest rate environment may be unlikely to persist beyond a few years.  The 10-year treasury rate was essentially flat, ending that quarter at 2.85% compared to 2.74% at the end of March.  Bonds also experienced generally flat returns in this period as the Barclays US Intermediate Government/Credit index gained 0.01%.  The yield spread between low grade and investment grade corporate bonds remained narrow, indicating investor acceptance of greater credit risk for only a nominal pickup in yield. This is poor tradeoff, in our view, and we are generally avoiding low grade corporate bond exposure in this environment. We’re expecting the Fed Reserve to hike rates at least one more time this year.

Well, the short answer to that question is a simple ‘yes’, but timing is a whole other matter. History has shown the markets and economy to be very dynamic and vexingly difficult to predict.  Consensus opinions often turn out to be wrong.  Our outlook is informed by monitoring a variety of diverse measures related to the economy, which we interpret in the context of how these factors tend to interrelate historically.  Based on our assessment, we believe a recession within the next 6-12 months is quite unlikely. Currently, the economy is enjoying very low unemployment, increasing wage growth, and the tailwind of tax reform that is enlarging corporate, and to a lesser extent, individual coffers. However, we are observing two emerging risks; inflation and protectionism, which have the potential to disrupt investment markets in the near-term and trigger economic weakness in the longer-term.  Until this year, inflation has been largely subdued, but now appears to be on a steady climb, finally moving above 2%, as measured by the consumer price index (CPI).  In isolation, moderate inflation isn’t necessarily problematic for the economy; however, if protectionist trade policies result in a large scale trade war, the combined effect has the potential to dampen consumer spending and corporate earnings. This risk is heightened in an environment where monetary policy is being restricted and corporate debt levels are rising. We still expect the U.S. economy to grow between 2.5% to 3.0% this year, up from approximately 2.5% GDP growth in 2017. Though our economic expansion is aging, it may yet endure for several years to come.  Will higher inflation, rising interest rates and the impact of global trade restrictions be enough to catalyze an economic reversal?  Only time will tell, but it’s something we’re watching closely and expect equity markets could grapple with these issues in the months ahead.

We remain optimistic that investors can experience positive returns in 2018 while also mindful of the various policy risks and economic factors that may pressure markets as the year unfolds.  Regardless of short-term market conditions, we stress the importance of taking a long-term, disciplined approach based on your personal risk tolerance and planning objectives.  It’s also important that investors set aside the cash needed to fund their near-term living expenses. This is a particularly important concept for retirees and near-retirees that are currently, or soon will be, withdrawing from portfolios to fund their lifestyle.  With a disciplined investment process in place, we believe individual investors are well served to tune out the noise and take a long-term perspective.  We believe this approach affords the means of enjoying what we have today while preserving financial independence for the future.

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Confluence Wealth Management, LLC is a registered investment adviser with the United States Securities and Exchange Commission (SEC). Registration of an investment advisor does not imply any level of skill or training. As a registered investment advisor, Confluence Wealth Management is not engaged in the practice of law or tax preparation. As such, you are encouraged to consult with a CPA or tax professional about your individual situation prior to implementing any tax related strategies. See All Disclosures