Q3 2018 Smooth Sailing
Q3 2018 - Smooth Sailing?
The third quarter came and went without much to be disappointed about as most of the major U.S. indices finished positively. The market yawned at the tariff fight between the U.S. and China and didn't seem to have any interest in the Washington squabble regarding the nomination of Brett Kavanaugh. The S&P 500 returned +7.71% for the quarter and is higher by +10.56% YTD which is impressive given the geopolitical backdrop. The technology heavy NASDAQ enjoyed a +7.14% quarterly return and continues to remain a fan favorite as the obsession with the FANG names continue. Technology, consumer discretionary and healthcare are largely responsible for the market performance this year with many other sectors failing to participate. On the economic front, employment data released for the quarter was strong with the unemployment rate staying comfortably below 4.0% with all indicators pointing to higher wage data in the coming months. Manufacturing, GDP revisions and services data released in September also validated the strong economic environment. Investors are gearing up for third quarter earnings season which unofficially opens the week of October 15th. Expectations are for 19% earnings growth year over year which is down from the 24% growth rate in the first two quarters this year but remains strong enough to justify market levels. The drama in the quarter came primarily from overseas markets as Turkey found itself behind the curve in protecting the country from a currency crisis and inflation surge. Italy presented a budget that put the nation's deficit at 2.4% of GDP causing Italian bond yields to spike higher. Consequently, this has put pressure on foreign markets and raises concerns of European Bank exposure.
So far, these issues seem to be contained within these countries' respective borders, but investors nonetheless remain on guard. On top of the political news abroad, the U.S. dollar strengthened putting pressure on Emerging Markets and foreign investment from a U.S. investor perspective. Dollar denominated debt in emerging nations has suddenly become more expensive to pay down pressuring those regions. Finally, the tariff fight with China has put the Chinese market indices into a bear market provoking the Chinese government to implement countermeasures such as letting the Chinese currency drift lower and reducing the bank reserve ratio to stimulate lending. The MSCI EAFE index was modestly positive returning +1.35% for the quarter and Emerging Markets was down -1.09% on the quarter.
With interest rates on the rise there is no question that the world has gotten a little more expensive than just a year ago. The 10-year treasury ended the quarter at 3.05% moving 65 basis points, or 0.65% higher, since 12/31/2017. The yield curve remains uncomfortably flat with the two and 10-year yield difference at about 25 basis points. Market observers will be watching carefully to see how the FED balances future rate hikes while attempting to avoid a yield curve inversion. Foreign bonds, on average, are down YTD while the Barclays Aggregate Bond Index is down -1.60% YTD. High Yield remains a lone bright spot in fixed income returning +2.57% YTD according to the Barclays High Yield index. Short-duration fixed income has been the best performing fixed income segment in traditional U.S. fixed income. The upside bias on rates should persist into 2019 and we continue to recommend a short-duration position in bonds until there is further clarity on when the rising rate campaign will conclude.
THOUGHTS ON ASSET ALLOCATION
There will be no shortage of news as we enter the final quarter of 2018. As we write, the markets have briskly sold off as interest rates are starting to attract more attention causing market participants to rethink the "growth" area of the market. To put this pullback into perspective, the S&P 500 has been up six months in a row, so we are not surprised to see a brief correction or pause. Since the first interest rate hike of this cycle in December 2015, markets have been slowly transitioning from a liquidity driven market to more of a fundamental driven market and it is understandable that turbulence will happen along the way. Several positives remain such as 4.0% + GDP, multi-year highs in manufacturing and services sectors and positive employment trends. These trends have not shown any sign of buckling near term, so we believe the uptrend is still in place. We are eager for the third quarter earnings season to get started to reveal clues on the state of corporate America. Our Investment Committee will soon begin discussions related to our 2019 positioning. The following meetings will be dedicated to thoroughly reviewing our international exposure and domestic strategies to explore possible adjustments for 2019. Important themes we are focused on include additional rate hikes and bond market reaction, margin compression due to higher input costs (higher rates and tariffs), currency direction and corporate earnings. We remain confident that we have the managers to guide our client portfolios through any market environment. Included below are investment managers that experienced solid quarterly performance within their mandate vs. their respective benchmarks.