As has been our firm tradition, we would like to present our 2018 Mid-Year Review. We are pleased to share our thoughts and insights with our clients and friends. After more than 9 years into a bull market, it is important to reflect on where we’ve been, the current state of the economy and where we are heading.

Where We’ve Been
With the S&P 500 delivering more than a 300% total return from its lows in March 2009, investors have left “the lost decade” in the dust. The U.S. is now the envy of the developed world, more than doubling the return of the EAFE Index (Europe, Australasia, and Far East Index, an international developed market index excluding the United States and Canada) over this same period.

This strong performance by the U.S. has been driven by a return to low unemployment, mild inflation and strong, broad-based earnings growth. Unemployment has hit multi-decade lows, reaching 3.8% in May, with strong initial jobless claims implying employment trends will remain positive for the remainder of the year.

This improvement in unemployment levels has benefitted Gross Domestic Product (GDP, a measure of an economy’s total output) growth rates since 2009, when unemployment peaked. With the economy now nearing what most economists would consider full employment, it is likely we can expect a slower growth rate and an increased risk of inflationary pressures going forward. Risks to growth are balanced, with lower corporate tax rates expanding earnings, helping to offset increased risks of disruption due to tariffs and tightening monetary policy from the Fed. We expect strong earnings growth through the remainder of the year from tax reform but believe much of this benefit is already reflected in prices.

Year-to-date the S&P 500 is up 2.7% (through 6/29/18). These results have been led by strong performance from the Information Technology and Consumer Discretionary sectors, with interest rate sensitive sectors such as Real Estate and Consumer Staples lagging. Growth-oriented companies have continued their outperformance in 2018 with the Russell 1000 Growth Index up 7.3% YTD relative to the Russell 1000 Value Index, which is down -1.7% for the year.

After years of steady gains, investors were caught flat-footed early in 2018 with the S&P pulling back over 10% from all-time highs, before making back the bulk of these gains. This return of choppier markets and increased volatility brings us more in line with normal market conditions, with the Vix Index (“Fear Index”) returning from record lows in 2017 back toward its historical averages for the first half of 2018.

After a prolonged period of record low interest rates, we are now 3 years into normalization by the Federal Reserve. These slow and steady increases in interest rates have been a headwind for bond investors, with the Barclays U.S. Aggregate index down -1.5% for the year.

Because of modest levels of inflation and low unemployment, the Fed is expected to continue its measured pace of interest rate increases over the next few years, with these actions expected to continue to be a headwind to bond returns. As a silver lining, these actions have brought interest rates comfortably above inflation, allowing fixed income to return to its traditional role in a portfolio: producing income and stabilizing a portfolio during adverse market conditions.

Over the course of 2018 interest rates have increased by about 0.5% for short term treasury bills and 0.25% for longer dated treasury bonds, causing the yield curve to continue to flatten. A flat yield curve has several important impacts on portfolio construction. When short term bonds have comparable yields to longer dated bonds you can receive a similar return with less volatility by reducing the portfolio’s maturity. This action helps the portfolio perform better in a rising rate environment. Additionally, an inverted yield curve has been a reliable predictor of recessions, meaning a flattening yield curve is worth closely monitoring as its inversion can be useful as a forward-looking indicator.

While the Fed has been raising interest rates, the rest of the world has maintained a more accommodative monetary policy, which has caused the dollar to appreciate relative to other currencies. Dollar strength has caused international assets to broadly underperform, with emerging markets equities and bonds being particularly hard hit. Another notable market movement in 2018 has been oil. For the year WTI oil has increased 22.7%, with key OPEC members constraining supply, amid rising Middle Eastern geopolitical tensions.
International equities have lagged their U.S. counterparts, but despite short-term headwinds these assets have attractive fundamentals and have the potential to deliver attractive returns over a longer time-frame. GDP growth in emerging markets continues to outpace developed markets by a substantial margin. Forward expectations show emerging countries growing at 2.1% more over the next 12 months than their developed counterparts. Additionally, valuations in international and emerging markets are more attractive than U.S. valuations, with the US priced higher than most developed and emerging markets relative to forward earnings. Current cyclically adjusted price to earnings (CAPE) in emerging markets is 13.2, compared to 25 in the U.S., implying a nearly 3.5% higher future return expectation for emerging markets relative to U.S. equities over the next ten years.
We have trimmed our exposure to international markets due to near-term challenges but have maintained core exposure to these assets due to their long-term prospects.  Because of the long-term opportunities available and the low correlation to U.S. assets, international assets are an important piece of a diversified portfolio.

Where We Are: 2018 Themes Update

Continued Focus on Growth

Original Theme: “Tax reform in the U.S., coupled with a pick-up in capital expenditures may set the stage for an additional boost to economic output / activity in 2018.”

Update: Growth has continued unabated into 2018 with ~3% real GDP growth in the fourth quarter 2017 followed by 2.2% growth in the first quarter of 2018.  The $1.5 trillion dollars of income tax cuts should continue to benefit GDP growth going forward as it filters its way down into the economy as increased personal and business spending.  Offsetting this trend is the Federal Reserve’s tighter monetary policy and the risk of diminished international trade which could lower business investment and spending.

Keep an Eye on Inflation

Original Theme: “Tighter labor markets in the U.S. and other advanced economies are likely to lift wage growth and translate to a gradual inflation uplift.”

Update: U.S. Inflation has continued to increase throughout the year, with core consumer prices (core PCE) reaching as high as 2.0% in May 2018.  Tight labor markets could continue to push this number higher, although dollar strength has helped keep inflation from rising more.

With inflation reaching the Federal reserve’s target this is an important number to monitor as any increase or decrease in inflation could impact their policy decisions.  Higher than expected inflation would be a detriment to the fixed income portion of a portfolio, would have mixed results on equities, and would be advantageous to certain types of alternative assets such as real assets.

Expect the Unexpected

Original Theme: “Continued uncertainty surrounding North Korea, trading relationships, negotiations between the U.K. and E.U., and threats to scrap NAFTA could negatively impact markets and global growth.”

Update: 2018 has not disappointed. The Federal Government shutdown, spike in the volatility index, Federal Energy Regulatory Commission (FERC) surprise announcement regarding MLPs, trade wars and uncertainty in Italian markets after political disagreements are just a few headlines that have moved markets. We believe the majority of these events are transitory and are not likely to have a lasting effect on the market. However, they nonetheless create investor angst. We continue to comb through these events to identify elements that may change our forward outlook. As of this update, we see none to date.

Policy Divergence Ahead

Original Theme: “After a decade of unprecedented monetary stimulus, developed markets are expected to follow the U.S.’s lead and begin tightening monetary policies to varying degrees, setting the stage for potential volatility and opportunities across fixed income markets.”

Update: The U.S. has indeed continued its measured pace of interest rate increases and has reduced the size of its balance sheet, tightening monetary conditions while the rest of the world continues its accommodative monetary policy.  This tightening relative to the rest of the world has contributed to dollar strength, which is likely to persist if the U.S. continues to tighten.  Eventually global growth will necessitate that central banks outside the U.S. begin to tighten, or a slowdown would likely cause the U.S. to pause or reverse course.  Uncertainty as to future monetary policy in the U.S. and abroad has the potential to increase volatility, but diverging policies have already generated opportunities, with higher real fixed income returns in the U.S. compared to other developed markets.

International and Emerging Markets

Original Theme: “The global economy has been in a synchronized expansion, driving steady earnings growth in international and emerging markets. Despite recent gains, valuations continue to appear reasonable relative to more expensive domestic markets.”

Update: International and Emerging markets have underperformed U.S. equities in the first half of 2018, with U.S. dollar strength contributing to the decline in international assets.  Based on the potential for growth and relative valuations, investors stand to benefit from holding on to their international equities, however, we are not increasing allocations at this time. Potential continuation of U.S. dollar strength and trade tensions may lead to additional short-term volatility in these markets.

Risks

Despite markets generally benefitting from strong fundamentals, additional geopolitical and regulatory risks have surfaced this year.  These risks increase the potential range of outcomes for equities and could lead to a greater dispersion of returns across different countries and sectors.

Chief amongst these risks is that trade wars or other geopolitical disputes could derail global growth.  The U.S., looking to reduce its trade deficit, has worked to renegotiate trade agreements and impose new tariffs, with China often in the headlines but the Eurozone and other large trading partners also affected.  Europe has a similar risk of continued fragmentation with Italy becoming increasingly populist and Brexit negotiations still ongoing.

An increase in international trade barriers has the potential to slow the overall global growth rate and could cause additional supply chain disruptions over a shorter time-frame.  Although these tensions are worth monitoring, the complexity involved in reshaping these long-standing agreements means these developments are likely to play out over years, not months.  We believe investors will continue to be served by not focusing on the daily market fluctuations around these events as the market is likely to overreact to news items.

Outlook

We see continued steady growth in the U.S. and abroad due to positive economic conditions. Currently 7 of 10 Leading Economic Indicators (LEIs) are positive, implying further growth in the economy.

New orders for consumer goods and non-defense capital goods (2 components of the LEI Index) continued their positive trend, showing the economy has continued to strengthen. Strength in consumer spending is also supported by strong consumer expectations survey results and positive results in the leading credit index.
We remain positive on equities compared to fixed income, with a focus on the U.S. market due to its relatively strong fundamentals.  We remain overweight the Information Technology sector due to its attractive long-term growth prospects, strong fundamentals and reasonable valuations.  We also believe small and mid-cap equities are attractive due to their relative insulation from international markets and currencies, and their above average growth.

We see continued rate hikes pressuring bonds over the coming years.  We have responded to these continued pressures by reducing our overall exposure to fixed income and lessening the duration of our fixed income portfolio.  We have sought to allocate to segments of the fixed income market which tend to be less affected by a rising rate environment, such as floating rate, high yield and convertibles.  Additionally, we have increased exposure to alternative investments which serve as an additional source of diversification and potential return.

We thank you for placing your confidence in us as your most trusted wealth managers.  We look forward to continuing to work with you and your families to develop long-term planning and investment strategies for now and long into the future. Please contact us if you have any questions.

 

NEIRG is an investment advisor registered with the SEC. Registration with the SEC does not imply a certain level of skill or training. The information contained herein is based upon sources believed to be true and accurate, but no guarantee is made to the completeness and accuracy of this information. The content above does not represent a specific investment recommendation. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Past performance is not indicative of future results. NEIRG and its employees do not provide tax or legal advice. NEIRG maintains the necessary notice filings, registrations and licenses with all appropriate jurisdictions.