The Markets This Week

by Connor Darrell, Head of Investments
As was anticipated by markets, the Federal Reserve increased interest rates last week and officially removed the word “accommodative” from its description of current monetary policy. While parsing words can be trivial, the Fed selects its language very carefully when crafting its statements, and the change represents a symbolic shift in how the Fed views the current rate environment. The days of “easy money” policies are now officially behind us.

Global equity markets were slightly negative in the final week of the third quarter, with U.S. markets pulling back slightly from the all-time highs achieved the week prior. Investors’ attention will now turn to Q3 earnings season, which officially kicks off next week. Factset is currently predicting Q3 earnings growth of 19.3% for S&P 500 companies, which would mark the third highest growth rate since the first quarter of 2011.

The Markets This Week

by Connor Darrell, Head of Investments
U.S. large cap stocks reached new all-time highs last week as both the Dow Jones Industrial Average and the S&P 500 managed to climb above their January peaks. Financial stocks led the way due to an increase in longer-term bond yields, which bodes well for bank margins. It was also a nice bounce back week for international stocks, with both developed and emerging markets equities climbing well over 2%.

Bonds produced modestly negative returns as the yield curve steepened considerably. The yield on a 10-year U.S. Treasury bond now stands at 3.07%, and the Federal Reserve is widely expected to increase interest rates following its meeting this Wednesday. Bond yields could continue creeping higher depending on Chairman Jerome Powell’s post meeting comments on future policy decisions.

Watching Only the S&P 500 Doesn’t Provide a Complete Picture
The S&P 500 is up more than 11% in 2018, climbing higher as a result of a healthy economic backdrop. However, after leading the way in what was a strong 2017 global equity market, foreign markets have struggled to keep pace in 2018. Emerging markets have been troubled by a strong dollar and some major uncertainty in some regions (Brazil, Argentina, and Turkey have been the main culprits), and developed markets have also struggled as economic growth has cooled in Europe.

Investors who (prudently) own a broadly diversified global portfolio may feel somewhat disappointed in their returns thus far this year, especially if they are using the S&P 500 as their benchmark (which we don’t recommend). But it is good to remember why diversification is so important, especially as U.S. equity markets are near all-time highs. An allocation to international stocks was additive to returns in 2017, and while that leadership was short-lived, it is impossible to predict when the pendulum will swing back the other way again. We don’t know when the next crisis will occur, but we can be virtually certain that it will eventually happen. As investors, the best thing we can do is own a variety of uncorrelated assets with positive expected return over our investment horizon.

The Markets This Week

by Connor Darrell, Head of Investments
Equity markets around the globe managed to climb higher last week as they recovered from a difficult start to the month. The constant strategic pivoting in the trade negotiations between the U.S. and its global trading partners (particularly China) has been the primary catalyst for markets over the course of 2018, and we expect this to remain the case at least until the mid-term elections in November. For better or for worse, polling data may begin to influence the aggressiveness of President Trump’s negotiating tactics as he strives to rally voters and keep the Republican majority in the legislative branch. In the meantime, investors will need to keep focusing on fundamentals and accept that daily headlines may foster a particularly “noisy” few weeks.

August inflation data indicated that prices rose 2.7% year over year, marking the first month in 2018 where the rate of inflation cooled. The Federal Reserve’s next policy meeting is next week, and markets are expecting another 0.25% interest rate hike.

Monetary Policy Primer
With the Federal Reserve meeting again next week, we thought it might be a useful exercise to discuss the basics of monetary policy and the role of the central bank in monitoring/influencing the economy.

As the U.S. economy emerged from the depths of the financial crisis, the Federal Reserve implemented multiple rounds of an aggressive monetary policy initiative known as quantitative easing (QE). At its core, QE involves actively purchasing bonds on the open market while simultaneously lowering the short-term interest rate in the economy.  Both actions work together to keep interest rates on all maturities artificially low. The theory is that lower interest rates make it more palatable for businesses to borrow money and invest in growth opportunities, stimulating the economy. Ten years later, rates are still very low in historical terms, and the U.S. stock market has benefitted from the decade of “easy money” policies. However, as the economy heats up and evidence mounts that it can stand on its own footing, the Federal Reserve must now unwind its actions and begin pushing the economy to a more “normal” state.

The influence of the central bank has certainly expanded during the 21st century, and QE was in many ways an experimental policy. Never in history had central banks implemented such a bold and large-scale policy initiative aimed at actively combating a recession. So far, with the U.S. economy looking quite healthy, it appears to have been a success. But it should be noted that we have not yet seen this play out in its entirety, and only time will tell whether the policy was optimally implemented. The one thing that seems certain however, is that it helped to support the U.S. stock market over the past 10 years. Following the 2008 recession, the U.S. stock market took only four years to recover and reach its previous highs. This is in stark contrast to the recovery following the Great Depression, when it took more than 10 years, plus the organic stimulus of a world war, to finally reach the previous market peak.

The Markets This Week

by Connor Darrell, Head of Investments
Stocks trended lower last week with U.S.-China trade tensions again taking the blame for the market’s weakness. Friday brought news that the U.S. economy added a higher than expected 201,000 jobs in August, causing interest rates to jump higher amid speculation that the Fed would be more likely to keep its current pace of rate hikes. Internationally, the uncertainty surrounding global trade has made it difficult for companies to make investment decisions and has weighed on stocks. International stock markets (in both developed and emerging countries) were down close to 3%.

Preparing for the Next Storm
With many on the eastern seaboard bracing for the impacts of Hurricane Florence, it seems appropriate to evaluate what investors can be doing to prepare their portfolios for the next storm in financial markets. In the tenth year of a healthy bull market, the action plan for many investors should simply be to rebalance and re-evaluate their changing goals. A global investor who has remained disciplined throughout the last 10 years is likely to now be overweight stocks relative to bonds, and overweight U.S. equities relative to international equities simply as a result of how market returns have been distributed over that time. As a result, that same portfolio is likely to contain more risk (as a result of the higher allocation to stocks) than it did 10 years ago despite the investor being 10 years closer to retirement (which would typically call for a more conservative portfolio). As bond yields continue to creep higher, the rebalancing required to bring a portfolio back to its target allocation is likely to become easier to stomach since the relative income from bonds will be more favorable.

The Markets This Week

by Connor Darrell, Head of Investments
Trading activity was expectedly below average last week, as many investors were more likely focusing on the upcoming holiday weekend than on the limited new developments in global markets. With Q2 earnings season finally winding down, trade policy once again took back the spotlight. Stocks reacted positively to improving relations between the U.S. and Mexico, but some of the positive momentum was lost on Friday when it became clear that Canada was not ready to take part in any new trade agreements.

The S&P 500 managed to climb about 1% on the week, with international markets positive as well. The bond market was largely flat.

A Note on “Short-Termism”
There is an argument gaining traction that investors are too “short-term” focused, which leads to inefficient decision making at the executive level in response to shareholder demands that do not align with a long-term view of value creation. This argument is the essence of why Elon Musk made headlines earlier this month, claiming he desired to take the company private to avoid the incessant demands heavy scrutiny of public shareholders. It is also the core of a new bill being proposed in Washington aimed at taking power from shareholders and giving it to employees and the government.

Ironically, Tesla itself is a perfect example of shareholders not falling into the trap of “short-termism.” Tesla currently reports losses on its income statements on a regular basis due to its heavy investment in new technologies. In other words, Tesla doesn’t actually make any money because it invests all of its revenues back into research and development. However, the market values Tesla at about $13 billion dollars, more than it does Ford and about equal to General Motors, both of which have a much larger foothold on the automobile marketplace and are considerably more profitable. The reason that markets value Tesla so highly is precisely because there is an expectation that down the road, Tesla will be more profitable than both Ford and GM. Shareholders and the investment community at large do a tremendous job of taking a long-term view, and serve a pivotal role in keeping corporate decision makers accountable for properly running their respective businesses.

The Markets This Week

by Connor Darrell, Head of Investments
The stock market continued to brush off the ever-growing list of political headlines on its way to another positive week. The S&P 500 climbed 0.88%, while international stocks bounced back from a turbulent month, posting strong gains as well. Last week also brought further flattening of the yield curve, with the yield on the 30-Year Treasury dropping below 3%.

On Wednesday 8/22, the current bull market officially became the longest on record, which prompted a litany of columns and conversations dedicated to trying to hypothesize when it will finally come to an end. However, the age of a bull market really has no predictive value in determining whether or not it can endure, and we continue to instruct clients to focus on the core foundations of the economy (including the “heat map”), which continue to suggest that a general aura of optimism is justified.

It Still Makes Sense to be Globally Diversified
It is no secret that international equities have underperformed their U.S. counterparts in 2018, and the volatility has caused some investors to question the merits of holding a globally diversified equity portfolio. While much of the uncertainty has been due to a weakening macro backdrop in Europe (as well as the currency crisis in Turkey), it should be noted that sector concentrations have also played a part. The S&P 500 has been bolstered by the performance of fast growing technology stocks, which have outperformed by a substantial margin in comparison to the overall market. The MSCI EAFE (a commonly followed benchmark of international stocks) on the other hand, has not benefitted from the same tailwinds due to its different sector/industry weightings (see chart right).

As this has played out over the past several years, the valuation “gap” between U.S. and international equities has expanded to its widest margin in more than 15 years (see chart below).

Valuations are a notoriously ineffective market timing mechanism but have been historically very helpful in predicting long-term variations in relative performance across markets. It will be interesting to watch this dynamic moving forward, as the U.S. inches closer and closer to the theoretical “inflection point”, where monetary policy tightens enough to become a meaningful headwind to market expansion. Internationally, Central Banks are significantly behind in their tightening cycles, and are only just beginning to contemplate adjusting the “easy money” policies of the last decade.

The Markets This Week

by Connor Darrell, Head of Investments
Despite a bumpy ride mid-week, U.S. stocks managed to push higher on the heels of a strong Thursday rally. Globally, markets remained jumpy amid a softening economic growth outlook and lingering concerns over instability in the Turkish financial system.

While foreign economies have struggled to gain momentum, the U.S. has been able to break the barrier and establish a more sustained period of economic strength. With two solid quarters of GDP growth behind us, many investors are looking for insights into whether that growth momentum can be carried further; and for how long. One potential window was opened last week with reports of strong retail sales growth (+0.5%), which was further demonstrated in Walmart’s quarterly earnings release. The country’s largest “brick and mortar” retailer posted its best sales growth in over a decade, suggesting that the U.S. consumer is still in a strong position to help keep the momentum going.

Strong Momentum Can Shift Expectations
While the strength of the U.S. economy should help to alleviate any concerns that the next recession will occur in the near future, it doesn’t preclude us from experiencing periods of market weakness in the meantime. We have discussed in the past that the global investment landscape looks quite a bit different now than it did a year or so ago, and that there are more risks that threaten to bubble up and cause disruption in markets. The currency crisis in Turkey is but one example of the types of obstacles markets may face as they continue to scrape higher.

But another potential “obstacle” is the shifting of investor expectations. Markets are naturally forward-looking instruments, in that the price of any given security is determined by the aggregate of investors’ expectations of its future growth opportunities. As companies continue to post strong profit numbers and investors keep hearing about how great the economy is, the natural result will be for them to raise their expectations of future performance. And it is at the point where expectations meet reality that markets can become a little unstable. Often, markets react more to relative changes than to whether something is “good” or “bad” on a standalone basis. In other words, the U.S. economy may remain “strong” but if it fails to keep pace with rising expectations, the market may not react as positively as might be expected. As the U.S. economy keeps humming along, investors may run the risk of setting their expectations too high and would be well advised to maintain a more balanced, pragmatic approach to portfolio construction.

The Markets This Week

by Connor Darrell, Head of Investments
Economic turmoil in Turkey weighed down markets last week, as the nation’s leadership has come under criticism for failing to properly manage its growing debt burden and plummeting currency. There are now increasing concerns that Turkey’s financial instability could lead to higher default rates on loans from European banks, which could have ripple effects throughout global markets. Turkey’s problems were exacerbated by escalating diplomatic and economic tensions with the United States, which have led to threats of further retaliatory action in response to Turkey’s detainment of a U.S. pastor on charges of espionage.

The uncertainty led to a selloff in the S&P 500 on Friday that erased the week’s gains. International markets were hit a bit harder.  Elsewhere, the U.S. bond market pushed higher as investors sought the relative safety of U.S. Treasuries.

Turkish Turmoil Worth Watching, But Long-Term Impacts Negligible
The fears of “contagion” emanating from the turmoil in Turkey have been brewing for several months now, but are ultimately unlikely to have a lasting, meaningful impact on the U.S. economy. The primary concern from a global perspective is that Turkish borrowers will find it much more difficult to repay their debts as the currency continues to decline. However, the reality is that while some pain could certainly be felt by rising default rates in Turkey, the Turkish economy is not large enough for an isolated crisis to have a sustained impact on a global scale. Turkish stocks make up only about 0.7% of a market cap weighted Emerging Markets Index, which is itself only a small fraction of global equity markets. U.S. investors are thus very unlikely to have meaningful exposure to Turkish assets (if any at all). There is an old market adage suggesting that “when the U.S. sneezes, the world catches a cold.” Fortunately, the adage does not apply to the Turkish economy.

The problems in Turkey do however serve as a reminder of the importance of sound economic policy. Many economists believe that the Turkish government should bare much of the blame for its current predicament, as it has exerted pressure on the nation’s central bank to prevent it from raising interest rates; a move that many believe could help to stave off inflation and stabilize the currency. The role that central banks now play in maintaining global financial stability has grown considerably over the past decade or so and is particularly relevant here in the United States as the Federal Reserve moves forward with its tightening process.

The Markets This Week

by Connor Darrell, Head of Investments
A relatively quiet week in terms of market returns was highlighted by a major milestone in market history. On Thursday, Apple became the first company ever to achieve a market valuation of $1 trillion. The story of Apple’s rise from a startup company headquartered in its founder’s garage to $1 trillion tech behemoth is one of the greatest narratives in the history of capitalism, and that story understandably dominated headlines. But more pertinent to everyday investors, the U.S. economy added 157,000 new jobs in July and the unemployment rate ticked back down below 4%. Wage growth, which has been closely watched by the Federal Reserve, remained subdued.

International equities (as measured by the MSCI EAFE index) traded down 1.45% for the week, while U.S. equity markets (as measured by the S&P 500) produced a 0.8% gain. Interest rates moved higher to start the week, with the 10-year treasury briefly pushing back above 3% on Wednesday before dropping lower and finishing the week largely unchanged.

Mega Cap Stocks Dominate the Index
Apple’s trillion-dollar milestone highlights another phenomenon that we have discussed in the past; that the world’s largest companies have an outsized impact on index returns. In the first 6 months of 2018, the top 5 largest companies in the S&P 500 contributed over 80% of the index’s 2.7% gain. Indexing is a popular and low cost means of capturing market returns, but as the biggest companies continue to get bigger, index investors would be well served by reviewing the concentrations that exist within their index of choice. The strongest argument in favor of indexing stems from how notoriously difficult it is for stock pickers to consistently beat the market.  There exists a natural and inexpensive means of achieving diversification within an index fund, and by purchasing a fund that tracks the index, an investor is not exposed to the risks of choosing the wrong stocks. However, as the biggest companies continue to capture a larger share of market cap weighted indexes, that diversification benefit begins to fade.

The Markets This Week

by Connor Darrell, Head of Investments
Markets (and politicians) were given reason to cheer on Friday as the first (of three) Q2 GDP estimate(s) showed a 4.1% annualized rate of economic growth, closely in line with expectations. U.S. equities (as measured by the S&P 500) moved slightly higher on the week but underperformed their international counterparts which benefitted from an apparent easing of trade tensions between the U.S. and the European Union. Bond yields inched higher, and the 10-year treasury is now close to re-testing the psychologically important 3% mark.

More than 50% of S&P 500 companies have now reported Q2 earnings, and while there have been some high-profile disappointments (Facebook, Exxon Mobil), Factset is reporting a blended earnings growth rate of 21.3%. We expect strong earnings growth to continue for the rest of 2018, as the benefit of tax reform continues to inflate year over year comparisons.

Breaking Down GDP
Four percent GDP growth is an excellent headline number and is the highest year over year growth rate in U.S. GDP since 2014. Under the hood, the key drivers of increased growth in Q2 were American consumers, who bounced back strongly following a disappointing first quarter that was likely impacted by bad weather. All data seems to suggest that consumption (the largest component of GDP measurement) is quite healthy. And while not a component of GDP, M&A activity in 2018 is at an all-time high as businesses are digging into their deeper pockets to make strategic acquisitions. That businesses (who typically take a long-term, forward-looking view when making decisions) are willing to take risks in executing mergers and acquisitions is a positive sign for the U.S. economy.

Looking forward however, there are reasons to expect GDP growth to return to more modest levels. Late in the economic cycle and with unemployment already at very low levels, it is unlikely that consumer spending will be able to continue leading growth forward for a lot longer. Additionally, rising housing prices and higher mortgage rates are likely to begin eating into housing demand. All told, the U.S. economy is one of the healthiest in the developed world, but it is unlikely that we have ushered in a new era of explosive economic growth.