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.

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.

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.

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.

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.

by Connor Darrell, Head of Investments
U.S. equity markets finished roughly flat last week as Q2 earnings season kicked into full gear. Small cap stocks continued their recent leadership amid ongoing uncertainty over global trade. Small cap stocks tend to be more domestically focused than their large cap peers, and this has helped insulate them from some of the pressure felt by companies that rely on global commerce as a key revenue driver. International markets managed to creep higher in the aggregate but produced mixed results by region. European stocks have been troubled recently by some signs of slowing economic growth and uncertainty surrounding the ongoing Brexit negotiations.

In the bond market, interest rates ticked higher and the recent trend of curve flattening was bucked for the time being. The 10-year treasury now sits at about 2.89%, still well below the peak of 3.11% that it reached back in May. In an interview with CNBC last week, President Trump commented that he was “not happy about interest rates going up,” but it remains unlikely that the Federal Reserve (which operates independently of government) would adjust its policies based upon the president’s comments.  Part of the president’s concerns stem from the resulting rise in the U.S. dollar, which makes it relatively more expensive for foreign investors to allocate capital to U.S. based projects/companies.

Trump and the Fed
President Trump’s comments regarding the Fed’s interest rate policies caught the attention of some segments of the market but were not significant enough to cause any major disruption. In fact, it is unlikely that anything the president says about Fed policy will be material enough to meaningfully move markets because the Federal Reserve was created as an independent body, designed to function free of political interference.

This was not the first time President Trump has commented on the efficacy of the Fed’s policies, and it likely will not be the last, but we anticipate the Fed to continue its interest rate increases for as long as the economic data suggests that it is prudent.

by Connor Darrell, Head of Investments
The last few weeks have finally brought some stability back to markets, with the S&P 500 now up 5.86% year to date. Q2 earnings season begins this week, and investors are expecting more strong growth in corporate profits amid a strong economic backdrop. On the bond side, yields remained relatively stable last week, though the trend of yield curve flattening remains firmly intact.

Now May Be a Great Time to Rebalance
Since emerging from the depths of the financial crisis in early 2009, the S&P 500 has produced a total return of over 360%. Disciplined investors who stuck through the turmoil of the great recession and were able to maintain exposure to equities have been richly rewarded for their patience. However, while the US economy remains on firm footing and the risk of recession in the near future remains relatively low, the next 10 years for investors are likely to look very different from the last 10 years. Investing is about achieving goals, and it is likely that the market’s strength over the past several years has put many investors ahead of schedule in terms of their long-term plan. Additionally, that strength in equity markets has likely pushed equity allocations toward the upper end of many investors’ target range, which can lead to a riskier portfolio. Nobody will ring a bell announcing when the current market cycle finally comes to an end, and the official “top” of the market may not be officially identified for quite some time after it occurs. But we can say with a reasonably high degree of confidence that we are much closer to the top than the bottom.

All of the above suggests that it may be prudent for investors to take a step back, evaluate their long-term asset allocation targets, and rebalance to ensure that their portfolio is properly tuned for the road ahead. 2018 has already presented investors with a number of new risks to consider and managing these risks will become increasingly difficult as the environment becomes less accommodating to the complacent investor.

by Connor Darrell, Head of Investments
Markets managed to climb higher during the abbreviated holiday week, bolstered by the June jobs report, which provided evidence of further strengthening of the U.S. labor market, but not quite enough to suggest the Federal Reserve would need to accelerate its policy tightening. Although the official unemployment rate pushed back up to 4%, the U.S. economy added another 213,000 jobs in June and the increase was due primarily to higher labor force participation (a higher percentage of the population is looking for employment). Wages, which are being watched closely by economists due to their logical connection to inflation, rose 2.7% from a year earlier.

Monetary Policy Update
While they pose challenges over the short term for both stock and bond investors, rising interest rates aren’t all bad. As a result of the Federal Reserve’s policy tightening, the yield on a one-year treasury bill is now roughly even with the core rate of inflation (core inflation removes more volatile energy and food prices from the measurement) for the first time since before the financial crisis. This is good news for savers, as it means that those invested in short-term treasuries are no longer “losing” out in real terms. This will be an interesting area of focus over the next 12-24 months, since inflation expectations are also heating up due to the low rate of unemployment and overall health of the US economy.

As rates rise, the opportunity to earn a higher yield on short-term bonds without increasing credit or interest rate risk will be a welcome change from recent years.

by Connor Darrell, Head of Investments
After a bumpy start to the week, markets ended the first half of the year on a high note, with financial stocks leading equity indices higher. The Federal Reserve’s annual stress tests revealed that banks appear to be on sound financial footing, and bank stocks rallied on the news. However, Friday’s rally could not erase losses from earlier in the week, as global equities traded lower amid ongoing trade tensions.

As geopolitics and trade have dominated headlines in recent months, U.S. small cap stocks have managed meaningful outperformance due to their more domestic focus. The Russell 2000, which measures the returns on a broad basket of US small cap stocks, has outperformed the S&P 500 by about 5% year-to-date.

Tech is Taking Over, and It’s Given the S&P 500 a Serious Boost
As technology has become an increasingly important part of our daily lives, it has also become an increasingly dominant influence of stock market returns. The S&P 500 currently has a total market capitalization of about $23 trillion, and technology stocks make up about 23% of that number. The index’s four largest constituents (Apple, Microsoft, Amazon, and Facebook) are all deeply entrenched in the tech community. Those four stocks make up over 12% of the index, up from 5.9% just five years ago. The rapid rise of the so-called “FAANG” stocks (which include Facebook, Amazon, and Apple along with Netflix and Google) has been a major driver of S&P 500 performance over the last several years.

The proliferation of passive investing in recent years has largely coincided with tech’s dominance, and it begs the question as to whether there are risks lurking beneath the surface. Portfolio managers often seek to minimize the risk that any one (or four) stock(s) dominate the risk profile of a portfolio. Historical data suggests that the average annualized volatility of a single stock is more than double that of a typical diversified equity portfolio.¹  As a result, portfolio managers will tend to underweight the largest stocks in an index in an attempt to more efficiently diversify risk across different stocks. As these tech giants have grown into tech behemoths, that underweight has been a difficult hurdle for stock pickers to overcome.

Passive investing provides a myriad of benefits to investors, including low fees, tax efficiency, and better discipline, but investors need to be aware of what’s in their index of choice. The significant boost that the S&P 500 has gotten from the successes of its largest constituents could just as easily go the other way if the market decides that valuations in those stocks have gotten too stretched.  [1] Source:  FactSet, Fidelity Investments (2017)

by Connor Darrell, Head of Investments
Global markets slid lower last week due in large part to ongoing global trade tensions.  Emerging markets stocks were hit hardest and are now down over 5% this year. On a rolling one-year basis however, they have still managed a return in excess of 10%.

Bond yields remained relatively stable, with the 10 Year Treasury still sitting at around 2.90%. The yield curve (which plots the yields of bonds of differing maturities along one line) continued its trend of flattening last week. The 10-2 Treasury Spread (measured as the difference in yields of the 10 Year and 2 Year Treasury Bond) now stands at just 0.33%, a 58% decline from just a year ago. Those in the business of trying to forecast market movements (a notoriously difficult, if not impossible proposition) typically watch the yield curve closely during the latter stages of an economic expansion, as an inversion of the curve has historically preceded a recession. An inversion of the curve occurs when the yield on longer term maturities drops below that of shorter term bonds.

The other major development in the US equity market last week was the removal of General Electric (GE) from the Dow Jones Industrial Average. GE was an original member of the oft quoted stock index but has fallen on hard times as its earnings and profitability have collapsed under the weight of its highly complex business model. GE has been replaced by Walgreens Boots Alliance, which contrary to its name is actually a retail pharmacy (of which you are likely familiar) and is not in the business of selling footwear. This was major news for markets in that GE has been a member of the DJIA for over 100 years. The fall from grace has been substantial for GE, which had the largest market capitalization of any company in the world as recently as 15 years ago.

Tariffs and Trade Wars Revisited
As a result of the Trump Administration’s hard stance on trade, it has been difficult to avoid discussing the potential implications of the policies that the US, China, and now the EU, Canada, and Mexico have been threatening each other with. The probability that rhetoric evolves into policy, and to what extent the policies under discussion change prior to implementation is extremely difficult to ascertain, and the market is having a difficult time making sense of everything as a result.  It is for this reason that we have not been able to point to one major market move while placing blame on trade tensions. Instead, we have experienced a number of smaller moves as the market reacted to the latest headlines. This is likely to continue until the market either has reason to focus on other news (strong Q2 GDP growth anyone?), or we get more clarity regarding what is a threat and what is likely to actually be implemented.

The only things we can say with confidence are the following:

• Tariffs are an inflationary force. Any time a tax is levied on a product, regardless of its nation of origin, the price of that product is likely to increase.  Rising prices are the definition of inflation.
• Tariffs will reduce global economic growth potential in the long run. Trade works because it creates a mutual benefit among the parties involved.  Goods and services are produced by those who can do so most efficiently.  Trade barriers create inefficiencies that lead to a sub-optimal allocation of resources in the global economy, which reduces growth in the long-term.

This is not intended to serve as a critique or endorsement of any political view. There are very real problems that need to be addressed in the way that countries do business with one another, and after all of the dust has settled, those of us with a stake in the success of the global economy may very well be better off. But our job as investors and asset allocators is to identify the key issues that can impact financial markets so that we may best position our portfolios to protect our hard-earned money. This often involves trying to gain an understanding of how economics and policy react with one another.