All In All, An Okay Quarter Despite Some Continued Choppiness

After an unnerving first quarter which saw a 10%+ correction, markets stabilized during the second quarter. That’s not to say there weren’t hiccups. Volatility is persisting at higher levels than experienced in 2017. The S&P 500 ended the second quarter positive by a few percentage points for the year (the Dow Jones finished down about a percent), while the aggregate bond market is down by just a little less. Add it all up, and markets are essentially flat for 2018. We understand this can be frustrating for investors, particularly when the back drop for equities looks to be a favorable one. Over the next few paragraphs we’ll discuss the reasons we believe there is caution in the air and our outlook for the back-half of the year.

It’s Hard To Find Fault With The Current US Economy

The US economy remains a workhorse despite sitting 108 months deep into an expansion, the second longest on record that could become the longest by next summer. Despite the expansion’s length all indicators on which we judge the economy appear healthy. Let’s start with jobs. Year-to-date the US has added almost 1.3 million jobs, or approximately 214,000 per month. This compares to ~182,000 per month in 2017 and ~192,000 per month since the financial crisis ended. So, when many have expected slowing, an acceleration has taken place. Consumer confidence sits near post-crisis highs while wage growth is improving. All this is materializing in the form of stronger corporate profits (which grew 20% in Q1) and GDP growth. First quarter GDP at +2.8% marked the highest level since mid-2015 and prominent forecasts call for second quarter to register a +3.9% gain.

Given this, an obvious question emerges: why is the stock market treading water if the economy and corporate profits are firing on all cylinders? In our view, there are two primary reasons: 1) fears over an international trade war and 2) the pending mid-term election. Let’s discuss both.

Trade Wars: Let’s Put Them In Context: Tariffs. The word de jure. It’s inescapable if you read or watch essentially any news or financial program. We’re going to try to address this from a pragmatic angle. To date, a grand total of $8.5 billion in tariffs have been implemented on China (25% x $34B). China retaliated in kind, bringing the total to $17 billion. This amounts to less than 0.1% of GDP. Or said another way, a trivial amount. The fear, of course, isn’t what’s been announced, but what could be in the offing. So, let’s look at the current worst-case scenario, which we estimate to be $120 billion of tariffs, or a 0.7% hit to GDP. That is more problematic, especially if business confidence wanes (not happening yet) and delays investments needed to boost productivity and restrain inflation. The $120 billion, however, is dwarfed by the $800 billion in fiscal stimulus recently passed. This almost 7:1 ratio (800/120) is worth keeping in mind.

Mid-Term Election Year Adding To Uncertainty: The other less talked about factor influencing markets are mid-term elections. Historically, the stock market struggles during the first 3 quarters of mid-term years with an average decline south of 6% before surging following the election. Why does this happen? The most logical explanation is that investors fear the possibility of different government policies. Once the election passes, regardless of outcome, markets tend to perform well. In short, removing the unknown is a positive. Going back to 1950, the S&P 500 has not declined once in the 12 months following a mid-term election with an average gain of over 15%. For full disclosure, we knocked on several pieces of wood immediately after typing that last sentence.

We Remain Encouraged By Fundamental Data

2018 has been a roller coaster compared to the tranquil days of 2017. But, we remain impressed with the resiliency of the US economy and the speed at which corporate profits are growing. We understand tariffs are causing a good deal of trepidation, but believe the impacts are being overblown while full credit is not being given to fiscal stimulus. We maintain our stance that global equities offer a sound risk/reward profile due primarily to fair valuations and a strong earnings growth profile. These factors could help historical mid-term data manifest again with a stronger back-half of 2018 than first. Stay tuned. The bond market unfortunately still warrants caution as global central banks are pulling liquidity and compensation for lower-rated credits is near all-time lows. As always, no market is perfect and the best investing offense over time is a sound defense in the form of a well-diversified portfolio.

Please let us know if you have any questions, comments or concerns.

Regards,

The Investment Committee

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