Quarterly Market Commentary - Second Quarter 2018

Markets in Review

The second quarter of 2018 saw lots of themes emerge, but increasing trade tensions seemed to drive the markets and the return of volatility. In fact, investors would be hard-pressed to find an asset class, sector or region that didn’t see decent-sized swings over the second quarter as investor sentiment seemed to change every day.

On the heels of most equity markets being down in the first quarter of 2018, generally speaking, the U.S. equity markets recovered during the second quarter. International markets, on the other hand, didn’t fare nearly as well.

Index Returns	2Q 2018	YTD
S&P 500	2.9%	1.7%
DJIA	0.8%	-1.1%
NASDAQ	6.3%	8.8%
MSCI EAFE	-2.3%	-4.5%
RUSSELL 2000	7.5%	7.1%

The big story was how much small cap stocks –as shown in the Russell 2000 Index – dramatically outperformed their large-cap counterparts (DJIA and S&P 500). In addition, investors saw Growth continue to outperform Value across the large and midcap spectrum for the 2nd quarter after 2017 saw Growth outperform across all cap sizes – by historical margins.

Fixed-Income Markets

In fixed-income, interest rates continued to move upward, in line with the Fed’s second interest rate hike of 2018 coming in June. Fixed-income investors saw:

Interest rates rise for short-term U.S. Treasury securities in the second three months.
The 10-year U.S. Treasury note yield end the second quarter at 2.85% vs. 2.73% at the end of the first quarter.
The yield on the 3-month U.S. Treasury bill increase to 1.91% by quarter-end, up 21 basis points from prior quarter-end.
The Bloomberg Barclays U.S. Aggregate Bond Index (investment grade U.S. bonds) return -0.2% (-1.6% YTD).

Sector Performance

For the quarter, seven of the S&P 500 sectors were in the green and four were in the red. Energy, Consumer Discretionary and Information Technology were the strongest performers and Industrials, Financials and Consumer Staples sectors were the poorest.

Tariffs Go into Effect

President Trump’s proposed tariffs on $34 billion worth of imports from China went into effect at the end of the second quarter. China predictably responded with tariffs of its own, targeting U.S. imports including soybeans, aircraft and autos.

No one will debate that trade worries weighed on the markets and the markets outside the United States were generally most affected, especially in China and emerging markets. But European equities were also affected, with auto companies suffering on fears that US tariffs could be applied to car imports.

Glass-half-full economists are quick to point out that the $34 billion represents less than two-tenths of 1% of U.S. GDP – and if you add the additional $200 billion that President Trump is considering, it still is only about 1% of GDP.

Glass-half-empty economists, however, suggest that any trade war between the world’s two largest economies would have significant negative effects on global growth as well as inflation here in the U.S. and most certainly stop the current bull market dead in its tracks.

The answer is probably somewhere in the middle.

Oil Prices Rebound

Oil prices bounced back in June after slipping in May, ending the month at $74.15/barrel, a 10.61% increase from the May closing price of $67.04. For the year, oil is up 22.72% after closing 2017 at $60.42.

Simple supply and demand economics saw oil prices rise in June as the supply of domestic crude dropped by almost 10 million barrels in the third week in June, according to the U.S. Energy Information Administration. That supply drop also happened to be the largest weekly drop of the year.

Oil prices have been rising due to increasing global demand and as a response to sanctions on sales of Iranian oil.

Solid Economic Data Points

U.S. GDP came in at a 2.0% annualized rate for the first quarter of 2018 information is reported in the second quarter); and this was slightly below the expected rate, but above the 1.4% annualized rate for the same quarter last year. Despite being slightly below expectations, the economy is now in its 9th year of expansion, the 3rd longest on record.

The jobs market stayed strong and the current unemployment rate has fallen to 3.8%. The housing market is mostly mixed as year over year home sales were flat while home prices were up 5.6% from the preceding year.

In March, the Fed raised the federal funds rate target by 25 basis points to a range of 1.50% –1.75%. Then in June, the Fed again raised the federal funds rate target by 25 basis points, to a range of 1.75% –2.00%. Market expectations are that the Fed will likely deliver 1 or 2 additional increases before 2018 comes to a close.

Corporate cash remains plentiful and more is being repatriated, as told by the Bureau of Economic Analysis report highlighting that $308 billion was repatriated, which led to a record $189.1 billion in stock buybacks.

Can the First Half Predict the Second Half?

The short answer is no. But,

Since 1950, when the S&P 500 was positive at the mid-way point, the market was higher for the entire year 94% of the time.
In years when small-caps were positive and leading large-caps – as is the case now – the S&P 500 finished the year higher 83% of the time.

But, Keep an Eye on the Yield Curve

Interestingly, the yield curve has historically been a good indicator of a coming recession when it inverts –the shorter end moving above the longer end. But as of the mid-way point, most economists believe that the Fed won’t do anything to push the yield curve to invert. But the curve does seem to be flattening, pointing toward financial conditions and global liquidity tightening overall. Clearly both would have implications for the markets around the globe and are worth keeping an eye on.