Market Update: Third Quarter 2018


    Market Update: Third Quarter 2018

    The third quarter delivered the best quarterly US stock market performance in years, underpinned by solid corporate earnings growth, increased investor confidence, and a booming economy. There was also progress in what so far this year has been a highly chaotic global trade picture, with a newly negotiated North American trade agreement, awaiting Congressional approval. The unemployment rate dropped to 3.7% (the lowest in almost 50 years), a hopeful sign for higher wage growth in the months ahead.

    If you believe that the “trend is your friend,” then perhaps the US stock market may be in for an excellent fourth quarter as well. US equity markets suffered small losses in the first quarter, followed by decent single-digit gains in the second quarter. Now that the third quarter is in the books, an even larger gain has put US stocks in solid positive territory for the year.

    US large-cap stocks led the way with the S&P 500 gaining 7.2% in value during the year’s third quarter, rallying to a 9.0% gain so far in 2018. US small-cap stocks weren’t too far behind. The Wilshire US small-cap index posted a 3.7% gain over the third quarter and now stands up 11.0% in 2018.

    The good news is that US stocks continue to hit all-time highs. The bad news is that, on the whole, global equities are still 4% or so below their all-time highs. The uncertainty around trade and the strong US dollar has put pressure on international and emerging market stocks.

    The broad-based MSCI EAFE index of companies in developed foreign economies gained just 0.8% in the third quarter, and is overall down 3.8% for the year. Emerging market stocks of less developed countries, as represented by the MSCI EAFE EM index, went into negative territory for the quarter, down 2.0%, for a loss of 9.5% for the year.

    The asset classes that led the way in 2017—emerging market stocks and international small company stocks—are negatively impacting globally diversified portfolios so far in 2018.

    Looking over the other investment categories, real estate, as measured by the Wilshire US REIT index, gained 0.7% during the year’s third quarter, just eking out a 2.2% gain for the year. Gold prices were down 4.7% for the quarter, falling to negative 8.6% for the year.

    Bonds barely moved in the third quarter with a gain of just 0.02% for the Barclay’s Aggregate Bond Index. For the year, the index is down 1.6%. There has been pressure on bond prices as interest rates have continued their incremental rise, with the 10-year Treasury rising to 3.06%. As of this writing, the 10-year Treasury bond sits at 3.22% the highest it’s been since May 2011.

    For years, economists have been predicting that higher interest rates are right around the corner. Finally, they are here. While it may suppress bond prices in the near-term, higher interest rates are good for fixed income investors. After all of these years with record low interest rates, they are finally getting a raise.

    To protect your portfolio against rising interest rates and the impact that has on bond prices, we have intentionally kept your bonds very short in maturity. As these bonds mature, they will be able to reinvest into higher yielding bonds. As a result, your bonds have fared much better than the bond index in this rising interest rate environment.

    What to expect next? (Please hold while I grab my crystal ball…)

    There are plenty of unknowns and potential headwinds that could impact stock prices in the short run, e.g. the upcoming midterm elections and escalating trade tensions. It wouldn’t be surprising to see increased volatility heading into the elections. However, historically, the S&P 500 has delivered strong fourth quarter returns during midterm election years.

    We continue, however, to be in unchartered territory with the trade disputes with some of our biggest trading partners. While we have concluded a new trade agreement with Canada and Mexico, our #2 and #3 trading partners behind China, there is still no telling how this game of trade chicken will play out with our other trade partners. It may be that the heated rhetoric from both sides is just a negotiating tactic and that a deal will get done. Or, the tariff tit-for-tat may escalate, negatively impacting global growth and stock prices. Time will tell.

    There are also plenty of reasons stocks can continue their accent. For example, there is a lot of pessimism surrounding the high level of trade tensions the world has experienced this year. It’s possible that the leaders of the two largest economies in the world—the US and China—could come together and work out a deal that would remove that layer of uncertainty. If that occurs, we could see a resurgence in emerging market stocks and developed international stocks that have been impacted the most during the trade tussle.

    Other economic indicators give investors hope that stock prices can continue to rise: the US unemployment rate is 3.7%, its lowest level since 1969, inflation is currently contained, and we are experiencing strong growth in corporate earnings. We are also finally seeing wage growth which puts more money in peoples’ pockets.

    The problem areas so far in 2018 have been emerging market and international stocks. Last year they were the darlings, this year they are the dogs. So goes it with a globally diversified portfolio. It is also worth pointing out that last year US small-cap stocks were the worst performing equity asset class. This year, they are leading the way.

    If history is any guide (and it usually is) the sharp selloff in emerging market stocks and international stocks presents us with potential buying opportunities. In the case of emerging market stocks, prices are 20% or more lower than they were in late January. In almost every single case in the past where emerging market stocks fell by 20% or more, their subsequent one, three, and five-year returns have on average been in the double digits.

    The average gain in emerging market stocks for those investors brave enough to buy following a 20%+ decline has been:

    Average One Year                      20.0%
    Average Three Year                   62.2%
    Average Five Year                      73.4%

    Not too shabby. One of the most challenging things for an investor to do in a volatile asset class, like emerging markets, is to stick it out during periods of pain, like right now. However, as you can see the benefits of being patient and looking for buying opportunities most certainly pays off over the long run.

    Whether we see a recovery in emerging market stocks or US stocks continue to lead the way is anyone’s guess. What we do know is that maintaining proper diversification and looking for buying opportunities has served investors well in the long run. There’s no reason to expect that to change.

    That said, we understand that real market risk can generate very real concerns when it unfolds. As always, please let us know if we can answer any questions. In the months, quarters and years ahead, we remain here for you.