Second Quarter 2018: A Mid-Year Look Backward and Forward

Mid-Year is always a good time to assess what’s happened so far in the year, as well as the factors that may influence the rest of the year. As we mentioned in the first quarter commentary, 2018 will likely go down as the year of transition. Volatility in the stock market has picked up significantly, while inflation and interest rates have risen, signaling an expanding economy. Additionally, there have been changes at the Federal Reserve, including a new Fed Chairman and the implementation of a plan to reduce the Fed’s balance sheet by not reinvesting an increasing amount of maturing treasury and mortgage bonds. We view this plan as a positive indicator that the most influential central bank in the world would like to return to a more normal environment for the first time since the financial crisis/recession in the 2007-2009 period.

The second quarter delivered better results and was much less volatile than the first quarter of the year. Last year was the least volatile year in the history of the markets, so it was not a surprise that a pick-up in volatility was inevitable; however, that did not make it easier for investors to be faced with a significant number of days in which the Dow Jones Industrial Average (DJIA) and the S&P 500 experienced declines of 2% or more. While it is important for investors to focus on the long-term, it is somewhat difficult to do that when internet stories and the nightly news focus on declines of more than 500 points on the DJIA. Thankfully, there was a little bit of a reprieve in the April-June timeframe with fewer big swings in the daily and weekly returns.

In terms of positives, there are plenty of things about which to be excited:

• Corporate profits (which ultimately determine stock prices) will likely be up 20% this year, relative to last year’s earnings, and Corporate America is very healthy.
• Consumer confidence and small business optimism are both at very high levels.
• The unemployment rate is among the lowest reading in the last 50 years.
• Leading Economic Indicators continue to be strong, showing no signs of recessionary pressure in the next 12 months.

For those who think the glass is half-empty, there are things about which to be worried:

• Trade wars and higher import taxes among developed markets and emerging markets have the potential to cause a global economic slowdown.
• Higher gas prices, as we approach the summer travel season, will reduce discretionary spending on other items.
• Rising budget deficits in a period of economic prosperity may make it more difficult to borrow money at reasonable interest rates when the economy eventually weakens.
• There is an increase of focus on the long-term sustainability of Social Security, Medicare and Public Pension Plans.

In a sign of the times, General Electric, an original member of the DJIA in 1896 and a continuous member since 1907, has been replaced in this iconic index by Walgreens. Our economy is constantly changing, and the DJIA has tried to reflect those changes by adding companies like Apple, Home Depot and McDonald’s.

In terms of recent market performance, the second quarter results were a mixed bag, with domestic stocks rising, but international stocks declining. The proxy for U.S. large company stocks (S&P 500) was up 3.4%, while the Russell Mid-Cap index rose 2.8%, and the Russell Small Cap index was by far the best performer, returning 7.8%. International stocks in the developed markets of Europe and Japan, as measured by the MSCI EAFE index, declined 1.2%, while the MSCI Emerging Markets benchmark (most impacted by trade war discussions) declined by 8.0%. Rising interest rates caused the bond market to finish with a slightly negative return of 0.2%, based on the Barclay’s Aggregate index. For the year-to-date period through June 30, the broad U.S. stock market (Russell 3000 Index) outperformed the non-U.S. stocks (MSCI ACWI Ex U.S. Index) with the former generating a 3.2% return and the latter declining by 3.8%. Bonds continue to be in the red with a 1.6% return.

No one can accurately predict how the second half of the year will play out; however, as long as corporate earnings continue to be strong, investors should ignore the short-term noise. Trade wars can be very serious, given the virtual cycle of retaliation by many countries. If world leaders can sit down at the table and hammer out some fair trade agreements, markets could get back on track; however, until this happens, the issue of tariffs and import taxes will be a huge black cloud over global markets.