Despite a rough beginning to the quarter — the S&P 500® Index posted its worst start to the month of April since 1929 — U.S. equity markets ended the most recent three-month period in positive territory and extended the nine-year bull market for yet another quarter. The S&P 500 finished up 3.43% and the Dow Jones was up 1.26%. On the heels of strong performance in the Technology sector, NASDAQ finished the quarter up 6.61% and set an all-time high for the index during the month of June.
Despite the prolonged length of the current bull market, the U.S. economy continues to be in expansion mode and both business and consumer sentiment remain at historically strong levels. Moreover, the full impact of the Tax Cuts and Jobs Act — President Trump’s keynote tax reform legislation — has yet to be felt, as the majority of the cash held overseas by U.S. companies has yet to be repatriated. Depending on how companies utilize these dollars — buying back shares, making dividend payments, paying down debt, investing in capital expenditures and bolstering corporate bank accounts are all possible options — they could provide a further boost in economic growth and overall confidence in the economy.
While the first quarter experienced a meaningful uptick in volatility, the second quarter saw a decline in volatility of over 30%, as measured by the VIX. Despite this downtrend over the past three months, we believe volatility will likely return to higher — and historically normal — levels, as investors now appear to be reacting more quickly to negative headlines, while tightening financial conditions (rising interest rates, inflation and oil prices) should reduce investors’ desire for risky assets over time.
A strong U.S. dollar was a headwind for international equities during the quarter. The dollar has rallied as investor risk appetite has fallen and as a result of the faster pace of tightening imposed by the Federal Reserve relative to foreign central banks. The MSCI EAFE Index was down -1.24% over the past three months, while the MSCI Emerging Markets Index was down -7.96%. It will be important to watch the directionality of the U.S. dollar going forward, as international equities tend not to perform well when the dollar is appreciating. Continued dollar appreciation could signal challenging times for international — and especially emerging markets — equities.
The Bloomberg Barclays U.S. Aggregate Index ended the quarter relatively flat at -0.16%, while the Bloomberg Barclays U.S. High Yield — Corporate Index finished up 1.03%. Despite a large sell-off in May, oil prices rose during the past three months, topping $70 per barrel for the first time since mid-2015. OPEC announced in June that it would increase oil production by 600,000 barrels-per-day, a level that was less than feared, while falling U.S. crude inventories and fears of potential supply disruptions in Iran also boosted prices.
Tariffs and trade policy seemed to dominate the headlines in the second quarter, as President Trump pursued his “America First” campaign promise to level the playing field on trade. The president’s announcement in March that he wanted to tax aluminum and steel imports was a bombshell that sparked fears of a potential trade war with some of our largest trading partners. Over the past three months, the president has generally hardened his rhetoric, especially in relation to China. After initially levying a 25% tariff on approximately $50 billion of Chinese imports, trade tensions quickly escalated between the two countries. In response, China imposed retaliatory tariffs of the same amount on U.S. exports such as agricultural products and automobiles — many of which are produced in the American heartland where a large contingent of the president’s most ardent supporters reside. President Trump, responding to China’s retaliatory tariffs, proposed new tariffs on an additional $200 billion worth of Chinese goods. Despite this back-and-forth gamesmanship, the tariffs to date — both levied and threatened — remain fairly small relative to the overall size of the U.S. and Chinese economies. This will be an important issue to watch over the next several months, as small tariffs can quickly escalate into a trade war that can have significant ramifications on economic growth and financial markets.
U.S. unemployment was also newsworthy during the quarter, as jobs were added to the U.S. economy in each of April, May and June, extending the longest streak of job growth on record. The unemployment rate fell during the quarter, from 3.9% in April to 3.8% in May (while ticking up slightly to 4.0% in June due to a higher labor force participation rate). Despite the economy being at — or very near — full employment, wage growth has remained curiously sluggish at an annualized rate of 2.7% through June. It is odd for an economy in this stage of the economic cycle to produce such weak wage growth — for comparison, wage growth peaked around 4% during previous cycles in the 2000s, 1990s and 1980s. While many possible explanations have been offered for this phenomenon, it is likely attributable to a combination of factors, including increased globalization and technological advances. While the U.S. is unlikely to see sustained core inflation without wage growth, the Commerce Department announced in June that core PCE, the Federal Reserve’s preferred inflation measure, hit the central bank’s 2% target for the 12 months ended May 2018 — the first time it has done so in six years.
As expected, the Fed raised the Federal Funds rate at its June meeting, increasing it by 0.25% to a new target of 1.75% to 2.00%. Spurred by full employment and 2% core inflation, Fed chairman Jerome Powell indicated at his post-meeting press conference that two additional rate hikes are likely to occur this year, for a total of four in 2018 — a departure from previous Fed projections of three increases for the year. While the Fed is currently the most hawkish of the global central banks — and thus the farthest along in its tightening activities — another key central bank began to lay the groundwork this quarter for future financial tightening. At its June meeting, the European Central Bank announced its intention to wind down quantitative easing by the end of the year (yet also signaling its intention to keep interest rates steady until at least summer 2019). Barring a sharp reversal in the world economy, financial tightening should start to gradually proliferate across the globe — slowing the flow of money and reducing global liquidity while having a negative impact on investor demand for risky assets such as equities.
Some economists think that the probability of a U.S. recession has been delayed until 2020. With the economy continuing to post solid growth, there are reasons for investors to be optimistic. While we can’t say with confidence when a market or economic downturn will occur, it is our belief that higher risks currently exist to financial markets than to the broader economy, with the biggest risk being a Fed mistake — tightening too quickly or too much (a concern which is likely a cause of the recent flattening of the Treasury yield curve — a sign often associated with a pending recession). It’s also important to remember that the average market decline in a mid-term election year is approximately -18%, with the month of July being an historically difficult month.
Now may be a good time to evaluate portfolio allocations and consider whether an opportunity exists to de-risk into asset classes that perform better in a more volatile environment — especially if equity holdings now exceed the preferred target weight. During times of uncertainty, it is important for investors to be appropriately diversified and remain committed to their long-term investing strategy. As always, we do not recommend trying to time the market.
Thank you for your confidence in GuideStone®. Please feel free to contact us if you have any comments, questions or concerns.