2018 second quarter investment and economic review

June 29, 2018

Learn more about events and changes that impacted the U.S. equity markets, economy and interest rates in the second quarter of 2018.

U.S. equity markets delivered solid returns in the second quarter, driven by strong earnings growth coupled with continued strength in the U.S. economy (Exhibit 3). However, this has been accompanied by elevated levels of anxiety associated with high levels of uncertainty regarding the evolving U.S. stance on trade.

U.S. equity markets: Strong earnings growth

The S&P 500 Index posted first-quarter 2018 earnings growth of 26.6% when contrasted against the same quarter in 2017. The strong earnings growth is somewhat explained by the low corporate tax rates, but with 8.3% topline revenue growth, this earning cycle is indicative of a strong U.S. economy (Thomson Reuters).

Consensus earnings estimates (Thomson Reuters I/B/E/S) have robust expectations for profit growth for the remainder of the year with year-over-year earnings growth ranging from 9.85% to 15.29% across U.S. equity markets (Exhibit 1).

Exhibit 1

Index Equity asset class 2018 forecasted earnings* 2019 forecasted earnings* Earnings growth rate
S&P 500 Index U.S. Large Cap 161.08 176.94 9.85%
S&P 400 Index U.S. Mid Cap 112.90 127.08 12.56%
S&P 600 Index U.S. Small Cap 53.83 62.06 15.29%

*Source: Yardeni Research as of June 19, 2018

Valuations (P/E multiples) have moderated due to strong earnings growth while prices have not appreciated due to risk associated with U.S. trade policy. U.S. large-cap equity markets are in line with longer-term valuations, whereas U.S. mid- and small-cap equities have valuations that are elevated relative to longer-term trends. We believe U.S. mid- and small-cap equities have less exposure to international trade and consequently, we are maintaining our overweight to U.S. mid- and small-cap equities despite the stretched valuations due to the present risk associated with U.S. trade policy.

Equity volatility in the second quarter has largely been defined by the evolving U.S. trade policy with China. On June 15 the U.S. announced a 25% tariff on $34 billion of Chinese goods with an additional $16 billion pending public review. China immediately responded with a tariff of identical size and scope targeting U.S. agricultural and automobiles. President Trump has threatened tariffs on unspecified goods amounting to $200 billion if the Chinese do not back down from the “tit for tat” responses to U.S. trade policy.

Using the U.S. Census Bureau 2017 data, the U.S. imports $505.47 billion of goods from China while exporting $129.89 billion of U.S. manufactured goods to China. The difference creates a U.S.-China trade deficit of $375.58 billion. It should be noted these numbers do not capture the entirety of trade relations between the two countries. Chinese students going to school in the U.S. and Americans vacationing in China are examples of trade commerce that is not captured given these fall into the service sector.

Earlier in the year, we believed that an element of rational and a pragmatic minds would prevail regarding trade policy between the U.S. and China. That initial notion appears to have been overly optimistic and hopeful. We appear to be on a path to a more contentious trade dispute that could lead to a trade war unless diplomacy allows for each country to soften their respective stances while “saving face.” Unless this issue is resolved, we expect equity returns to remain muted until evolving U.S. trade policy is fully understood.

U.S. fixed income: Rising interest rates, but for the right reasons

The U.S. bond market has experienced rising interest rates due to three primary reasons (Exhibit 2):

  1. Federal Reserve is raising short-term interest rates
  2. The U.S. economy is strong, suggesting the potential for a future increasing inflationary environment
  3. The U.S. will have need to issue larger amounts of Treasury bonds to fund the government

The Federal Reserve raised the federal funds target rate by 0.25% for the second time this year to the current target rate of 2%. Chairman Powell referenced strong employment at 3.8%, strengthening corporate profits, increased consumer spending and raised 2018 expected U.S. economic growth to 2.8%. The CME fed funds futures places the probabilities of an additional 0.25% and 0.50% fed funds increase this year at 43% and 47% respectively.

We are maintaining our forecast for the U.S. 10-year Treasury yield to fall between 3% and 3.25% by the end of 2018. Consequently, we believe the returns in investment-grade U.S. fixed income markets will remain challenged throughout the year. The primary reason for these rising interest rates is materially linked to a strong economy. While we do not currently have “unhealthy” inflation, it is the Federal Reserve’s position that with continued economic strength core inflation will go beyond the target rate of 2%.

Exhibit 2

*Source: U.S. Department of the Treasury, January – June 19, 2018

Exhibit 3 (2018 return data)

Equity April May June 2nd Quarter Year to Date
U.S. Large Cap 0.38% 2.41%  0.62% 3.43% 2.65%
U.S. Mid Cap 0.24% 4.70% 0.72% 5.71% 5.46%
U.S. Small Cap 0.86% 6.07% 0.72% 7.75% 7.66%
Developed Country International 1.57% -1.99%  -1.97% -2.41% -3.32%
Emerging Country International -0.44% -3.54%  -4.15% -7.96% -6.66%
Fixed Income April May June 2nd Quarter Year to Date
U.S. Investment Grade -0.74% 0.71%  -0.12% -0.16% -1.62%
U.S. High Yield 0.87% 0.03%  0.46% 1.37% 0.84%
U.S. Inflation Protected -0.07% 0.38%  0.16% 0.47% 0.59%
Foreign Debt -1.46% -1.08%  -1.00% -3.51% -5.23%

Exhibit 3 footnotes: The following indices were used for the total return calculations:

  • U.S. Large Cap Equity: S&P 500 Index
  • U.S. Mid Cap Equity: Russell 2500 Index
  • U.S. Small Cap Equity: Russell 2000 Index
  • Developed Country International: MSCI ACWI Ex USA All Cap Index
  • Emerging Country International: MSCI Emerging Market Index
  • U.S. Investment Grade: Bloomberg Barclays U.S. Aggregate Bond Index
  • U.S. High Yield: Bloomberg Barclays U.S. High Yield Intermediate Index
  • U.S. Inflation Protected: Bloomberg Barclays U.S. Treasury TIPS 1-5 YR Index
  • Foreign Debt: JPM Emerging Market Bond Global Index

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Dave Isaacson is the Chief Investment Officer of Schenck Investment Solutions, LLC, a Registered Investment Adviser. Registration with the Securities and Exchange Commission does not imply any level of training or expertise. Schenck Investment Solutions, LLC is wholly owned by Schenck SC. Material presented herein is for informational and educational use only. The views, forecasts and opinions presented herein may change based on market conditions and other factors. Nothing herein should be considered to be legal, accounting or tax advice. Consult your lawyer, accountant or other advisor before making any financial, legal or investment decision. This information may not be duplicated or redistributed without prior consent of Schenck Investment Solutions, LLC and distribution or publication of this material does not represent a solicitation to complete a financial transaction with the Schenck Investment Solutions, LLC. In developing the forecasts and opinions contained herein, we have relied on data from third-party sources. Though information was prepared from sources believed reliable, Schenck Investment Solutions, LLC does not guarantee its accuracy or completeness.

Any investment advice contained in this publication is not specific to any individual, entity, or retirement plan, but rather is general in nature. Therefore, the investment advice contained herein should not be relied on for specific investment solutions. Investment decisions should be based on a number of criteria, such as individual’s risk tolerance, time horizon and personal goals. Suitability on products must be determined on an individual basis. Not all products are suitable for all investors.

Both the issuers and counterparties of fixed-income securities face inflation, credit, and default risks. Stock markets are volatile, especially markets outside the U.S. All markets may decline significantly in response to adverse developments caused by political, regulatory, issuer, or economic factors, including other markets. Bonds generally present less short-term risk and volatility than stocks. However, bonds have the risk of default and interest rate risk, or the risk that issuers will be unable to make income or principal payments. Investing involves risk. And risk includes loss. Past performance is no guarantee of future results.

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