2018 third quarter investment and economic update

October 8, 2018

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

The third quarter was a continuation of good profit growth, strong economic growth and rising interest rates combined with worrisome trade rhetoric and contentious politics in Washington D.C. At first blush, nothing directionally has changed since last quarter’s update. This quarterly update will shed light on the slight, but important changes with the Fed and what that means for interest rates, the encouraging trade discussions with Canada and provide some early thoughts on issues we may face as investors in 2019.

U.S. interest rate policy: No longer accommodating?

The Federal Reserve moved interest rates up for the third time this year to a 2.0 – 2.25% range. This in turn moved up the bank prime rates to 5.25%. The Fed started moving interest rates off a 0% policy starting in December 2015, with the recent move representing the eighth over the course of almost four years. Until now, the Fed Funds Rate has remained below core inflation as measured by the Personal Consumption Expense Index (Exhibit 1). One can argue that the Fed has embraced an accommodative interest rate policy up until now with Fed Fund rates above inflation. The markets forecast an additional 0.25% interest rate hike this year with a total of 0.75% in 2019. 

Exhibit 1

Source: St. Louis Federal Reserve

The moving up of interest rates by the Fed is fueled by the strong economy, labor market and the anticipation of future inflationary pressures. We do not anticipate rising interest rates to be a detriment to the stock market, but we do continue to expect investment grade bonds to struggle in this type of interest rate environment. Schenck Wealth Advisory continues to position the bond portfolios to be defensive against a rising interest rate environment. This has been expressed by having shorter maturities and investing in floating rate bonds that generally do well in a Fed-induced rising interest rate environment.

U.S. equities: Healthy top- and bottom-line growth

The U.S. equity market continues to benefit from the more favorable tax brackets that assisted in driving 15% year-over-year profit margin improvements for the S&P 500 Index. However, the real story resides with the fantastic top-line revenue growth of nearly 11%. This stock market is not being supported by just tax reform. The U.S. consumer continues to spend, powered by a strong job market and relatively low borrowing rates. While the U.S. equity markets do not reflect “cheap” valuations, they are also not at levels considered expensive. We continue to be constructive on U.S. equities and believe the economic framework continues to support a positive return environment.

International equities: Patience is the key

International equities have struggled due to a strong U.S. dollar and the uncertain environment surrounding trade tariffs. The international equity markets are trading at significant discounts to the U.S. market, causing the valuation disparity to be the lowest in 25 years (Exhibit 2). We believe this gap will normalize over time, creating a significant return opportunity for U.S. investors. Patience will be key, especially given the current strong market support for U.S. equities.

Exhibit 2:

Source: Yardeni Research

Trade tariffs: United States-Mexico-Canada Agreement (USMCA)

A little surprising to many pundits across the country, but the Trump administration has recrafted trade agreements with Mexico and Canada, replacing NAFTA with the USMCA. Some of the more significant parts of the agreement are as follows:

  • Canada will decrease their level of subsidization on various dairy products, which has kept Canadian dairy consumer products unnaturally low.
  • Canada will increase quotas for U.S.-produced dairy products. This will increase the amount of dairy product allowed to flow into the Canadian market from the U.S.
  • Seventy-five percent of all auto parts on a vehicle/truck must be manufactured in the U.S., Mexico or Canada to avoid auto tariffs. This is a material increase over the previous NAFTA agreement.
  • Forty-five percent of all auto and truck parts in Mexico must be made by workers earning at least $16 per hour. This will close the disparity of wages between the U.S. and Mexico. The cheaper wages in Mexico has been the primary driver for U.S. auto companies to build production plants in Mexico rather than in the U.S.
  • The agreement does not address the U.S.-imposed steel and aluminum tariffs that were put in place earlier this year.

Creating an agreement with Mexico and Canada is significantly more important to our economy than having a trade deal with China. We believe the trade disagreements with China will roll into next year, remaining a market risk issue in 2019.

The positive economic and investment catalysts remain in place with some of the trade risk issues softening due to agreements with Canada and Mexico. We continue to expect the market to be subject to increased volatility as global central banks start reducing their respective accommodating monetary policies (keeping interest rates low).

Exhibit 3: 2018 return data

 Equity July August September 3rd Quarter Year to Date
U.S. Large Cap 3.72% 3.26% 0.57% 7.71% 10.56%
U.S. Mid Cap 1.93% 4.29% -1.52% 4.70% 10.41%
U.S. Small Cap 1.74% 4.31% -2.41% 3.58% 11.51%
Developed Country International 2.14% -1.90% 0.26% 0.46% -2.88%
Emerging Country International 2.20% -2.70% -0.53% -1.09% -7.68%
Fixed Income July August September 3rd Quarter Year to Date
 U.S. Investment Grade 0.02% 0.64% -0.64% 0.02% -1.60%
U.S. High Yield 0.96% 0.68% 0.60% 2.26% 3.12%
U.S. Inflation Protected -0.21% 0.54% -0.31% 0.02% 0.60%
Foreign Debt 2.06% -1.92% 1.77% 1.87% -3.46%

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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