After a correction of more than 10% in the first quarter of 2018 in the S&P 500 Index and lackluster returns broadly through mid-year, investors were finally rewarded for continued strong economic and earnings growth in the U.S. as the S&P 500 Index returned +7.7% in Q3, its best quarter since Q4 20131. U.S equities looked past slowing economic growth in China, Europe and financial crises in certain emerging market economies (a trend much different than the “synchronized global growth" story of 2017), focusing instead on the recent +4.2% Real GDP2 growth domestically, an environment that has produced two consecutive quarters of +20% EPS growth for S&P 500 companies3. Market fear toward trade wars and tariffs have lessened with recent trade agreements with Mexico and Canada, providing optimism that the ongoing skirmish with China will be resolved in a similar, drama-free fashion. While the Fed did recently continue to “normalize” monetary policy with its third-rate hike in 2018, bringing the Fed Funds target to 2.00-2.25%4, investors were comforted with Chairman Powell’s comments that the Fed sees “limited risk of inflation taking off” and also of “limited implications”5 to the U.S. economy regardless of the outcome of trade discussions. Fears that the Fed may raise rates too far remains the greatest concern among institutional investors in a recent investor survey6.
Thus far, 2018 continues to be a period where U.S. investors have suffered from owning diversified portfolios. Only U.S. equities have generated meaningful positive returns this year as returns for indices of U.S. bonds, non-U.S. developed market and emerging markets equities are all negative (see below - total returns sorted by Q3 esults):
After moving towards our neutral benchmark positions in Fundamentum’s Tactical Portfolios in 2018 (through reductions in emerging market and developed market international equities) the Investment Committee continues to monitor (and debate) the counterbalancing forces of:
- the strong domestic economy where inflation pressures remain remarkably modest given full-employment, robust manufacturing sector and the impact of the fiscal stimulus
- the “yellow-signs” we see in variables we track, such as the flattening yield curve, the direction of monetary policy, the likely economic impact we anticipate in 2019 from the anniversary effects of this years’ fiscal stimulus
- the likely “second-derivative” change we expect to see in earnings growth in 2019.
Along with record-high levels of business and consumer optimism (factors we view as negative for future returns as these tend to be mean-reverting variables when extreme levels are reached) and valuation for U.S. equities that we see as rich (though not extreme), our conclusion has been that there is time remaining to benefit from the strong U.S fundamentals before we might take on a more defensive posture. While Healthcare stocks were the best performing sector in the Q3 (+14.3%)1, we are comforted by the fact that defensive sectors like Utilities, Consumer Staples, Telecommunications have NOT shown any signs of market leadership, a factor we view as positive. We are also comforted that U.S equity markets continue to move higher to record-highs, despite a falloff of the large-cap Technology leaders of late - a sign that the market is not as narrow as some would argue and fear. Both factors make up a portion of our “market top checklist” that we review on an ongoing basis.
Also, as long-term interest rates have broken out from their recent range, it bears monitoring to see what the impact will be on the underlying economy and on the valuation of equities, especially long-duration assets like growth stocks, which have been market leaders for most of 2018. Fundamentum Tactical portfolios continue to be underweight duration in our fixed income allocations, a positioning that has helped relative performance during this latest spike in long-term interest rates.
Finally, as stated earlier and in the recent piece we published entitled “Diversification…Doesn’t Seem Like Such a Free Lunch in 2018 So Far,” it’s likely that many investors will see news headlines of recent highs in US stocks and be disappointed when they see their more diversified portfolios lagging. We are afraid this will lead to poor decision making based on short-term performance. While our strategies are largely in-line or ahead of their benchmarks, they are diversified and are not as strongly positive as the S&P 500 so far this year. Diversification, by definition, should include assets that are going down when others are going up. We think this is an incredibly important year for Advisors to remain disciplined and educate their clients about the importance of not chasing performance. We are here to help in this regard. Please contact us if we can be of assistance. We believe investors are likely to be rewarded for being patient with diversification and risk management over the longer-term, but we recognize it may not feel good over shorter-time frames.
We appreciate your confidence in our team,
Fundamentum Investment Committee
Chad Roope, CFA® Portfolio Manager
Paul Danes, CFA® - Investment Committee
Trevor Forbes - Investment Committee
Matt Dunn, CFA® - Chief Compliance Officer
2-Bureau of Economic Analysis-10/3/18
3-Factset Earnings Insights10/3/18
4-Federal Reserve Board-10/3/18
5-Capital Economics “Fed still going it (almost) alone” 9/27/18
6-Strategas Securities, LLC-“Investor Snap Survey” 10/2/18
Investment advice offered through Fundamentum LLC a registered investment advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the investment objective of any investment strategy will be attained. Investing involves risk including loss of principal. Past performance is no guarantee of future performance. All indices are unmanaged and may not be invested into directly.