In the long-run, equity markets are driven by corporate earnings and investor confidence, functions of economic growth and monetary/fiscal policy. However, at the midpoint of the year, 2018 reminds us that in shorter periods, other elements enter the equation. The paltry +2.8% total return from the S&P 500 Index through June 30th does not reflect the strong economic picture in the U.S. which, combined with cuts in corporate tax rates, has driven consecutive quarters of +20% earnings growth for S&P 500 companies. 1 The forward PE ratio of the S&P 500 Index (currently 16.1x) 2 has lost two multiple points from its year-end level as the narrative coming into the year (synchronized and accelerating global economic growth with modest inflationary pressures) has shifted to one where concerns of tariffs and trade wars, slowing global growth, and cracks in various emerging market economies have dominated investor psychology. With the expansion entering its 10th year (2nd longest in history) and within the backdrop of rising Fed Funds rates as the monetary authorities attempt to stay in front of rising inflationary pressures, discussions of when the next recession will occur have slowly risen. The closely watched yield curve has flattened to its lowest level in a decade (+35bps spread on 2/10-year Treasury Bonds) 3 , an ominous signal, and many investors worry that the Fed will be “taking away the punchbowl” too soon by raising the Fed Funds rate and risking a policy error. This has occurred despite evidence that the U.S. economy remains strong today, with estimates pushing +4% in Q2 GDP growth. 4
Unlike 2017 which saw record-low volatility with only a 3% draw down throughout the year, 2018 has seen a return to more normal (higher) levels of volatility and we’ve already absorbed a 10% correction in the S&P 500 Index. 5 Rising wages, rising oil prices, rising interest rates and now the threat of tariff-driven inflation have resulted in lower equity market valuations despite the strong earnings outlook in the U.S. Tariffs also threaten to weaken the cycle-high level of business executive confidence, following the fiscal stimulus of the tax cuts and lowered regulatory burden. Fixed income alternatives to equities have also offered investors little in 2018, as most fixed income indices show negative YTD returns. While small-cap U.S. equities and a handful of large-cap technology darlings have provided solid returns, it has been difficult to find meaningful returns in U.S. risk-assets throughout 2018. In addition, the weak price action in important market sectors like Financials and the Industrials of late has sapped investor enthusiasm as we enter the second half.
Non-U.S. equities have fared even worse. This was the favored asset class coming into the year based on the same synchronized global growth expectations along with less demanding valuations vs. U.S. equities. Disappointing growth in Europe, continuing slower growth in China, and cracks in many Emerging Market economies have derailed last year’s rally in non-U.S. equities. After falling for most of 2017, the U.S. Dollar has risen for most of 2018 against many currencies, a backdrop considered detrimental for many Emerging Market economies. Chinese equities have entered bear market territory after declining 22% from their recent highs, as central authorities continue to wrestle achieving a ‘soft-landing” in this debt-laden economy. 6
However, there are reasons to be optimistic for better returns in the back half of the year. The passing of the midterm elections is typically a catalyst for better equity returns in midterm election years as the election uncertainty is removed, regardless of the outcome. Some resolution to the growing trade disputes would likely cause investors to bid equities higher and reward companies for their still-high margins and rising corporate earnings. Still, there is a growing sense within the Investment Committee at Fundamentum that investors are living on “borrowed time,” as capital markets are exhibiting many characteristics typical in the later stages of an economic cycle. There is some urgency to “get paid” now for strong corporate fundamentals, as the prospects of rising inflation, rising rates, potential peak margins and a less market friendly administration of late points towards more challenging periods ahead. U.S. fiscal policy right now - tax cuts and increased deficit spending - is adding to growth at a moment of already low unemployment, boosting an economy that’s already on strong footing and pushing up national debt. This will leave fewer policy options whenever the next recession ensues. This adds to the urgency of getting paid for current strong fundamentals. As is always the case, timing the turning point is difficult and outside of the flattening yield curve, there is little reason to expect a recession in the short-term. Within Fundamentum portfolios, previously more aggressive equity allocation positions have already been trimmed back in 2018 to more neutral positions versus our global benchmarks in this year of hard to find positive returns. As always, we are parsing the data daily and will make portfolio changes as more clarity become evident. Feel free to contact us with questions as we continue to navigate an interesting year.
1Factset Earnings Insight
2Factset Earnings Insight
3Wall Street Journal Market Data
4Wall Street Journal Market Data
5JPMorgan Chase Guide to The Markets
6Wall Street Journal Market Data
Chad Roope, CFA – Portfolio Manager
Paul Danes, CFA – Investment Committee
Trevor Forbes – Investment Committee
Matt Dunn – Chief Compliance Officer
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