The S&P 500 Index generated 7.7% total return in the third quarter as investors remained focused on a robust U.S. economy and strong corporate earnings growth. In contrast, international equities struggled in the face of a strong dollar and growing investor concern over international trade barriers. Developed international markets reflected slowing economic growth in Europe and Japan. The MSCI Emerging Markets Index has declined almost 17% from its January 2018 peak. A significant portion of emerging market debt is U.S dollar-denominated, creating a substantial burden for borrowers who must repay debt in their own weakened currency. In addition, the imposition of tariffs on Chinese imports contributed to a steep decline in the Chinese stock market.
The table below shows the performance of major equity indices for various time periods.
Equity Performance for Periods Ending on September 30, 2018
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||7.7%||10.6%||17.9%||17.3%||14.0%||12.0%|
|Russell 2000||Small U.S. Companies||3.6%||11.5%||15.2%||17.1%||11.1%||11.1%|
|MSCI EAFE||Developed Int’l Markets||0.8%||-3.8%||0.0%||6.3%||1.7%||2.4%|
|MSCI EM||Emerging Int’l Markets||-2.0%||-9.5%||-3.1%||9.8%||1.2%||2.9%|
|Wilshire Growth||U.S. Large Cap Growth||9.2%||15.9%||24.4%||19.6%||16.2%||13.7%|
|Wilshire Value||U.S. Large Cap Value||6.3%||5.4%||11.8%||15.0%||11.7%||10.2%|
We have observed a continuing divergence in the performance of growth and value stocks. Growth stocks generally have higher rates of revenue and earnings growth, whereas value stocks are less expensive when comparing their key valuation metrics, such as current price to earnings, cash flows, and revenues. Over the long-term, we would expect the performance of these two investment styles to be about the same, but year-to-date, growth stocks have delivered considerable returns of 15.9%, versus just 5.4% for values stocks. In prior market cycles, significant outperformance of growth stocks compared to value stocks was a signal of speculative investment decisions and greater risk for the stock market. For an extreme example, consider the one-year period preceding the stock market’s peak on March 10, 2000: growth stocks generated 28.8% returns compared to -3.4% for value stocks. What followed was a major bear market, particularly for growth companies. Although we do not believe that growth stocks are currently reflecting the same level of extreme valuation that characterized the “Dot-com Bubble”, we do believe certain stocks and sectors are overvalued and present elevated risk. Since one of the core tenets of our investment process is to maintain a high degree of diversification in order to manage risk, we invest in both value and growth companies. However, as growth stocks have become more expensive, we regard fewer of these companies as attractive investments at this time.
Although some market segments appear to be expensive, the overall U.S. stock market seems to be reasonably valued. According to FactSet Research, the price/earnings ratio of the S&P 500 using next 12-month earnings estimates is currently 16.8, compared to its 5-year average of 16.3. Bolstered by tax cuts and a strong U.S. economy, S&P 500 earnings are forecasted to grow by 20.3% for all of 2018. Analysts are currently estimating another 10.3% of earnings growth in 2019. This would be about the same pace as 2018, after excluding the positive impact of tax cuts from 2018 earnings. While these forecasts are above the long-term average for the S&P 500, rising interest rates and higher levels of inflation could begin to pinch the real return of stocks. To the extent stocks compete with bonds for investors’ money, the recent rise in interest rates has made bonds a relatively more attractive alternative to owning stocks than they had been in the past decade. For example, over the past two years, the yield on the 3-month Treasury Bill has increased from 0.26% to 2.19%, and the yield on 10-year Treasury Bond has risen from 1.60% to 3.05%. Rates remain historically low on interest-paying securities, but these securities are becoming an adequate alternative to stocks for risk averse, income-focused investors. The increase in interest rates will raise the borrowing cost for companies financed with debt, leading either to higher prices on the goods and services they sell or reduced returns for shareholders. It could also lead to slowing consumer borrowing and spending—cooling off the economy. The housing sector, for example, has begun to show signs of slowing with the recent rise in mortgage rates.
While the emerging market sector has been the worst performing market segment over the past year, we believe it has the potential to recover strongly, especially if the U.S. strikes a trade deal with China. The MSCI Emerging Market Index currently has a forward P/E ratio of 11.0, which represents a 35% discount to the U.S. market. Emerging market companies have higher forecasted long-term growth rates compared to those based in developed markets. Even after taking into account increased currency and political risk associated with these emerging market companies, the valuations appear to be compelling for long-term investors.
U.S. nominal GDP expanded at an estimated 4.2% rate in the second quarter, its fastest growth rate since the third quarter of 2014. In July, initial jobless claims fell to their lowest level since December 1969. The unemployment rate currently stands at 3.9%, well below its 5.8% average since 1948. Consumer and business confidence indicators are at 18-year and 45-year highs, respectively. And, the Conference Board Leading Economic Index is at its highest level since March 2006, signaling a continuation of the current strong economic trends. It is hard to see these levels being sustainable for long periods of time, but is also unclear when they will moderate.
We continue to regard potential government policy mistakes as the most significant risk to the economy and markets. In September, the Trump Administration applied 10% tariffs to $200 billion of Chinese imports, with the threat of increasing these tariffs to 25% by the end of 2018. These hidden taxes on American consumers and businesses are incremental to the first round which only applied to $50 billion of Chinese imports. Investors are just starting to understand the net impact on the economy and the earnings of affected businesses. As the quarter ended, Canada agreed to join a new trade agreement with the U.S. and Mexico, intended to replace NAFTA. If approved by all three governments in 2019, the deal may relieve some of the concern regarding trade policy and provide a framework for how this administration will negotiate with other trading partners. China, Canada, and Mexico represent 16.3%, 15.0%, and 14.3%, respectively, of U.S. foreign trade, according to the International Trade Administration. At this point, the market seems to regard the current trade stance with China as posturing, with the expectation of reaching an amicable agreement in the near future. If a trade war materialized, the stock market would likely have a very negative reaction due to its adverse economic and geopolitical implications.
The Federal Reserve’s current monetary policy is to gradually increase interest rates to “normalized” levels, without disrupting the current economic expansion. In September, the Fed increased its benchmark interest rate by a quarter of a percent to a target range of 2.00% to 2.25%. For the most part, the Fed has been transparent and consistent regarding its plan to increase interest rates. Barring any economic surprises, the Fed will likely raise rates again by 0.25% before next year. The yield on the 10-year Treasury Bond rose to 3.05% at the end of the third quarter, from 2.85% at the end of the second quarter and 2.41% at the beginning of the year. Rising interest rates cause lower yielding bonds to be less attractive to investors, resulting in a decline in value. With interest rates rising in 2018, the Bloomberg Barclays Aggregate Bond Index has produced a year-to-date loss of 1.6%. Since we view further interest rate increases as likely going into 2019, we have maintained a relatively short-term average maturity for the fixed income investments in our managed portfolios.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.