Executive Summary
The financial news continues to focus on “trade war” talk, which was in the very early stages of negotiation last quarter and has continued into actual tariffs taking effect on July 6th. However, thanks to a strong jobs report, stocks are up around the globe on the day the tariffs took effect and have continued their upward trajectory so far in July. We recently sent a note to everyone on our approach to this topic, https://www.laketahoewealthmanagement.org/news-notes/2018/7/2/tune-out-the-trade-war-talk
While we are keeping a close watch on the ongoing trade negotiations, we are also closely watching other important factors that affect stock prices, including corporate earnings, corporate debt as a percentage of GDP, GDP growth, the yield curve, and U.S. unemployment. While economic indicators look very good, the yield curve is flattening and international and emerging market stocks, most affected by global trade disputes, are lagging. The spread between the 10 year and 2 year Treasury yields (the yield curve) is the tightest it has been since 2007. Also of concern, the corporate debt to GDP ratio has exceeded 45% for the first time since 2007. Both of these measures usually indicate the end of economic expansion is near. The Russell 2000 small cap index is hitting numerous new record highs during the quarter, since smaller domestic companies are not impacted much by trade.
The current economic expansion is the second longest in U.S. history. It started in June 2009 and if the expansion continues until next summer, at 121 months (through July), it will break the record set during the 1990s tech boom. It has been a much slower expansion, GDP growth has averaged 2% per year, well behind the 3.6% average annual growth achieved during the 1990s expansion. While a new record expansion does look likely and the threat of inflation could cause the Fed to raise rates faster than anticipated. We are monitoring the fixed income markets for any signs of weakness.
For those who want to dive deeper into our market and economic commentary:
World Asset Class 2nd Quarter 2018 Index Returns
Second quarter index returns were positive for U.S. and global real estate stocks; and negative for international developed and emerging market stocks. The large decline in emerging market stocks is a result of the trade tariffs proposed, since emerging economies are much more reliant on export trade, which will likely decline. The current trade tariff actions are affecting capital flows in multiple asset classes.
A larger sample of world asset class returns shows the strength of U.S. small cap and real estate stocks; and small cap stocks were stronger than large cap stocks (Russell 2000 SC index up 7.75%, Russell 1000 LC index up 3.57%). More capital is flowing into small cap stocks since they are less affected by trade tariffs.
Here are additional details for the U.S. stock market:
Bond market values around the world declined due to a shift up in the yield curve, which was more pronounced at the short end than at the long end, (the 30-year Treasury rate barely budged). The larger upward shift at the short end caused a flattening of the curve. As a reminder, a steep curve is associated with strong economic expectations and a flat or inverted curve signals future economic weakness. Increasing interest rates act as a brake on the economy. Here is the shift up in rates, notice the larger move up for the short end of the curve over the quarter:
During the second quarter, the yield on the 5-year Treasury note rose 17 basis points (bps), ending at 2.73%. The yield on the 10-year Treasury note increased 11 bps to 2.85%. The 30-year Treasury bond yield rose 1 bps to finish at 2.98%. Most bond analysts were expecting the long end of the curve to shift up with the rest of the curve, since the Federal Reserve was raising short term rates and reducing bond purchases. However, the long end of the curve continues to be resistant to increasing rates, indicating expectations for a weaker economic picture in the future. The Fed has raised the overnight lending rate another quarter point this past quarter, up to 2.0% and the Fed is expected to raise rates a quarter point twice more in 2018.
Here is a look at fixed income returns:
Notice the short-term bond indices were negative for the quarter, while the high yield bond sector is still performing well over the past year, a sign of economic strength. As rates rise at the short end, it helps savers earn a higher return, providing confidence and more purchasing power.
Earnings growth for the largest 500 U.S. companies remains robust. S&P 500 earnings for the full year, 2018 are expected to be $157.58, which is an increase 8.08% YTD; and for 2019, earnings expectations of $174.95 have increased 9.32% YTD. In the past month, the consensus expectations have changed very little and we don’t expect the recent focus on trade negotiations to have much of an impact to earnings growth expectations, but it is not out of the realm of possibility that the tariffs begin to erode corporate earnings. Unemployment is very low at 4%, which is positive for consumer spending and its impact on GDP growth. This is not just an American phenomenon but a global one, with other countries (such as Canada) also experiencing very low unemployment. The housing market is robust in most areas of the country, even with increasing interest rates. The U.S. unemployment rate, at 4%, is near a decade low, and only popped up from 3.8% last month due to increased participation in the labor force, which is a sign of confidence in the economy (chart from Bureau of Labor Statistics):
One cannot time markets and the short-term news cycle is just noise. Our advice is not to react emotionally to markets and the news cycle. Maintaining a long-term focus is critical for your success as an investor. Here is a sample of how the global stock market responded to headlines news during the first quarter (notice the insert of the second graph that compares the last 12 months to the long term):
CONCLUSION
The second quarter decline in international and emerging market stocks improved valuations of those asset classes, while U.S. small cap stocks are near record levels. Stocks around the globe have pushed higher in July, even as trade tariffs take effect. We are closely watching bond markets for any increase in credit spreads, increasing short term rates that may attract capital flows out of stocks and into bonds, yield curve inversion or spike in interest rates that could cause a stock price correction. For now, it is wise to continue to monitor portfolios for rebalancing opportunities; and our investment committee will continue to monitor all of the hurdles facing the securities markets, as valuations are still elevated. Please reach out to us with any questions or concerns. As always we recommend focusing not on the news or short term market price shifts, but maintaining your long term focus and control what you can control (spending and savings rates) while you enjoy the balance of your summer.
Please click this link to enjoy this timely article from our friends at Dimensional Fund Advisors, as they explain how to manage your reaction to news events to achieve an outcome of success.
1. Standardized Performance Data and Disclosures
Russell data © Russell Investment Group 1995-2017, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Citigroup bond indices copyright 2017 by Citigroup. Barclays data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities. Diversification does not guarantee investment returns and does not eliminate the risk of loss.
Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.
Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.
Principal Risks:
The principal risks of investing may include one or more of the following: market risk, small companies risk, risk of concentrating in the real estate industry, foreign securities risk and currencies risk, emerging markets risk, banking concentration risk, foreign government debt risk, interest rate risk, risk of investing for inflation protection, credit risk, risk of municipal securities, derivatives risk, securities lending risk, call risk, liquidity risk, income risk. Value investment risk. Investing strategy risk. To more fully understand the risks related to investment in the funds, investors should read each fund’s prospectus.
Investments in foreign issuers are subject to certain considerations that are not associated with investment in US public companies. Investment in the International Equity, Emerging Markets Equity and the Global Fixed Income Portfolios and Indices will be denominated in foreign currencies. Changes in the relative value of these foreign currencies and the US dollar, therefore, will affect the value of investments in the Portfolios. However, the Global Fixed Income Portfolios and Indices may utilize forward currency contracts to attempt to protect against uncertainty in the level of future currency rates (if applicable), to hedge against fluctuations in currency exchange rates or to transfer balances from one currency to another. Foreign Securities prices may decline or fluctuate because of (a) economic or political actions of foreign governments, and/or (b) less regulated or liquid securities markets.
The Real Estate Indices are each concentrated in the real estate industry. The exclusive focus by Real Estate Securities Portfolios on the real estate industry will cause the Real Estate Securities Portfolios to be exposed to the general risks of direct real estate ownership. The value of securities in the real estate industry can be affected by changes in real estate values and rental income, property taxes, and tax and regulatory requirements. Also, the value of securities in the real estate industry may decline with changes in interest rate. Investing in REITS and REIT-like entities involves certain unique risks in addition to those risks associated with investing in the real estate industry in general. REITS and REIT-like entities are dependent upon management skill, may not be diversified, and are subject to heavy cash flow dependency and self-liquidations. REITS and REIT-like entities also are subject to the possibility of failing to qualify for tax free pass through of income. Also, many foreign REIT-like entities are deemed for tax purposes as passive foreign investment companies (PFICs), which could result in the receipt of taxable dividends to shareholders at an unfavorable tax rate. Also, because REITS and REIT-like entities typically are invested in a limited number of projects or in a particular market segment, these entities are more susceptible to adverse developments affecting a single project or market segment than more broadly diversified investments. The performance of Real Estate Securities Portfolios may be materially different from the broad equity market.
Fixed Income Portfolios:
The net asset value of a fund that invests in fixed income securities will fluctuate when interest rates rise. An investor can lose principal value investing in a fixed income fund during a rising interest rate environment. The Portfolio may also be affected by: call risk, which is the risk that during periods of falling interest rates, a bond issuer will call or repay a higher-yielding bond before its maturity date; credit risk, which is the risk that a bond issuer will fail to pay interest and principal in a timely manner.
Risk of Banking Concentration:
Focus on the banking industry would link the performance of the short term fixed income indices to changes in performance of the banking industry generally. For example, a change in the market’s perception of the riskiness of banks compared to non-banks would cause the Portfolio’s values to fluctuate.
The material is solely for informational purposes and shall not constitute an offer to sell or the solicitation to buy securities. The opinions expressed herein represent the current, good faith views of Lake Tahoe Wealth Management, Inc. (LTWM) as of the date indicated and are provided for limited purposes, are not definitive investment advice, and should not be relied on as such. The information presented in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, LTWM does not guarantee the accuracy, adequacy or completeness of such information.
Predictions, opinions, and other information contained in this presentation are subject to change continually and without notice of any kind and may no longer be true after the date indicated. Any forward-looking statements speak only as of the date they are made, and LTWM assumes no duty to and does not undertake to update forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks and uncertainties, which change over time. Actual results could differ materially from those anticipated in forward looking statements. No investment strategy can guarantee performance results. All investments are subject to investment risk, including loss of principal invested.
Lake Tahoe Wealth Management, Inc.is a Registered Investment Advisory Firm with the Securities Exchange Commission.
