Market Commentary: 3Q 2018

The third quarter saw stock market performance vary widely across global markets.

The US market was propelled by continued strong profit growth, thanks in large part to the Trump corporate tax cuts. S&P 500 operating earnings per share grew 27% year over year in the third quarter and a record-high 80% of S&P 500 companies reported earnings that beat the consensus expectation. The S&P 500 index hit a new all-time high in late September.

Emerging market stocks fell 1.0% and developed international equities had a slight gain of 1.4%. There are always multiple factors behind short-term market moves, but the intensifying trade conflict between the United States and China was an important one for foreign markets and specifically EM stocks in the third quarter. Another factor was the US dollar, which appreciated against other currencies again this quarter. This currency appreciation created a drag on foreign stock market returns for dollar-based investors.

In the bond markets, the yield on the 10-year Treasury rose to 3.05% at the end of the third quarter, flirting with a seven-year high. As such, the core bond index had a negative 0.5% return in September and was flat for the quarter.

Here are the broad index returns through the Third Quarter of 2018*:

U.S. Large Cap Stocks 10.5% U.S. Aggregate Bonds -1.6% Allocation 30%-50% Equity 1.1%
U.S. Small Cap Stocks 11.5% International Bonds -3.6% Allocation 50%-70% Equity 3.1%
Overseas Stocks -1.4% Commodities 11.8% Allocation 70%-85% Equity 3.9%
Emerging Market Stocks -7.7% U.S. Real Estate  2.1%

Economic Outlook

The longer-term growth outlook remains intact for Emerging Market and US stocks.

Conditions in emerging markets still appear favorable. Given the negative headlines concerning emerging markets in recent months, there are several points worth highlighting based on additional research and analysis in this area. First, the prospect of an expanding trade war between the United States and China intensified in the third quarter and has caused investor sentiment to turn against emerging markets. Uncertainties remain, but logic suggests that a full-fledged trade war is unlikely since it’s in neither country’s interest. Second, a strong US dollar, as we’ve seen lately, lowers EM stock returns for US dollar–based investors and negatively impacts emerging markets with dollar-denominated debt. However, the US fiscal stimulus (tax cuts) implemented at a time when the economy is at or near full employment will likely cause fiscal deficits and debt levels to rise. This should be a longer-term headwind for the US dollar and a positive for EM stocks. Finally, the economic crises in Argentina and Turkey have made headlines. However, these economies and their financial markets are very small and the risk of contagion to other, more meaningful emerging markets is low. In contrast to the late 1990s EM crisis, most other EM countries’ fundamentals are healthier and their prospects positive.

The US market is a horse of a different color.

No one knows exactly when this record-longest and second-strongest US bull market will end. The fiscal stimulus from the tax cuts has goosed corporate earnings growth this year, but those benefits will fade soon. And as is often the case at turning points in financial markets, it is precisely because the recent cycle for US stocks has been so strong and market participants view the US as the best game in town, that the outlook for the next phase of the cycle is darkening. There are three things to anticipate: 1) S&P 500 earnings growth expectations are now exceedingly high and the US economy is operating at or near full capacity and full employment. These conditions are unsustainable and a negative for future stock returns. Strike one. 2) The tight labor market has finally translated into wage increases. History and economic theory suggest wages will continue to rise, negatively impacting corporate profit margins and earnings growth. Rising wages could also cause companies to raise prices, stoking inflation and forcing the Fed to tighten even more. Strike two. 3) The recent rise in the dollar is likely to be another headwind for US multinational corporate profits, as it was in 2015 when the dollar rose. Trade wars, if they continue to escalate, will also have a depressing effect on sales growth and margins—both are negative for earnings and stock prices. Strike three. So, US stocks are over-earning but still expected to grow earnings even faster than normal over the next year and are expensive based on the most reliable valuation metrics. That is not a recipe for good returns looking forward.

In times of unusual volatility, it is critically important to keep the longer-term perspective and diversification in mind. It is easy to be fooled by temporary divergence in the performance of the various asset classes, but a disciplined, fundamental approach will ultimately win in the end.

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*U.S. Large Cap=Russell 1000, U.S. Small Cap=Russell 2000, Real Estate=Dow Jones US Real Estate Index, Overseas Stocks=MSCI EAFE, Emerging Market Stocks=MSCI Emerging Markets, Commodities=S&P GSCI, U.S. Bonds=Barclays Aggregate Bond Index, International Bonds=JP Morgan EMBI Global Core: Data Source: Blackrock Benchmark Returns Comparison September 2018. Economic Data: Litman Gregory Analytics. Allocations=Morningstar® U.S. Fund Allocation Categories: Data Source: Morningstar®. Index returns are for illustrative purposes only and do not represent actual performance of any investment. Index performance returns do not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.