Summer is here, baseball is in full swing, we are still floating on the rarified air of the Warriors championship, and vacations are upon us as we continue to explore the financial markets. Please read on for our thoughts about past, current, and musings about future market conditions.
Second Quarter 2018 in Review
Despite the implications of a global trade war, the US economy continued its ascent during the second quarter. Equity markets rose, albeit a bit bumpy at times. In the US, the S&P 500 increased 2.9% while European and Asian markets experienced a similar trend on a local currency basis. Unfortunately, international funds suffered declines when adjusted for currency as the US dollar strengthened throughout the quarter. For example, the dollar rose over 5% against the Euro. Consequently, the MSCI EAFE, a measure of developed international countries increased 2.5% on a local basis but declined 2.3% on a USD basis.
There is no question that economic growth has strengthened into 2018. The first half of the year propelled corporate earnings growth forward and the labor markets to further tighten. One of the broadest measures being unemploymentwhich, currently at 3.8%, is the lowest level we have experienced since December of 2000. In addition, GDP growth has picked up in the past year, rising to almost 3% at the end of March. When compared to other major regions of the world, the US economy is the only one showing positive momentum.
Chart 1: Year of Year Gross Domestic Product Growth (GDP Growth YOY)Source: FactSet Research Systems.
Even with this strength, it certainly feels less stable than in years past. Market volatility has been on the rise in 2018, especially when compared to recent years. This means you may end up getting the portfolio gains that you would like, but with more bumps along the way.
The driver of these recent swings is multifold. Firstly, we have experienced many years of successive market growth and as a result, valuations remain at a premium. This is nothing new but has persisted as it is a consequence of a fundamentally strong economy. Illustrating the point, all else being equal, investors are currently willing to pay 85% more for earnings than they were in 2011 (see Chart 2). This exemplifies the confidence that investors have in the underlying economy today.
Chart 2: Price to Earnings Ratio (PE) from 2008-2018. This chart reflects the forward-lookingearnings estimates for the "next twelve months" (NTM) value. Source: FactSet Research Systems.
Secondly, as we look ahead, there are two factors driving underlying volatility on a global scale: trade and interest rates.
Trade wars, especially as the economy has become more globalized, are dangerous and disruptive. Leave aside for the moment any discussion of whether they are justified, or how effective they are. The implications of a significantchange in how trillions of dollars' worth of goodsaretaxed would be tumultuous. The US is the largest importer in the world at over $2 trillion dollars' worth of goods a year, with $500 million from China alone.
For now, the tariffs apply to things like washing machines, lumber, solar cells, steel, and aluminum (with some exceptions), amounting to roughly $50 billion, or about 2% of all US imports. In retaliation, about $34 billion in tariffs have been imposed on the US (about 1% of exports). As you can see, these numbers are relatively small and immaterial to US growth.
The fear is that the administration's actions, which are commonly less aggressive than its words, may catch up to the rhetoric and have a greater impact. For example, a worst-case scenario where tariffs are imposed on $450 billion of imports from China and $275 billion in automotive imports, would impact only 27% of all US imports and amount to 4% of US GDP. There is additional consideration from these figures such as the impact on consumer behavior and of course increased market volatility. For now, we feel the tariff figures are benign.
The other factor affecting markets is the impact of interest rate hikes. The prolonged period of market growth has offered the Fed policymakers an opportunity to revert to normalized interest levels. Since December 2015 the Federal Reserve has raised interest rates seven times; the effective Fed Funds rate started at near 0.25%, and is now approaching 2% (see Chart 3).We expect these rate hikes to persist as the economy continues to demonstrate its strength. By the end of 2019, we expect this rate to be near 3%.
Chart 3: Effective Fed Funds Rate from 2013 to 2018. The Fed has steadily raised rates starting in 2015. Source: Board of Governors of the Federal Reserve System
While these rate hikes are indicative of the health of our economy, a rising rate environment has made fixed income investing challenging for most. Our strategy of managers adhering to a multi-asset approach has allowed us to mostly sidestep the issues being felt by more traditional yield curve based managers where returns have been poor. Broadly speaking, the Bloomberg Barclays US Aggregate index, a common performance index for the general fixed income market was flat for the quarter and is down almost 1% year to date.
Another repercussion of market strength and rising rates is the expectation for growth. Investors commonly look to the yield curve, a curve which plots government bonds along a timeline from near term (0 - 3 months) out to 30 years. In healthy, growing economy, the line slopes up and to the right. This is logical because investors should get paid more (higher interest) for investing longer-term. Chart 4 shows several yield curves over the past year. The yellow one is from one year ago. The line is lower on the left and gets higher the farther you go out in time. The cluster of lines above that line are more recent. As you can see, the line has flattened out considerably. This flat curve is not indicating a recession is imminent, but instead signifies that while healthy and consistent, the economy is growing at a low and stable rate. There is cause for concern if theyield curve becomes inverted (where longer rates are lower than shorter rates), as an inverted curve commonly means we are headed into a recession.
Chart 4: The Yield Curve has flattened over the past year. Source: FactSet Research Systems.
As you can see the yield curve is not even close to inverted today. Headline driven "doom and gloom" actions based on hypothetical scenarios are just speculation, nothing more. Increasingly, we spend a considerable amount of time simply filtering out the noise in order to focus on the strategy ahead.
The interest rate scenario unfolding in the US is far healthier than in other regions. If you compare the US yield curve to that of Europe and Japan, you'll see that their economies are stagnated and on the shorter end, remain negative (Chart 5).
Chart 5: The yield curve for US, Europe, and Japan. Source: FactSet Research Systems.
We maintain the US is on solid footing and expect it to remain this way for the remainder of 2018. Interest rates will continue to rise, and strong earnings growth will reinforce premium valuations in equity markets.
Economies rise and fall. It is our job to assess what has happened and use this to think strategically about how to plan for future developments to safeguard and grow client portfolios. We think being consistent is the first step in the process. Those who waiver, oscillate between strategies, or rely on market timing or momentum usually do so at their peril. Asset allocation has proven to be a consistent strategy to offer growth and diversification for risk control.
As always, we appreciate your confidence and welcome your questions.
The Silicon Valley Wealth Advisors Team
Tracy Lasecke, CFP®
Chris Duke, CFP®
Scott Yang, CPA, CFP®
Raechel Cline, MBA
Robert Lopez, CFP®
What We've Been Up To
Tracy and Roberta managed a quick trip to Park City to visit and explore with daughter Jamie and son-in-law Matt. Tracy continues with his auto racing hobby while Roberta hikes and hikes!
Chris and family experienced highs and lows this quarter. Chris' grandmother, Anna Mae passed away in April 2018(his grandfather passed in May 2017). They were an inspiration to those that knew them - how to live, how to love, and how to give selflessly. Together they were Chris' first client. She will be missed.
Scott and the family just returned from an unforgettable trip to Italy. They saw the Coliseum and Vatican in Rome, the Uffizi art gallery in Florence, and enjoyed a ride in a gondola through the canals of Venice.
Adam and his kids visited Silver Mountain in Kellogg, ID to enjoy the scenery and spend some time at the waterpark. Now that summer has started they are looking forward to camp and other outdoor activities.
Ali and Guy are enjoying their time at home with their new daughter Penelope. They feel like they won the lottery getting a baby that sleeps through the night and barely cries. Every day is a new experience and at 4 weeks old she is already getting too big for her newborn clothes.
Robert and Shirley were able to enjoy two trips during the past quarter. The first, to celebrate their 1st wedding anniversary, included stops in London, Euro Disney, and Paris. They were even able to book a stay at the same hostel from a 2009 trip together. The second was a hiking trip to see the beautiful waterfalls found on the Havasupai Reservation in Arizona. The trip lasted three days and required over 30 miles of hiking.
Jim spent time traveling to La Jolla, CA and visiting kids Sophia and James at University of San Diego. He hopes his kids appreciate the fine education they're getting in a country club setting. He's been assured by both that the money is well spent. On the cultural front, Jim was involved in sponsoring Inland Northwest Opera. The upcoming season includes Marriage of Figaro with the Spokane Symphony orchestra.
Raechel is new to the team and we are excited to have her help. Raechel is a Navy veteran and received her Master's in Business Administration from the University of Maryland. When she is not busy chasing after her three-year old son, Ethan, she enjoys all things fitness related. Most recently, she ran her third half-marathon race in the Rocky Mountains of Denver!
Harmeet, our summer intern, has been actively enjoying living in the Bay Area for the summer. As a Central Valley native, she intends explore and make life-long memories with her boyfriend in the Bay before she heads back to finish her last year at Sacramento State University.
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