Dear Valued Clients & Friends:
Second Quarter 2018 Market Commentary:
April through June of 2018 witnessed familiar themes such as growing volatility in the stock markets and a flattening U.S. yield curve. However, new themes developed, the most significant of which were a slowdown in economic growth abroad and an increase in political risk, both from aggressive rhetoric around trade and the return of risk to the Eurozone project, as political groups in Italy struggled to form a coalition government. If domestic economic growth and corporate earnings continue their current trend, we believe it will be sufficient to counter the negative headlines and support stocks throughout the remainder of 2018. However, we also believe that the current growth cycle faces serious risks, and trade tensions escalating towards a worst-case scenario could derail the current positive trend.
Flattening Yield Curve
In June, The Federal Reserve raised the target for the Fed Funds rate for the second time this year. Most expect another two interest rate hikes in 2018. The Fed is attempting to normalize policy as quickly as possible without creating too large of a disturbance in the markets. The Fed’s preferred measure of inflation (Core Personal Consumption Expenditures) reached its target level of 2.0% this quarter, which likely means that there is a high bar for deviating from the current path of rate increases. Part of the Fed’s urgency in raising rates is a desire to have more ammunition for fighting the next recession. However, if the Fed moves too quickly, they risk causing a recession themselves.
While the Fed can exercise direct control over short-term interest rates, they have less influence over long-term rates, which generally reflect expectations for long-term economic growth. Since the end of 2015, the three-month U.S. Treasury rate has risen by 1.8%. Over the same time period, the ten-year rate has only risen by 0.6%, and the thirty-year rate has fallen slightly. This has resulted in a flattening of the yield curve, meaning short-term and long-term rates are close to the same level. This is a potentially bearish signal for future economic growth.
Compass Ion Advisors’ client portfolios have been allocated for the current interest rate environment. Bond prices fall when interest rates rise, and overall, our fixed income allocation has less exposure to interest rate movements than our benchmark, the Barclays U.S. Intermediate Government / Credit Index.
The changing interest rate environment has led to another intriguing story line for markets. The correlation between equities and bonds has been increasing. The low correlation in recent years between the two asset classes was highly beneficial for traditional stock and bond portfolios. However, the rising correlation between these two asset classes means that in order to create a fully diversified portfolio, one will need to include additional assets. While we still believe that fixed income will remain an important hedge for equity exposure, we also believe that alternative investments, despite having struggled in recent years, will play a valuable role in portfolios going forward.
In last quarter’s market commentary, we described the current environment as one where equity volatility and interest rates could rise together. When these events occur, equity and bond prices can fall at the same time and having an allocation to alternative investments can help protect portfolios. Compass Ion Advisors uses Reinsurance, Alternative Lending, and other alternative strategies in this segment of our clients’ portfolios. Each of these strategies has low to negative correlation with equities and fixed income.
International equities have been challenged as growth outside of the U.S. appears to be stalling. In the second quarter of this year, the S&P 500 Index gained over 3%, while the MSCI EAFE (Europe, Asia and Far East) Index and the MSCI Emerging Markets Index lost 1% and 8%, respectively. The growing risk of a trade war has increased uncertainty and appears to be creating a slowdown in business activity. The shift is illustrated by the Citi Economic Surprise Index for Major Economies. This index measures whether data releases are stronger or weaker than market expectations. After setting a record high at the end of 2017, the index has moved into negative territory this quarter, meaning that more data is coming in below expectations than above.
International markets have also faced increased political risk locally, particularly in Europe, as two anti-Euro parties gained power this year as part of a coalition government in Italy. Fears over the potential impact to the Eurozone effected overseas markets in May, with International Equities losing over two percent and Emerging Markets falling over 3.5%.
Domestically, growth in the United States has remained strong. The unemployment rate has touched lows not seen since the 1960’s, and while we did see Consumer Sentiment decline from the recent high set in March, the index is still trending higher. Also, significantly for equity markets, earnings growth for the S&P 500 is on track to meet market expectations of ~20% increases over last year.
Dispersion in markets has created opportunities for active managers to outperform their passive benchmarks. As they did in the first quarter, the majority of Compass Ion Advisors’ active managers continued to outperform their benchmarks in both equities and fixed income in the second quarter of 2018. As central banks withdraw stimulus from the markets over the next few years, we expect active managers to have additional opportunities.
Adding to the struggles for International Equities, the U.S. Dollar has rallied 5% against a broad currency basket since the end of March. The sharp rise caught many investors wrong-footed and caused a significant depreciation of Emerging Market currencies, particularly those viewed as most vulnerable such as the Argentine Peso and the Turkish Lira. The rising Dollar has been driven by strong domestic growth and rising interest rates. As rates rise in the U.S., holding dollars becomes relatively more attractive compared with foreign assets.
Perhaps the most widely debated, and certainly one of the most significant risks to markets, is the potential for a global trade war. Trade tensions are a downside risk to growth and could create higher volatility in capital markets. It is worth noting that as of mid- July, much of the news around trade has been noise rather than substance. Even with the implementation of tariffs on $34 billion of Chinese imports on July 6, the tariffs that have been enacted up to this point are relatively small, only affecting approximately four percent of imports, and should not have a significant impact on growth. However, if current threats come to fruition and we do enter a trade war, growth will be hurt. Even the rhetoric alone could be damaging to growth if it creates enough uncertainty and weakens business sentiment, which has been a strong source of growth since late 2016.
Tariffs are, by their nature, inflationary. This means that not only is the risk to the economy that consumers are not prepared to absorb higher costs, but also that rising prices could lead the Fed to increase rates at a faster pace than expected, thus choking economic growth. The tensions around trade clearly represent a downside risk for markets. However, it is unclear how the situation will play out, and as we mentioned, at this point the actual enactment of tariffs has been limited.
At the end of the first quarter, we stated that our optimism was rooted in a belief that consumer spending would remain strong in 2018. This comment was based on the strength of three indicators: consumer confidence, wage growth and unemployment. Halfway through 2018, all three of these indicators are strong, leading us to believe that consumer spending can continue to provide support for economic growth. In conjunction with strong consumer spending, we have a favorable outlook on corporate earnings, and expect year over year earnings growth in the second quarter for companies in the S&P 500 to be at least 20% for the second time this year. However, we do see the number of risks to the economy beginning to rise and expect the environment for equities to become more challenging. Now is an important time to reassess your goals and review your portfolio with your advisor. The last nine years have been an enjoyable ride for investors; however, this is not necessarily the normal experience. As we mentioned in our previous quarterly investment letter, the average intra-year correction for the S&P 500 is approximately 14%. We expect this to be more indicative of what investors will experience over the next few years as we move later into this economic cycle and the Federal Reserve becomes a less active participant in markets.
Recent Portfolio Updates: Our April investment letter highlighted some extensive equity repositioning. Click here if you missed it. Earlier this month, we sold Goldman Sachs Strategic Income. We invested the proceeds into two more traditional fixed income holdings, DFA Investment Grade and Metropolitan West Total Return. The Goldman Sachs fund was one of three Strategic Income bond strategies held by our clients. We have been overweight Strategic Income in recent years which was helpful as interest rates have been rising. Strategic Income tends to be a favorable category of bonds to hold during calm and rising equity markets. They typically have higher credit exposure and less interest rate risk, but as a result they tend to also have higher correlation to equities than many traditional fixed income strategies. Given the length of the economic cycle and the concerns about growth potentially slowing, we believe it is time to begin to trim Strategic Income in favor of Traditional Fixed Income.
We thank you again for your continued loyalty and trust and we welcome any questions you may have about your financial situation.
James C. Baird, Chairman | Founding Principal
Compass Ion Advisors, LLC
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Sources: Bloomberg, Keel Point, Tamarac