3Q2018 Market Summary The third quarter was positive for US stocks with the total return of the S&P 500 Index coming in at +7.7%, but international equities and US bonds lagged and were approximately unchanged in the quarter. The common themes of the year continued through Q3 relatively intact: US equities outperforming international, growth and momentum outperforming value stocks, and stocks still yielding more than bonds.
The market has recently experienced a material spike in volatility. Investor confidence has been hit by a series of profit warnings, particularly from industrial companies, citing input cost inflation and global trade worries. In a sense, these first few warnings potentially “broke the ice” for other companies to follow suit and admit growing pressures. Among the ominous comments by specialty chemicals company PPG Industries in its October 8th press release: 1) the company “experienced continued and unprecedented cost pressures in raw materials, freight, distribution and labor, across every region.”, and 2) “during the quarter, [PPG] saw overall demand in China soften, and we experienced weaker automotive refinish sales…due to lower end-market use demand.”
These inflation and trade pressures are combining with higher interest rates to darken the outlook further. After ending 2017 at 2.41% and ending Q2 at 2.86%, the benchmark, US 10-year bond, closed Q3 at 3.06% and touched a recent high close of 3.23% on October 5th. Monetary conditions are still generally relaxed but certainly moving in a tightening direction where borrowing conditions are less favorable to corporations and housing is less affordable for homebuyers. There is also more hiring competition in a tight labor market—for example, though small business optimism is quite high, those businesses will be competing with each other over a shrinking pool of available workers as they strive for growth.
All things considered, there is growing competition for the major building blocks of economic growth: labor, capital and raw materials. The happy, delicate balance of “Goldilocks” growth conditions (not too hot, not too cold) is unlikely to continue indefinitely. While the bull market might not be at an end, it is hard to argue that global conditions are as good, friendly and synchronized as they were earlier in the year. However, on the positive side, corporations generally have some room in their healthy margins to partially absorb some cost increases and are still flush with cash, which should provide a floor of sorts via supportive buybacks, dividends and strategic merger activity, particularly if prices get cheaper. Q3 earnings will be announced in the coming weeks, and fundamentals are largely expected to remain solid despite the handful of profit warnings that have cropped up in the last two weeks. Forward guidance will again be even more important than the backward looking Q3 results.
On a technical note, equity trading volume increased at the end of the quarter due to Standard & Poor’s and MSCI index services reorganizing the way they define industries and sectors under their Global Investment Classification System (GICS). The index providers initiated these changes in order to rebalance the sector weightings of their indexes as a result of the large market capitalization increase in technology-related stocks. The primary change was to rename the Telecommunication Services sector to Communication Services. This change allowed a group of stocks like Facebook and Google to be reclassified from the Information Technology and Consumer Discretionary sectors into a new home in Communications Services. Information Technology and Consumer Discretionary remain as sectors, but at smaller sizes going forward.
Equities: Positioning and Outlook
Our baseline equity view remains neutral and we have been generally tilting more conservative since mid-year by trimming overweights in growth and technology and swapping in some value stocks and dividend payers as opportunities arise. We are not necessarily comfortable with “the market” on a wholesale basis, but we are still optimistic that differentiated stock picking will be rewarded over the long term.
We are cautious on international equities, but do acknowledge that the underperformance during 2018 (versus US equities in particular) has made valuations more relatively attractive and could soon offer an entry point to increase exposure. We are balancing these more attractive valuations with the realization that the China trade conflict could be a longer term drag on the market than is currently priced in.
Fixed Income: Positioning and Outlook
In fixed income, US bonds are starting to offer more reasonable yields in relation to stocks as the Federal Reserve keeps raising short term interest rates. We do not hope for negative outcomes, but if yield spreads do widen, we would welcome the opportunity to get some higher yielding fixed income into client portfolios. In the meantime, client portfolios are benefiting from higher yields now available on cash and short-term instruments. These more attractive short-term yields mean there is less incentive to extend the duration or maturity of holdings, and we remain underweight on a duration basis.
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