June 2018 Monthly Summary: What Trade Spat?Submitted by NFG Wealth Advisors on July 10th, 2018
Shorter term, I believe the market is trying to push higher. The tech-heavy NASDAQ Composite, and key measures of mid-sized and small companies touched new highs in June. When small caps hit new highs, it oftentimes is a leading indicator of more upside for the broader market.
The S&P 500 was thought to finally be in a reversal only to recover almost to its previous all-time high. A couple of days of positive moves and it will get there.
Much of the underlying momentum can be traced to faster economic growth, rising corporate profits, and still-low interest rates, even though inflation is starting to pick up, which will lead the FED to continue to raise rates. As we enter earnings season, we will know shortly if those corporate profits are still rising.
Another factor that lends support–S&P 500 companies repurchased a record $189.1 billion of their own shares in the first quarter, according to S&P Dow Jones Indexes Senior Analyst Howard Silverblatt. He expects buybacks to remain strong through the rest of 2018, although I would caution investors not to rely on buybacks for price appreciation. Business investment has been on the rise, which means that companies are finally starting to invest for future productivity instead of trying to financially engineer higher profits.
The Dow Jones Industrials and the S&P 500 Index failed to recapture their January highs. Call it fear of a trade war or a wait and see attitude from investors as we approach the beginning of earning season. These larger indexes are made up of the nation’s largest companies, some of which derive a significant share of sales from overseas. Any kind of trade spat could hurt sales, which is probably why small caps have surged recently.
Though not far from the January highs, a strong dollar may be putting modest pressure on these stocks as well since a strong dollar makes exported goods more expensive for overseas consumers. Moderation in overseas growth may also be a factor.
Free trade/fair trade–it’s a very complex issue that’s being fought with simple Trumpbites. The President believes America has not been treated fairly, and he is using his authority to selectively levy tariffs against offending nations. It’s a risky strategy that may eventually break down barriers. Or, it could escalate into a series of retaliatory measures that impede the U.S. and global economy.
A quick review of the economic data strongly suggests the noise from the trade headlines isn’t affecting the U.S. economy, and GDP growth in the second quarter appears poised to surpass 4%. Once again, this is a positive for companies that rely more on US consumption than those that export a higher percentage of sales.
Currently, the trade spat has injected volatility and uncertainty into the headline-grabbing major averages though the VIX is still relatively low by historical measures.
Portfolios should continue to be overweight towards equity although I'd pare back some International and EM exposure in the short-term until the trade war issue is better understood or comes to some sort of resolution. Within the US, I'd find safety (tongue in cheek) in small caps that don't rely so much on foreign trade.
On the fixed income side, things are a bit trickier. The yield curve is ever flatter and with the FED still on its rate raising path, it could invert. Longer dated bonds provide higher yields but also have higher duration. Even if long-term rates aren't expected to rise as much as short-term rates in the short-term, duration risk can still hurt. On the other hand, short-term yields are becoming just as attractive as long-term rates without the duration risk. The sweet spot might be in what is often called the belly of the curve. Not too long, not too short.
High yield bonds, which have been an excellent alternative for investors looking for yield, are now trading at lower yields than a year ago – the only bond category whose yields have declined. So that option is running its course too. I would remain underweight fixed income and focus on mid-range credits.