The following is our Third Quarter 2018 investment commentary sent to clients in mid-October 2018.
U.S. Economic Trends Persist
The U.S. economy continues to experience steady, strong growth which has picked up slightly in the current quarter to a 2.9% increase in GDP year over year. This growth rate reflects the positive influence of tax reform as well as healthy investment spending by businesses and consumers.
Thus, 2018 is the 10th year of economic expansion, making it one of the longest on record. The economy is essentially at full employment, yet inflation is still low. Given the length of the expansion, the tight labor market and the tax reform boost, the question of where the economy goes from here is pertinent. While it appears the economy is likely to stay in the 2-3% growth range, uncertainties exist that could pose challenges in 2019 and beyond.
Steady Strong Economic Growth is Supportive of U.S. Equities
Performance of U.S. equities has stayed positive year-to-date with growth-oriented stocks still besting value-oriented stocks in the third quarter, albeit with a narrower gap. In a reversal, larger companies outperformed smaller companies. While overall U.S. stock valuations measured by the price-to-earnings ratio are only a little above their historical average, growth stocks are now expensive relative to their history and value stocks are more attractive. We continue to hold to our philosophy of investing in both growth and value because each leads at different points in time.
Non-U.S. Equities Face Currency Headwinds
While most economies in the world are growing, international investment returns face headwinds from a stronger dollar. Emerging economies are encountering an additional headwind from trade tariff rhetoric. Returns for developed market equities are slightly negative year-to-date at -1% for the EAFE index and emerging markets equities are more negative, at -7.4%. In local currency, developed markets are up 1.8% and emerging markets are down 2.6%, illustrating the impact of currency on non-U.S. holdings.*
Bonds Become More Attractive as Interest Rates Rise
Another positive of a strong economy is that it allows the Federal Reserve to continue normalizing interest rates. So far there have been three 0.25% increases this year.
Overall, core fixed income returns year-to-date are slightly negative. However, fixed income funds focused on short-term investments are benefitting from the increase in short-term interest rates. At quarter end, the 2-year Treasury yield was 2.8% versus 1.9% at the end of 2017. While the market value of bonds and bond funds focused on intermediate maturities has dropped as interest rates rose, their yield is now higher. For example, the Barclay’s Aggregate Index is down 1.6% year-to-date and one component of return, the yield, was 3.5% at quarter-end. Higher interest rates mean fixed income investments look more attractive now.
The Importance of Balance and Diversification
There is a natural temptation to invest in what is doing well, which is dangerous since trying to time markets has proven to be a poor strategy over time. We understand the frustration of seeing double-digit returns for a small group of U.S. stocks while well-diversified portfolios generate single digits. However, history tells us that no single asset category outperforms the average forever. Risk and return are connected and high returns can belie high risk. By looking forward, diversifying portfolios and concerning ourselves with both risk and return, client portfolios are better protected against the unforeseen and potential losses that can cause lasting damage.
If you have experienced significant changes in circumstances recently or wish to review your situation please contact us.
*Source JPMorgan, MSCI indexes