The Federal Reserve hiked rates for the 3rd time this year, global trade agreements and alliances are being redrawn, US inflation and yields are on the rise, but the US equity markets hit all-time highs. The news overseas is none too cheery – the UK and the EU still don’t have a Brexit deal with the March 2019 deadline looming, Argentina and Turkey were on the brink of currency crises, there are concerns about Chinese debt levels as well as the impact of tariffs on the Chinese economy, elections in Brazil have produced more drama than their famed telenovelas, Australia has had four Prime Ministers in eight years (actually, five, if you count the brief return of Kevin Rudd). Finally, the surge in Italian bond yields is resurfacing fears of a Eurozone crisis as well as the possibility of Italy leaving the European Union.
No wonder the US seems like a bastion of tranquility, and its equity markets have strongly outperformed the rest of the world. The 3rd quarter of 2018 was notable for the divergence in performance between the US and the international equity markets. While the US equity market indexes set all-time highs, there was little for investors in international equity markets to cheer about. The Russell 1000 Index returned 8% during the quarter, while MSCI ACWI ex-US Index returned only 0.6%. The following are a few reasons for the difference in returns.
US Economic Strength
Real GDP growth in the US accelerated from 2.2% in Q1 to 4.2% in Q2 (source: Bureau of Economic Analysis). The corresponding numbers for the Eurozone were 1.6% annualized (source: Eurostat), and for Japan was -0.8% and 2.8% respectively. Economic commentators have attributed this decoupling in growth between the US and other economies to the impact of the fiscal stimulus that was enacted through tax reform at the end of 2017. The Atlanta Fed’s GDPNow model estimates that GDP growth in the 3rd quarter will exceed 4% again. By the end of the quarter, the Fed had raised its estimate for real growth for all of 2018 to 3.1%. Unemployment fell to less than 4% for much of the quarter, and at the end of the period it stood at 3.7%, close to a fifty year low. The labor force participation rate, which has seen a substantial decline since 2000, stabilized, not only during the last quarter, but over the last 18 months as the economic expansion progressed. Consumer confidence increased to a level approaching an 18 year high, perhaps reflecting the low unemployment numbers.
US Dollar stability
The US dollar (as measured by the Bloomberg Dollar Spot Index) had appreciated significantly in the 2nd quarter (likely due to divergence in central bank monetary policies), but was relatively flat during the 3rd quarter. Interestingly, the US Dollar depreciated against the Canadian Dollar, but was little changed against the Euro and British Pound. It did appreciate a little against the Japanese Yen and Australian Dollar, and significantly against various emerging market currencies.
A pause in USD appreciation has favored US Large Cap equities over non-US equities and US Small Cap equities owing to higher exposure to overseas revenues as well as the translation effect of those revenues in boosting reported earnings.
Rise in US Treasury Bond Yields
The yields in Treasury bonds across maturities rose during the 3rd quarter. There are two possible reasons for this:
- According to Bloomberg, Fed Funds futures indicate that the forward rate by Dec 2019 will be 2.84%. This would imply a total of four rate hikes by the Federal Reserve in 2018, and two rate hikes in 2019. Interestingly, the Fed itself has signaled three rate hikes in 2019.
- Inflation in the US is running at its fastest pace since 2012. The year-over-year change in the Core PCE (personal consumption expenditures) Index recorded its highest change, 2%, in over 6 years. The New York Fed’s Underlying Inflation Gauge is at its highest level since 2007.
2018 Q3 Factor Analysis
An analysis of the performance of the stocks in the S&P 500 Index during the 3rd quarter across a variety of factors reveals the marked preference for stocks with large size, positive revisions and upgrades by sell-side analysts, high earnings quality, and positive price momentum. Conversely, stocks that were ‘cheap’ on measures of valuation such as low forward price-to-earnings ratios were out of favor during the quarter. The underperformance of the valuation factor has been a feature of the equity market throughout the first three quarters of this year. An analysis using Refinitiv’s Eikon application shows that the quintile of stocks in the S&P 500 that had the lowest forward price-to-earnings ratios underperformed the quintile that had the highest ratios by nearly 18 percentage points. The underperformance of valuation is a major cause for the Affinity Large Cap strategy’s performance lagging that of the S&P 500 this year.
Corporate profits are expected to increase at a nearly 20% rate for the quarter. While this earnings increase is substantial, the Price Earnings Ratio for the market, as represented by the S&P 500 Index, on estimated twelve months forward earnings, stood at 16.8 at the end of the quarter. This valuation is above the ten year average of 14.5. Elevated valuations increase the market’s vulnerability to disappointments and shocks. The disappointments might be earnings increases below expectations or interest rates above consensus estimates. The set of shocks might include abrupt changes in economic policy or more than normal political turmoil in the US.
The market’s favorable performance in the quarter might have been more robust were it not for lingering concerns about foreign trade policies and the likely path of the Fed’s monetary policy. The current Administration has embarked on a policy of trying to renegotiate existing trade agreements and arrangements, and has shown a willingness to increase tariffs on imported goods as a method to motivate our trading partners to reduce or eliminate tariffs on our exports. The potential for economic instability resulting from escalating tariffs diminished somewhat, when near the end of the quarter, a new trade agreement that included the US, Canada, and Mexico was put in place. This new agreement is set to replace NAFTA which was adopted during the Clinton Administration. The US and China have yet to come to an agreement which would establish the level of tariffs on goods traded between the two countries. Thus, there remains some possibility for disruptions in the flow of goods across borders as a result of this dispute.
The primary threats to future advances in stock prices and continued economic growth arise as a result of the Fed’s determination to raise interest rates to their estimate of a ‘neutral rate’. Bond yields did rise, and further increases could potentially increase equity discount rates and compress valuations. The Fed has announced its intention to have short term rates in the range of 3.5% to 4.0% by the end of 2019. Currently, the rates fall in a range of 2.0% to 2.25%. As the Fed has raised rates, the yield curve has flattened indicating lowered expectations for real growth on the part of market participants. If the Fed continues to both raise rates and decrease the level of the money supply, economic growth could falter.
While investors have not been rewarded for emphasizing attractively priced stocks this year, we continue to believe in our value-oriented philosophy that has stood the test of time over 26 years. The portfolio continues to sport a significantly lower forward P/E relative to the S&P 500 Index. We should note that Affinity does not merely purchase statistically cheap equity securities, but only those that have also received positive earnings and revenue estimate revisions, and recommendation upgrades by sell-side analysts.
Please do not hesitate to contact us should you have any further questions.