August recap: Bulls surge into autumn bucking trade winds

Mike Loewengart, Vice President of Investment Strategy

E*TRADE Capital Management

09/04/18
So much for the dog days of summer. After the dust settled, August looked more like a street in Pamplona with only the bears gored. Despite continued trade tensions and pockets of market turbulence, US equities went on a tear during our last full month of summer. Aided by stellar corporate earnings, accelerated economic growth, and continued strength in the labor market, the current bull run became the longest in the modern era.
US equity performance, Sept. 4, 2018

Source: FactSet Research Systems, Aug. 31, 2018

US equities  

August marked a return to full-throttle bull market conditions—a classic “risk-on” environment that favored growth companies as a whole, and small- and mid-cap stocks in particular. Equity gains were largely the product of macroeconomic tailwinds and strong corporate earnings. During the most recent earnings season, roughly 80% of S&P 500® constituents posted quarterly results that exceeded consensus analyst estimates.1

Although rattled at times, equity investors seemed to shake off a fresh round of economic one-upsmanship, including billions of dollars in new tariffs between the US and its major trading parters. The escalating trade war is beginning to pinch US manufacturers by increasing the cost of inputs like steel, aluminum, and lumber, although the US-Mexico Trade Agreement could signal some respite from trade tensions. Nonetheless, the S&P 500 and Nasdaq indexes both climbed to record highs in late August, propelled by the strong performance of the information technology, telecom services, and consumer discretionary sectors.

Sector performance, Aug. 31, 2018

Source: FactSet Research Systems, Aug. 31, 2018

International equities  

On the flip side, international equities disappointed in August, with all major international indexes finishing in the red. In Turkey, a rift with the US, combined with weak economic fundamentals—rising inflation, a growing current account deficit, and mounting debt owed to foreign lenders—triggered a selloff in the Turkish lira, which has lost roughly 40% of its value this year.

The financial crisis in Turkey overshadowed positive narratives in a number of emerging markets, including India, which has seen strong equity gains, and Mexico, where the peso was one of the few emerging market currencies to appreciate against the US dollar during the month. While Turkey does not represent a significant portion of international indexes, some market participants fear contagion.

International equity performance

Source: FactSet Research Systems, Aug. 31, 2018

Fixed income

In the fixed income markets all major segments advanced. Narrowing credit spreads and the strong performance of high-yield bonds underscored improving investor sentiment and a willingness to take on more risk. Still looming in the shadows, however, is the flattening Treasury yield curve. During the month, the spread between the two- and 10-year Treasury notes briefly narrowed to 19 basis points—the lowest level in more than a decade. 

Fixed income performance

Source: Morningstar, Aug. 31, 2018

Looking ahead

Given the strong state of the US economy and exultations over the historic bull market, it may seem improbable that the markets will lose steam anytime soon. Still, many economists are expecting US growth rates to moderate in 2019, and we have yet to see the full outcome of recently imposed tariffs. To what extent diminished growth expectations and protectionism undermine investor sentiment could play a role in the direction of equities over the balance of the year.

In the meatime, there are a number of themes we’ll be paying attention to as we count down to the autumnal equinox:

•  International equities – Sure, international stocks have not fared well this year, but they are coming off a solid stretch that resulted in double-digit gains in both 2016 and 2017. While talk of synchronized global growth has tapered, many developed economies continue to expand, and there is plenty of upside in emerging markets. Moreover, the low return correlations between US equities and international stocks witnessed so far in 2018 could make international holdings important ingredients in a diversified portfolio.

•  Tariffs and trade – Although useful for political posturing, trade wars can increase the risk of inflation and could put a dent in corporate earnings. As a result, some investors may be eyeing a healthy allocation in defensive holdings, value stocks, and fixed income securities to help mitigate these risks.

•  Flattening yield curve – All eyes are on the Treasury yield curve due to the recessionary implications of an inverted shape. Though some have dismissed its significance, history tells us to ignore the signals of a flattening yield curve at one’s peril. Shoring up a portfolio’s defenses could make sense if the gap between two- and 10-year Treasury narrows further.

Additional considerations

Although we’ve seen some whipsawing in sector performance, a robust US economy has provided the markets as a whole with considerable momentum. Still, given international trade discord and the likelihood of higher interest rates after the Federal Reserve’s next meeting later this month, the markets could turn choppy at a moment’s notice.

Further down the road, there are a number of additional cautionary signs to heed, including pockets of weakness in the housing sector and a ballooning federal budget deficit fueled by last year’s tax cuts. Sprinkle in November’s mid-term elections and the porridge of today’s Goldilocks economy could turn into a witch’s brew of uncertainty.

Investors may be well-served evaluating their current holdings to make sure they can withstand a range of market conditions. After all, a well-diversified portfolio is perhaps the best defense against shifting market sentiment.

Thanks for reading, and we’ll talk to you again next month.

Mike Loewengart

Vice President, Investment Strategy

E*TRADE Capital Management, LLC

 

Additional contributor:

Andrew Cohen, CFA

Director, Investment Strategy

E*TRADE Capital Management, LLC

Mike Loewengart is the Vice President of Investment Strategy for E*TRADE Capital Management, LLC. Mike is responsible for the asset allocation and investment vehicle selections used in E*TRADE’s advisory platforms. Prior to joining E*TRADE in 2007, Mike was the Director of Investment Management for a large multinational asset management company, where he oversaw corporate pension plan assets. Early in his career, Mike was a research analyst focusing on investment manager due diligence for the consulting divisions of several high-profile investment firms. Mike holds series 7, 24, and 66 designations, as well as the Chartered Alternative Investment Analyst (CAIA) and Certified Investment Management Analyst (CIMA) designations. He is a graduate of Middlebury College with a degree in economics.

Andrew Cohen is a Director of Investment Strategy for E*TRADE Capital Management, LLC. Prior to joining E*TRADE, Andrew was the Director of Investments and Operations for a large Registered Investment Advisor, where his responsibilities included investment manager research, asset allocation, and portfolio construction. Previously, he was a Senior Research Analyst and Team Leader for a leading wealth management platform. He is a CFA charterholder and a member of both the New York Society of Security Analysts and CFA Institute. He is a graduate of Virginia Tech with a B.S. in Finance.