July: U-turns allowed

Mike Loewengart, Vice President of Investment Strategy

E*TRADE Capital Management

08/01/18

Pick your analogy: The markets are heating up with the weather, or they’re changing course as fast as a July twister across the plains. Either will do given the events of the past month.

Stocks advanced at a healthy clip in July, with large-cap shares leading the pack and growth generally outperforming value. The S&P 500® Index had its best month since January and every major equity asset class was in the black. The past month also saw a number of turnarounds, with some of June’s worst-performing market segments rebounding in July.

The US economy continued to expand, with gross domestic product growing by 4.1% in the second quarter—its fastest pace since 2014 and an increase from last quarter’s 2.2% rate of growth. However, headwinds to sustained economic momentum remain in the form of punitive tariffs that are already taking hold, as well as a nine-year-old economic expansion that is beginning to show its age.

US equity performance, Aug. 1, 2018

Source: FactSet Research Systems, Aug. 1, 2018

Domestic equities

In a reversal from June, large-cap stocks outperformed small- and mid-cap shares in July, which again saw escalating trade tensions between the US, Europe, and China. President Trump even hinted at expanding tariffs to include all Chinese imports into the US. The tariffs have become more than just talk, and are having a tangible effect on export-dependent manufacturers and soybean growers—to the point that the Trump administration has approved $12 billion in farm aid to farmers and ranchers hurt by tariffs.

Given that large companies with supply chains and customers all over the world can be vulnerable to trade disruptions, it may seem counterintuitive that large caps outperformed stocks associated with smaller, domestically focused firms. Part of the explanation could lie in strong corporate earnings growth. With just over half of the companies within the S&P 500 having reported earnings by month-end, more than 80% of reporting constituents posted results that exceeded consensus estimates.

July saw a sector rotation as well, with some of the worst-performing sectors in June—including financials and industrials—among the best performers in July. Nonetheless, several high-profile earnings disappointments sparked sporadic market volatility, highlighting sector concentration risk—particularly among the so-called FAANG technology stocks comprising Facebook, Amazon, Apple, Netflix, and Google.

US equity performance, Aug. 1 2018

Source: FactSet Research Systems, Aug. 1, 2018

International equities

Emerging market equities were July’s comeback kids, bouncing back from a second-quarter beatdown and flexing some muscle during the month. Latin America led the resurgence, with investors swooping in to pick up shares that may have been oversold amid political upheaval in Venezuela, Mexico, and Brazil. However, the lead-up to this fall’s elections in Brazil could spark renewed volatility in Latin America, and the recent zigzag in performance underscores the inherent volatility of emerging markets.

Developed market equities delivered mixed, but generally positive returns, with Europe and Asia generally underperforming the US. President Trump’s bellicose tone at the NATO summit may have unsettled international markets, but not enough to drive them into negative territory.

International equity performance

Source: FactSet Research Systems, Aug. 1, 2018

Fixed income

High-yield and municipal bonds paced fixed income performance in July, with municipals aided by a continued dearth of supply. The flattening Treasury yield curve cast shade on an otherwise sunny economic picture. The spread between two- and 10-year Treasury yields narrowed further to roughly 0.30%, stoking concerns that the yield curve could eventually invert, an occurrence that has historically foreshadowed recession.

Contributing to the flattening trend were diminished expectations for future growth, despite solid second-quarter economic data, coupled with monetary tightening and a rising supply of two-year Treasury notes. Longer-term US Treasury yields surged late in the month after the Bank of Japan hinted at backing off its accommodative monetary policy.

Fixed income performance

Source: FactSet Research Systems, Aug. 1, 2018

Bottom line

Global equities have thus far showed resilience in the face of tariffs and economic brinksmanship. Based on earnings results and the pace of GDP growth in the second quarter, investors have much to cheer.

However, we’re now seeing a tug of war between fiscal stimulus and monetary tightening. Despite the president’s attempts to intervene in monetary policy, the Federal Reserve is still signaling additional rate hikes in 2018. And on the heels of last year’s massive tax cuts, the Trump administration is reportedly eyeing a $100 billion tax cut on capital gains.

Given these opposing forces, how sustainable the current growth trajectory is could hinge on how much of an economic toll the growing global trade war takes.

With this in mind, investors may wish to consider some broader investment themes:

•  International equities. If fragile market conditions in Europe, Japan, and any number of developing countries can withstand global trade disputes, attractive valuations could add to the appeal of international equities.

•  Fixed income. After a recent rough patch, high-quality corporate bonds are showing signs of life and could serve as a stabilizing agent through stretches of equity market volatility. Moreover, investors hungry for yield should be less incentivized to pursue riskier asset classes if the Federal Reserve follows through on its declared course of rate hikes.

•  Growth versus value. There’s no sugar-coating the fact that value investors have had a rough time of it in recent years. But with economic growth potentially leveling off and a renewed focus on the quality of corporate earnings, value stocks stand a chance of eventually coming back into favor.

At some point, lawmakers will also have to come to terms with an exploding federal budget deficit in the face of an expanding economy. If the budget can’t be brought under control during the good times, what happens when revenue begins to shrink? Fortunately, a diversified investment approach can help position investors for a wide range of market conditions, which may become increasingly important over the balance of the year.

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.