This July, no independence from market volatility

Mike Loewengart, Vice President of Investment Strategy

E*TRADE Capital Management

07/02/18
June ushers in some of the nicest weather of the year in North America. That’s good, because June has traditionally not been a sunny walk in the park for investors. In fact, history has typically shown June to be the financial equivalent of overcast with a slight chance of showers. Since the end of World War II, the Dow Jones Industrial Average has risen in 52% of Junes and fallen in 48% of them.1 Given the roughly even odds, it seems appropriate that the markets finished June relatively flat as we reach the halfway point of 2018.
US equity performances, July 2, 2018

Source: FactSet Research Systems, July 2, 2018

Stocks gained ground early in June, before yielding ground amid tariff threats and trade concerns. Fixed income performance varied by region. Recent market volatility may seem contradictory given the ongoing strength of the US economy, but most investors are forward-looking by nature and have chosen to focus on the threat of tariffs. If international brinksmanship is an enemy of the markets, investors can at least take solace in strong domestic fundamentals.

As expected, the Federal Reserve (the Fed) increased the target fed funds rate to a range of 1.75%–2.00%, marking the second rate hike of 2018. The real news was in the Fed’s outlook. At its June meeting, Federal Open Market Committee (FOMC) members signaled two additional rate hikes this year, which is one more than the Fed had originally telegraphed. Tighter monetary policy increased short-term Treasury yields and exacerbated an already-flattening Treasury yield curve. Given the historical tendency of inverted yield curves to precede recessions, the Fed’s actions did little to soothe investor sentiment.

Trade tensions escalated in June, with President Trump threatening to slap $450 billion worth of tariffs on imports from China. It was the latest in a tit-for-tat with Beijing, which has pledged to retaliate with tariffs of its own on US exports. President Trump also left some of America’s largest trading partners rattled by pledging to upend long-established trade agreements and withdrawing US support for a joint statement with US allies at the G-7 summit in Quebec.

Domestic equities

Large-cap equities were generally flat for the month. The blue-chip Dow Jones Industrial Average was off 0.49%, while the S&P 500® Index eeked out a modest gain of 0.62% In June. That marked a sharp reversal from May, when the S&P 500 Index turned in its best May performance in four years. For the quarter, the S&P 500 was up over 3%.

As noted, volatilty spiked late in the month amid tough trade talk and potentially stiff tariffs that could raise input costs for US manufacturers. Small- and mid-cap shares fared better, however, perhaps because investors view smaller companies as less dependent on exports and more insulated from international trade turmoil.

Consumer staples stocks outperformed in June. Investors tend to view consumer staples as havens in a trade-war scenario. On the flip side, industrials, which appeared caught in the undertow of swelling trade tensions, were the worst-performing sector in June, followed closely by financials. The tech sector was off slightly for the month, despite four of the five FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks reaching all-time highs.

US equity performance, July 2, 2018

Source: FactSet Research Systems, July 2, 2018

International equities

In Europe, German Chancellor Angela Merkel and French President Emmanuel Macron discussed ways to stabilize the eurozone amid fallout from Italy’s election results this past spring. Some view Italy’s new populist government as a fundamental threat to the European Union. With so much political and economic uncertainty, the European Central Bank has pared back its bond-buying program, which should provide dry powder in the event of an economic downturn but will likely keep the euro under pressure relative to the US dollar.

Stocks in Europe and Japan trended lower during the month but outperformed emerging markets, which have struggled since late January. Pullbacks in Brazil and China were particularly damaging to emerging market returns, with some questioning how well China will be able to weather a potential trade war. Over the coming months, Brazil is likely to face continued structural challenges ahead of its presidential elections in October.

International equity performance

Source: FactSet Research Systems, July 2, 2018

Fixed income

Bond returns were generally lower for the month, although US issues outperformed international developed and emerging market credits. Despite a “risk-off” environment that lowered 10-year Treasury yields, high-yield bonds paced the fixed income market.

During the month, all eyes remained on the Treasury yield curve. Investors have grown increasingly wary of the narrowing spread between 2- and 10-year Treasury yields, which has flattened the curve considerably since last year. This is a concern, as historically an inverted yield curve has typically foreshadowed recession. Most of the flattening was triggered by the short-end of the curve following the Fed’s decision to raise short-term interest rates. After crossing the psychologically significant 3% mark and then falling to 2.83% at the end of May, the benchmark 10-year Treasury yield closes out June at roughly 2.85%.

Fixed income performance, July 2, 2018

Source: FactSet Research Systems, July 2, 2018

Bottom line

Despite the headline risks that have roiled the markets of late, it can be easy to lose sight of the fact that the US economy is still on solid ground. The US unemployment rate has fallen to levels not seen in nearly 50 years, industrial production remains robust, and inflation appears contained. In fact, one of the greatest hurdles facing employers is how to fill more than 6.5 million job openings nationwide.

Looking ahead to the second half of the year, corporate earnings will bear watching. With second quarter earnings season about to kick off, the direction of the financial markets could hinge in part on whether companies can meet or surpass investor expectations. Downward revisions to earnings guidance could be a sign of economic deceleration.

Similarly, the Treasury yield curve is providing its own signals. Historically, an inverted yield curve has foreshadowed recessions, which is why flattening trends can give investors pause. But a flattening curve is far different from an inverted yield curve, and it seems unlikely that the Fed would consciously tighten the US economy into recession.

Also keep in mind that the current economic expansion—now the second-longest on record—is getting a few grey hairs. While it’s difficult to say just when the economy will peak, there are indications that we are heading toward, or perhaps already in, a late stage of the business cycle. Ebbs and flows in the business cycle are part and parcel of investing and are no cause for alarm, but may require fine tuning portfolio allocations.

Given the health of the US economy, there’s a lot for investors to feel good about right now, but there are potential threats lurking in the shadows. Let’s hope they’re not bears. Remember that a properly diversified portfolio can serve as an investor’s closest ally in any market climate.

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.


1. Prestbo, John. “U.S. stocks have a long history of June swoons” MarketWatch, June 4, 2015. https://www.marketwatch.com/story/us-stocks-have-a-long-history-of-june-swoons-2015-06-04, historical data since 2015