The major averages continued to tack on further gains in the 2nd quarter heading towards what could end up being the 10th consecutive annual gain for the S&P 500 (SPY).
Large-caps, however, haven’t been where the action is. In fact, the large-cap core and large-cap value groups have 2018’s worst performers struggling to stay above the breakeven mark. If 2017 was the year where you could make money almost anywhere, 2018 has been the year where investments in growth areas, such as tech, momentum and small-caps have paid off most.
The tech-heavy Nasdaq (QQQ) continues to provide leadership for the market. It tacked on another 6% gain in the 2nd quarter pushing its return for the first half of the year almost 9%. Small-caps (SLY), however, were the quarter’s biggest winners. The S&P 600 also pushed its first half gain to nearly 9% on the heels of stronger earnings growth, less exposure to international turmoil and the benefits of corporate tax reform. The Dow (DIA) is back underwater on the year thanks in large part to the struggles in the consumer sector. Components, such as Procter & Gamble (PG), Walmart (WMT), 3M (MMM) and Johnson & Johnson (JNJ) were all down double digits in the first half.
Earnings
S&P 500 companies reported 25% year-over-year earnings growth marking the highest growth rate since Q3 2010. Revenue growth was roughly 8%. FactSet estimates are calling for 20% earnings growth for the full year 2018 with the biggest earnings and revenue gains coming from the energy, materials and tech sectors. 78% of S&P 500 companies beat their earnings estimates in Q1.
Thanks to last year’s Tax Cuts & Jobs Act, the trend of double digit year-over-year earnings growth is expected to continue through the next several quarters. If there’s any concern in these results, it’s that the majority of these gains are coming from tax savings and stock buybacks as opposed to organic growth.
The Economy
The economy has added an estimated 1.2 million jobs through the first half of 2018 and hasn’t posted a monthly loss of jobs since 2010. June’s report saw an uptick in the unemployment rate from 3.8% to 4.0%. While it may seem initially concerning that the rate climbed, it might actually be a good sign since, coupled with more than 200K jobs added, it could indicate that workers are coming off the sidelines and looking for employment again. The core inflation rate remains just a hair above the Fed’s target 2% rate and, for the time being, remains in check.
The big wild card right now could be the Fed’s path of interest rate hikes. A third rate hike before the end of the year seems like a foregone conclusion and the Fed Funds futures market is currently pricing in a 57% chance of a fourth hike in December. With the yield teetering perilously closing to becoming flat or even inverting, any further rate hikes at this point could push the economy into recession. Historically, every time the curve has inverted, it’s been followed by a recession about 18 months later. A 25 bp increase on the short end without a corresponding lift on the long end would put the yield curve nearly at the point of inversion.
Ryan Detrick on Twitter posted this nifty little infographic that helped show how the markets have responded to flat rate curves in the past.
On average, the economy takes nearly two years on average to slip into recession following a curve inversion. Perhaps more interesting is the fact that the market still tends to post gains immediately following the inversion. In other words, no reason to immediately panic, but it should put you on alert for when it happens.
Washington’s Focus on Protectionism
Activity in Washington is almost entirely centered around tariffs and their impact to the global economy. Just this week, President Trump announced the intent to levy tariffs on another $200 billion worth of Chinese imports to go along with the $50 billion in total either already in effect or expected to go into effect soon. The news, of course, sent Chinese stocks downward with the U.S. indices following suit.
The big question now is when does it end. Rising tariffs will almost certainly have a negative impact on global growth, which makes coming to an agreement on when begin easing them that much more important. So far, it’s just been Chinese imports which have been affected, but imports from Mexico, Canada and Europe could soon be impacted as well. As I mentioned in an earlier post, trade wars raise the prices of goods for consumers and force to companies to reassess how and where they’re doing business (see Harley-Davidson (HOG) and their plan to move some operation out of the U.S.).
Trump appears to have no plans to ease tariffs any time soon and that could be bad news for the global economy.
Tech and Consumer Discretionary Lead; Utilities Stage Furious June Rally
Tech (XLK) and consumer discretionary (XLY), two segments of the economy that are most impacted by a strong economy and the corresponding growth in spending and consumption that come with it, have been 2018’s top performing sectors posting gains of 9% and 11%, respectively. June, however, was an interest rate story. As yields began pulling back, so did these two sectors, which opened the door for more rate-sensitive sectors, such as utilities (XLU) and real estate (XLRE) to rally. The Utilities Select Sector SPDR ETF, at one point in June, was up in 15 out of 16 trading days.
The financial sector (XLF) has to be the biggest disappointment of the year. Favored by many at the beginning of the year due to several anticipated rate hikes, it has been one of the market’s worst performing groups. The big banks begin reporting 2nd quarter earnings at the end of this week. I’m still optimistic for good results from these banks, but forward guidance could be weak leading to further declines.
The energy sector (XLE) has done well as expected, but the consumer staples sector (XLP) has me intrigued. It’s gotten left behind in 2018, but the group has rallied over the past several weeks along with utilities and real estate. Investors have begun returning to staples lately (XLP has had net inflows of nearly $700 million since June 1st) and could be viewed as a good landing spot for stock pickers if they feel that global growth is slowing or U.S.-China trade relations are worsening. XLP is up to a 2.8% yield, roughly the same level as 10-year Treasuries. Consumer staples performed well a few years ago when these two yields began converging.
Is the Fed’s Rate Hike Plan Too Aggressive?
At the beginning of the year, most expectations were for three quarter-point hikes from the Fed during 2018 with an outside shot at a fourth. Right now, the Fed futures market is telling us that a third hike later this year is virtually guaranteed, and there’s a 58% chance of hikes in both September and December. But is that a good thing?
It was anticipated that rates on the long end of the curve would continue their slow ascent throughout the year. That was the case in much of the first half, but now the Fed might want to think twice now that long-term Treasury rates have started to come back down. The current data – inflation, job growth, GDP – all support further rate hikes, but raising rates amid concerns over slowing global GDP growth could grind the economy closer to a zero growth environment.
It’s a delicate balancing act for which there’s no good answer. A hike in September seems like a done deal, but the next few months could be key in determining if the Fed is ready to pull the trigger for a fourth time. I’m leaning towards believing the Fed will not raise in December, but there’s a lot of time for things to change.
The Treasury Curve Gets Flatter and Flatter
The spread between different Treasury maturities has gotten to the point where there’s almost no yield advantage to venturing into long-term securities.
Investors have been nervous about committing assets to riskier investments so far in 2018. Using the iShares Treasury ETFs (SHY) (IEI) (IEF) (TLH) (TLT) as proxies, we’ve seen money flowing into government notes across virtually all maturities.
ETFs focused on short maturities and durations, in particular, have attracted money. The iShares Floating Rate Bond ETF (FLOT) and the iShares Short Treasury Bond ETF (SHV) have brought in more than $10 billion in new money combined so far in 2018.
I’m going to post this chart one more time since I think it bears repeating. Each one of the last five recessions has been preceded by an inversion of the yield curve. We’re getting awfully close to it inverting again as the 10-2 Year Treasury spread is at its lowest level since before the financial crisis.
Those gray bars are recessionary periods. As mentioned earlier, this isn’t a sign of imminent disaster, but it’s a warning sign that trouble could be on the way as early as 2019.
Oil Prices Getting Whipsawed
After languishing below $50 a barrel as recently as one year ago, WTI crude finally enjoyed a sustained that had the price about the $70 mark multiple times in 2018. The price of oil, however, has been incredibly unstable. The news of the day, whether it’s OPEC production cut agreements, inventory levels or concerns over production levels in Iran and Libya, the price of oil remains volatile, which makes judging the future path of oil and energy ETFs a challenge.
$70 oil makes it profitable for oil companies to produce, especially after they trimmed things back in order to handle oil prices in the $50 range not too long ago. Oil prices have doubled since the beginning of 2016, but oil and energy ETFs, for the most part, have struggled to gain.
The energy sector has been the market’s third-best performing group, so it’s not like it’s underperformed this year, but certain segments have done better than others. The VanEck Vectors Oil Services ETF (OIH) was my top energy pick at the beginning of the year, and while it looked good for much of the first half, it’s given back much of its 2018 gains as it suffers from the volatility of oil prices.
I’m still a believer in energy ETFs here. I think that the strong earnings growth that’s expected to come with higher oil prices is not fully being reflected in the sector’s returns. This area will no doubt be volatile for, probably, the rest of 2018. If you’re willing to ride it out, I think there are further gains to be had. Given some of the global political tensions and concerns over the global economy, I’d expect the price of oil to drift back into the mid-$60s as it tries to establish a new normal.
Is Gold Going Up or Down?
Gold is something that I haven’t spent a whole lot of time on this year. The precious metal has been mostly a declining asset during the 2nd quarter with prices about $100 per ounce off of earlier year highs.
Treasuries seem to have replaced gold as the go-to safe haven asset of choice lately. A lower demand for risky assets should be in gold’s favor but that just hasn’t been the case. If Treasury yields drop further, I could see a rally in gold again, but at this point I don’t see a catalyst for a big move in the near-term.
Carnage in Cryptos
This nifty little chart from Charlie Bilello pretty much says it all.
After last year’s bubbly rally, almost everything has come crashing back down to earth. I’m not a crypto investor, nor will I likely be, but I did find interesting the filing for the VanEck Solid X Bitcoin Trust ETF (XBTC), the latest attempt to bring bitcoin to the ETF masses.
I covered it here about a month ago. I think the fact that it addresses some of the concerns brought forth by the SEC when it essentially rejected all bitcoin ETF proposals, it probably has the best chance yet of getting approved, but I still think this one gets the thumbs down. I don’t get the sense that the SEC’s position has changed at all, but I’m sure a cryptocurrency ETF will hit the market eventually.
Conclusion
In the short term, I think the markets are still in fairly good shape, but there are signs that investors are getting more defensive. Flows into Treasuries, utilities and staples suggest that investors are getting a little worried about the trade war with China and how that could impact economic activity globally. It will almost certainly have a negative impact on GDP growth, but the bigger question is how long it could go on for. There’s little reason to believe that either side is willing to budge, and the longer this carries on, the worse it figures to get.
Heading into the 2nd half of 2018, I’m liking small-caps and consumer staples, but I’m nervous about energy and financials. I don’t think there’s any real obvious candidate for an outperformer in the 2nd half other than maybe Treasuries or short-term corporate bonds. Most sectors will be affected by a global slowdown, so defensive posturing could be the theme over the next few months.
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Disclosure: I am long OIH.