ARQ Wealth Advisors Q3 2018 Commentary
The third quarter of 2018 saw strong 7 percent returns for U.S. stocks and with significantly less volatility than we experienced during the first half of the year. Foreign equity markets turned in meek returns for the quarter as a strong U.S. dollar and trade war/tariff negotiations weighed on performance. Globally, stocks turned in a respectable 4.25 percent for the third quarter. While the benchmark 10-year Treasury yield stabilized and flanked the 3 percent level, bond returns were flat to slightly positive for the period. So far, this year has been lukewarm for asset allocators, in that only U.S. stocks have performed well. Most other asset classes, including bonds, foreign stocks, commodities and REITs, have lagged in a big way.
ARQ Wealth Advisors does not speculate in one area of the capital markets and we do not chase the hot stock or the trend du jour, and for good reason. Nobel Prize winning Modern Portfolio Theory has proven that broad diversification delivers solid returns over the long run without taking on high levels of risk or volatility. This is why the largest institutions like pension funds use this approach, even if it means lagging the market over the short term.
The illustration below, compiled by Towers Watson, shows that Fortune 1000 pension fund capital allocations are consistent with the thesis that portfolios need to be broadly diversified in order to comply with mandates so they can perform over the long-term to meet the retirement benefit obligations of their retirees.
Strong GDP Growth: 4.2%
Lowest unemployment rate in 50 years: 3.7%
Wage inflation highest since 2008: 2.8%
U.S. Manufacturing is at a 14-year high
Due to the strength in the economy, the Fed has continued on its path of rate normalization with short-term rates now at 2.25 percent, up from 0.0 percent just a few years ago. The latest CPI inflation reading stands at 2.70 percent, which has been slowly moving higher but far from a problem for the U.S. economy. It has been nine years since our economy has been in a recession, but the potential of a contraction could be a couple of years away. A valid predictor of previous recessions has been when the inflation rate moves up, the unemployment rate moves down and the numbers meet. Currently, these readings are 1 percent apart. This dynamic preceded the last three recessions and a topping of the stock market by six months to a year.
Another major indicator of recession is an inverted yield curve, which we have highlighted over the past few quarters. This means that the short-term rates the Fed controls would move higher than the benchmark 10-year Treasury yield. If and when this were to occur, a recession and peak stock market levels follow approximately 18 months later. Obviously, we are watching closely.
Since World War II, there have been 18 mid-term elections in the U.S., the next one being Nov. 6, 2018. The incumbent’s party has lost seats in the House of Representatives in all but three mid-term elections.
In this coming election cycle, Democrats need to pick up 23 seats to win back the House majority. This would create gridlock in Washington D.C., which historically hasn’t been a bad thing for the markets. The chart below illustrates that in the calendar year following every mid-term election since the post-war era, the U.S. stock market posted positive returns. These returns range from 1.35 percent in 2015 to as high as 37.43 percent in 1995, with an average gain of 19.13 percent. It seems that even though there is uncertainty, volatility and stress leading up to mid-terms, the stock market tends to breathe a sigh of relief when they are over.
Markets at a Glance
With the weak performance of most all asset classes thus far in 2018, with the exception of U.S. stocks, it is important to give a longer-term perspective. We illustrate below how various asset classes have performed in the last two full-market cycles. Notice that with the exception of commodities, the higher the risk exposure, the higher the returns tend to be.
Our outlook on U.S. equities remains constructive until we can identify the warning signs of above-average inflation, higher interest rates, higher valuation metrics and lower corporate earnings growth. Foreign equities, although a point of pain in recent months, look very attractive. Valuations are well below their historical averages and well below U.S. stock valuations on a relative basis.
Additionally, foreign governmental bodies are not yet raising their interest rates and are therefore more accommodative with their monetary policies. Regarding bond investing, we’ve been able to avoid any significant losses in value in the face of rising rates. That said, as rates move higher, bond prices and yields look much more attractive.
The fly in the ointment at this point in time would be a policy error by the administration. This could be negative ramifications of an all-out trade war with China or the Fed raising rates too high and too fast. We think that the likelihood of an event like this happening is small.
Hopefully, history will repeat itself as we are heading into the best months of the year for the stock market.