2018 Second Quarter Commentary

SeanCommentary, Recent Highlights

Market performance across the globe was mixed during the second quarter, with broad U.S. markets posting gains of just under 4%, despite market volatility driven primarily by concerns about tariffs and interest rates.  International stocks in developed markets were slightly negative, down a bit less than 1%, while emerging market stocks were strongly negative, down almost 8%. US bond markets were flat while international bonds at large where up about 0.5%.  This quarter’s gain in the U.S. markets reversed the losses we saw during the first quarter.


What Were the Salient Issues That Drove Market Returns in Q2?

Two factors which put downward pressure on financial markets during the quarter were the Trump administration’s continuing escalation of tariff-related threats against China (and our other trading partners) and the continuing rise in interest rates.  The first round of tariffs went into effect on July 6th, with a 25% tariff on $34 billion worth of Chinese goods. China—just as they said they would—immediately responded in kind.  Despite China’s retaliatory response, President Trump has said more tariffs would follow, and announced additional such tariffs on July 10th. While most trade experts agree that the US has legitimate concerns with some of China’s trade-related practices, very few think tariffs are the right tool to address those issues, and most think that a tariff war is the economic equivalent of two neighboring households settling their differences by throwing Molotov cocktails at each other—a battle no one is likely to win.

On the interest rate front, the Federal Reserve has raised rates twice this year, including once in Q2, with indications of two more rate hikes by year’s end.  The Fed’s long-stated objective has been a 2% inflation target, and its primary tool toward this end is the adjustment of short-term / overnight interest rates. The US central bank uses this tool as both a gas pedal and a brake in its effort to achieve its 2% inflation target.  While the knee-jerk reaction of most casual observers to rising rates is, “they are a bad thing,” the actual reality is a bit more complicated.  In the short-term, rising rates—or even the hint of rising rates—can cause market volatility and some initial downward fluctuation in both stock and bond prices; in the longer term, however, the relationship is less clear.  Rising rates do portend higher borrowing costs for businesses and consumers (thus the “brake effect”), but they also lead to higher interest rates for long-suffering savers on both bonds and other savings vehicles. Further muddying the waters, the effect of rising rates on stocks is much more complicated and can go either way depending on a host of other related factors.  For brevity’s sake, I’ll point anyone interested in the topic to this excellent and somewhat technical discussion by Aswath Damodaron, a professor at NYU’s Stern School of Business.


Given the threat of a tariff war and the prospect of rising interest rates, why haven’t markets gone down more than they have?

Although the factors that drive the market are never completely clear—except perhaps with the benefit of long-term hindsight, there are three possible reasons that US markets have only dipped about 5% on these worries.  First, although the recent trend in both interest rates and tariffs has been adverse to markets, this doesn’t necessarily mean these trends will continue unabated. The Fed’s gameplan is certainly subject to revision based on economic conditions (and those conditions may, in turn, be affected by the outcome of any tariff related knock-on effects).  Secondly, despite the tough tariff talk from the Trump administration, it’s entirely possible that good sense—along with pressure from the strongly anti-tariff Republican Congress and most corners of the business world—may eventually prevail and diminish the attractiveness of a protracted trade war. As this post goes to press, Vice President Mike Pence is embarking on a damage control tour to calm tariff-related fears of farmers and business leaders in the mid-west, which are among those most likely to be affected by China’s retaliatory agricultural tariffs.  Finally, markets have almost certainly been buoyed by the continuing stream of strong economic data—especially in the U.S., including last Friday’s jobs report.  The markets are certainly factoring all of these considerations—and no doubt many more—into their asset price valuations.


But still, should I get out of the way for a while, just to be safe?

It’s not often a good idea to let short-term market concerns drive what, for most clients, should be a long-term and well-thought-out portfolio strategy.  This isn’t to say that portfolio changes aren’t ever warranted; it is to say that such changes should seldom, if ever, be driven by what’s going on in the market this week, month, or year.  Instead, any such change should primarily be driven by the same two factors that underpinned the construction and selection of the portfolio in the first place, namely: 1) consideration of both your short- and long-term objectives, and 2) your fundamental tolerance for risk. Aside from changes in personal goals and/or risk tolerance, it is rarely advisable to make wholesale changes other than periodic rebalancing and opportunistic tax planning moves, both of which we do in our managed portfolios, and which can add materially to net realized portfolio returns.


Anything else I should be thinking about or expecting?

I’ve been saying for some time that I have been expected some kind of a market correction, and it has been quite a while since we’ve had a “good one.”  Equity investors should always be prepared for a garden variety market downturn of 20% about once every three to five years (at least for the equity portion of their portfolios), and something more substantial (30% to 40%) every 10 years or so. We have to go back to 2011 for the last twenty-percenter, so draw from that what you will.  Of course, such corrections are part of the equity-owning experience and are also the reason equities have historically provided superior long term returns compared to other less volatile investments.

Perhaps of more importance from long term retirement planning perspective, this kind of volatility is factored into every retirement plan we construct for our clients.  We build in and assume the kind market volatility that we know is part of the equity experience and most plans generally don’t require—or benefit from—reactionary adjustments, other than perhaps some opportunistic buying during the most difficult times for those brave-of-heart and with some spare cash.

As always, I’m happy to discuss any of this in more detail or talk over your specific situation, so please don’t hesitate to call or email if you have any questions or would like to do so.