Jul 20, 2018 2nd Quarter 2018 Commentary

Market Summary

Record U.S. corporate profits and healthy U.S. economic data helped U.S. stocks to positive returns. Both the technology-focused Nasdaq Composite Index and small cap U.S. stock, as measured by the Russell 2000, reached new all-time highs. Small cap stocks aren’t as exposed to global trade which, along with political uncertainty, a strong U.S. dollar and slowing global growth, hurt returns in international stocks. U.S. tariffs on various imports triggered retaliatory measures from China, Canada, Mexico and the European Union (E.U.).  Investors feared that continued trade actions could hurt global commerce and global economic expansion.

In this environment, stock performance varied considerably between country, capitalization and industry during the quarter. Large capitalization U.S. stocks, as measured by the S&P 500, rose 3.4% during the quarter, led by growth stocks. Within the S&P 500 Index, energy shares performed best as oil prices climbed to four-year highs.[1] Meanwhile, non-U.S. stocks finished the quarter in negative territory. A new Italian government increased the possibility of Italy exiting the E.U. Italian equity markets sold off sharply while bond yields rose, which pushed Spanish and Portuguese yields higher. It was less extreme than past European debt scares, but a similar playbook nonetheless. Chinese stocks, as measured by the Shanghai Stock Exchange, were hit particularly hard by the trade tariffs as they finished the quarter down nearly 15%.[2] China is over 30% of the MSCI Emerging Markets so this weighed heavily on the index performance.

Despite a slowdown in the global economy, the U.S. economy remained on solid footing. U.S. economic growth continued at a slow but positive pace, with Real Gross Domestic Product coming in at 2% for the quarter and on track for 4% for next quarter[3]. The unemployment rate reached 3.8%, an 18 year low, and below the 4% level that the Federal Reserve targets. Manufacturing and non-manufacturing indexes remained healthy as well. Amid this backdrop, the Federal Reserve raised the fed funds target rate range to 1.75%-2% in mid-June. Below is a summary of market returns.

Trade Tensions

Over the course of the quarter, the Trump administration steadily escalated the threat of tariffs on many trading partners. In late May, the U.S. imposed tariffs on steel and aluminum imports from the European Union, Canada, and Mexico. They countered with their own packages of tariffs. The U.S. then responded by proposing a 25% tariff on imported automobiles, again raising the stakes and the prospect for a trade war. Then in June, the U.S imposed 25% tariffs on $34 billion of Chinese exports, which was on top of the tariffs already imposed on Chinese steel and aluminum in March. China retaliated with tariffs on a similar amount of U.S. exports. The U.S. then threatened to go further, threatening tariffs on an additional $200 billion of Chinese export.

If all of Trump’s proposals were carried out, nearly 90% of all Chinese exports to the U.S. would be covered by tariffs. The graph below shows the growth in U.S.-China trade as well as the imbalance.[4] Trump seemed to be betting that tariffs will hurt the Chinese economy more than the U.S.’s since China sold almost four times more goods to the U.S. than the U.S. sold to China in 2017.

While there is near universal agreement that tariffs harm the global economy and the average U.S. citizen via higher prices, the economic impact is uncertain. Investor nerves have certainly been tested, but so far, the tariffs remained manageable. The greatest price shocks occurred across the agriculture and metals complexes, including car manufacturers, copper prices and soybean prices. However, investors grew concerned that the longer the trade disputes last, the greater the possibility of more sectors and more companies getting caught in the crosshairs.

It’s important to understand there are always many different potential risks that can hurt portfolio returns. That is why Leonard Rickey Investment Advisors emphasizes diversification across different asset classes, sectors and companies. We try to differentiate information (i.e., there is a possibility of a trade war) from valuable information (i.e., can I profit off this information). In many cases, economic or geopolitical news is not very valuable, unless you have a copy of tomorrow’s newspaper. Our advice is to ignore the noise of the market and remain focused on your goals.

The chart below shows the different risk over the last seven years according to the Global Fund Manager Survey conducted by Bank of America[5]. The latest survey reported trade war as the “biggest tail risk”.

Emerging Markets Update

Emerging markets faced some challenges after a two-year rally: Global trade tensions, political election uncertainty in Latin American countries and a strengthening U.S. dollar all contributed to the 8% decline during the quarter. Despite the poor performance and the risk that trade tariffs may escalate further, we remained optimistic about the longer-term outlook for emerging markets and international equities in general. International stocks, especially emerging markets, started the quarter with better valuations than U.S. stocks. During the quarter, valuations improved even further and finished at more attractive levels than where they started the quarter. We saw the steepness of the decline compared to U.S. equities as more of a buying opportunity than a risk. The chart below shows that a combination of International Developed and Emerging Markets underperformed the S&P 500 in May and June by as much as any two-month periods since 2008.[6]

In addition to low valuations, most emerging markets, continued to have the twin tailwinds of attractive demographics and a rapidly growing middle class. China, for example. radically changed their economy over the last ten years. The Chinese economy is no longer export-driven. Domestic consumption accounted for the majority of China’s economic growth and more than half of its GDP last year[7].

Economic Update

Economic growth continued its slow but positive trajectory during the quarter. Unemployment remained near historically low levels and wage growth continued to increase at a slow but healthy pace (see chart)[8].

In addition, the Conference Board’s Leading Economic Index (LEI), which consists of 10 components designed to signal peaks and troughs in the business cycle, continued to strengthen (See chart)[9]. The LEI includes data such as home building permits, manufacturers’ new orders, interest rate spreads and consumer expectations to business conditions.

Inflation remained low by historical standards, but increased to 2.2% during the quarter,[10] its highest level since 2012 and above the Fed’s target level of 2%. During the recovery stages of this business cycle, the Fed’s primary concern was increasing inflation and spurring growth by keeping rates low. With both inflation and unemployment hitting the Fed’s target, the Fed has shifted and become more concerned with keeping inflation and economic growth in check. Higher interest rates are the primary tool the Fed uses to keep inflation and growth in check. While we acknowledge higher rates are a risk to the economy, a federal funds rate of 2% is still below inflation and overall accommodative. Fed policy and the level of interest rates is an important factor we continue to monitor.

The passage of the Tax Cuts and Jobs Act of 2017 put more cash in companies’ coffers, and they ramped up spending on their businesses. Capital expenditures – such as spending on factories, equipment and other capital goods – by S&P 500 companies totaled about $167 billion in the first quarter, the fastest pace in seven years (see graph).[11] Higher spending on technology, equipment and facilities could give the U.S. economy a fresh set of legs and help extend an expansion now in its ninth year. In addition to capital spending, record corporate profits and healthy industrial and manufacturing production pointed to a healthy U.S. economy.

In short, the conditions that historically have brought on a recession, an overheated economy, high inflation and higher interest rates, did not appear to be in place. Besides Fed policy, another risk worth monitoring is how overseas economies respond to the current geopolitical environment. Business done abroad accounts for more than 40% of the earnings of the S&P 500[12]. The continually escalating nature of trade tariffs may have the most potential to derail the global economy. If overseas economies slow down or geopolitical events interrupt the continued expansion of the world economy, then the current positive cycle in the U.S. may come to an end earlier than expected.

This Isn’t Your Father’s Dow

For many reasons, a move of 100 points on the Dow Jones Industrial Average (Dow) feels like a big move. It’s likely due to a behavioral bias called anchoring, which is when we use psychological benchmarks or rules-of-thumb for reference or to influence our decisions. Not too long ago 100 points on the Dow was a large percentage, but basic math tells us that 100 points is about half of what it was back in 2000 and about 1/10 of what is was in 1987. Below is a table that shows the price of the Dow at various market peaks and what a 100-point loss equates to in percentage terms[13].

In 1987 the day before Black Monday, a 100-point loss on the Dow meant a 4.45% loss, in 2000, at the peak of the Tech Bubble, the same 100-point loss corresponded to a .85% loss and in 2007, at the peak of the Financial Crisis, a 100-point loss meant a .71% loss. Today, as of June 30, 2018, the Dow stood at over 24,000 points, so a 100-point loss corresponds to not even a .5% loss.

Further, we looked at the same peaks and corresponding bear markets and compared the points loss then to what the point loss means in today’s terms. For example, in October of 1987, in one day (2nd column) the Dow fell 508 points (3rd column) which corresponded to a 22.6% loss (4th column). If we experienced a 22.6% loss today, it would correspond to over 5,400 points on the Dow (5th column). And if the Dow fell by the same 508 points, it would correspond to “only” a 2.1% decline (6th column). You can also see how the bear markets of 2000 and 2007 stack up against today’s numbers[14]. Certainly not your Father’s Dow!

 

As always, please call if you have any questions or would like to discuss your account in more detail.

 

 

[1] Data from Morningstar
[2] Data from Morningstar
[3] GDPNow, Federal Reserve Bank of Atlanta
[4] Capital Group
[5] BofA Merril Lynch Global Fund Manager Survey
[6] LPL Financial
[7] Matthews Asia
[8] JPMorgan, 3rd Qtr Guide to the Markets
[9] Advisor Perspectives
[10] Core CPI
[11] Capital Group
[12] Fortune.com
[13] Source: LRIA, using price returns on the Dow Jones Industrial Average (DJIA) from Yahoo! Finance
[14] Source: LRIA, using price returns on the Dow Jones Industrial Average (DJIA) from Yahoo! Finance

 

 

IMPORTANT DISCLOSURES
Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).
This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.
Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any particular strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility therefore.
Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.
Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.
For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.
INDEX DEFINITIONS
The Barclays Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment-grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
The Standard & Poor’s 500 Index is a capitalization-weighted index of 500 stocks designed to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. It cannot be invested into directly.
The Russell 2000 Index is an unmanaged index generally representative of the 2,000 smallest companies in the Russell Index, which represents approximately 10% of the total market capitalization of the Russell 3000 Index.
The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices of approximately 800 stocks and is designed to measure equity market performance in 23 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, , Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates.
The MSCI EAFE (Europe, Australasia, Far East) Index is a free float-adjusted market capitalization index of approximately 900 stocks and is designed to measure equity market performance in 21 developed market countries outside of North America.
The Nasdaq Composite Index is the market capitalization-weighted index of over 3,000 domestic and international based common type stocks listed on the Nasdaq stock exchange.
The Dow Jones Industrial Average (DJIA) is a price weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ.
The Shanghai Stock Exchange Composite Index is a capitalization-weighted index. The index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.