Calling the second quarter of 2018 “eventful” would be an understatement. On one hand, we had inflation pressure continuing from previous quarters that led to the Federal Reserve raising the Federal funds rate by another quarter of a percent in June. The U.S. dollar appreciated against the currencies of most emerging-market and developed countries, dragging down returns for U.S. investors in overseas markets. Meanwhile, the looming trade battle continued, with Europe, Canada, Mexico and China threatening to retaliate by imposing their own tariffs against U.S. imports. Despite these overhanging clouds, the U.S. economy is on strong footing — the unemployment rate is at a historic low (4.0% as of June1) and wage growth is increasing (2.7% as of June2). Business fundamentals are very strong, with the first-quarter earnings growth rate at approximately 25%.3
Returns shown in the chart above are for second quarter 2018.
Source: Morningstar®, data as of June 30, 2018.
The U.S. equity market, while volatile, posted solid performance in the second quarter, supported by positive earnings momentum and strong economic data. U.S. large-cap stocks, represented by the S&P 500 Index, ended the quarter with a sizable 3.4% gain. Small-cap stocks were the strongest performers with the Russell 2000 Index (which represents small-cap stocks) returning +7.8%, surpassing most other indices. This partially can be explained by international trade concerns weighing more heavily on large-cap stocks that have a global presence, rather than on small-cap stocks. Growth stocks continued to outperform value stocks among large caps, with the Russell 1000 Growth Index up +5.8% versus the Russell 1000 Value Index return of +1.2%. The outperformance of growth stocks was led by solid returns from growth-oriented sectors such as consumer discretionary (+8.2%) and information technology (+7.1%), of which FAANG (Facebook, Amazon, Apple, Netflix and Alphabet, also known as Google) stocks were the main contributors.
We experienced headwinds on the international front this quarter, as both international-developed and emerging-markets equities declined. The appreciating U.S. dollar dragged down returns for U.S. investors in overseas markets. International-developed stocks, represented by the MSCI EAFE NR Index, gained 3.5% in local currency terms but fell 1.2% in U.S. dollar terms. In addition to the currency factor, trade war concerns also weighed on European equities, though not as hard as they weighed on emerging-markets equities. The MSCI Emerging Market Index was down by 3.5% in local currency terms but declined 8.0% in U.S. dollar terms.
On the fixed income side, the Federal Reserve raised rates again in June, which signaled their confidence that the economy is on the right track, and indicated that it will likely hike rates two more times in 2018. Since the end of the first quarter, the 2-year Treasury yield rose from 2.27% to 2.52%, and the 10-year Treasury yield rose from 2.74% to 2.85%, which resulted in further flattening of the curve. As rates rise, bond prices decline; the Bloomberg Barclays Aggregate Index, representing investment-grade U.S. bonds, declined slightly by 0.2%. Municipal bonds (BBgBarc Municipal 1-10Y), which tend to be less sensitive to rising rates than U.S. Treasurys, regained traction after a turbulent first quarter, gaining 0.8%.
Source: Morningstar®, data as of June 30, 2018.
After five consecutive quarters of strong performance, emerging-markets debt encountered the strongest headwinds among all asset classes this quarter. The JPM GBI-EM Global Diversified Index (UH) declined 10.4% in the second quarter of 2018. As in other international markets, the strong dollar weighed heavily on returns; the Brazilian real, Turkish lira and South African rand each depreciated by over 13% against the U.S. dollar (in the second quarter alone). Emerging-markets debt is becoming an increasingly important part of the global investment spectrum, given the improving credit profile and quality of financial markets in emerging-market countries. Therefore, despite the unfavorable current market conditions, we believe in the long-term attractiveness of this space. Meanwhile, high-yield bonds, represented by the ICE BofAML BB-B US CP HY Index, showed more resilience and returned +0.7% for the period.
The U.S. equity market was the lone bright spot in the second quarter, as international markets suffered due in large part to dollar strength. A globally diversified portfolio that benefited from international exposure over the past several quarters felt the opposite effects in the recent period. Currency movements are unpredictable and can have a significant impact on short-term results. However, over the longer term, evidence shows that the impact of currencies on portfolio returns tends to even out, and that a portfolio with exposure to international markets can reward long-term investors.
U.S. Stock Market: Russell 3000 Index
International-Developed Stocks: MSCI EAFE NR Index
Emerging-Markets Stocks: MSCI EM NR Index
U.S. Bond Market: Bloomberg Barclays Aggregate Index
Emerging-Markets Bonds: JPM GBI EM Global Divers TR Unhedged
Return data represent past performance and are not indicative of future results. Historical returns of indices do not reflect applicable transaction, management or other applicable fees, the incurrence of which would decrease historical performance results. Index information has been compiled by Wipfli Financial from sources Wipfli Financial deems reliable, but has not been independently verified. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only. Indices are unmanaged. It is not possible to invest directly into an index. Any charts and graphs represented herein are for informational purposes only and cannot in and of themselves be used to determine which securities to purchase or sell, or when to purchase or sell securities.
