We experienced another rough patch in the market last week. A trade truce with China appeared to be a welcome development last Monday, but then many investors grew concerned that a trade agreement would not be reached within the agreed-upon 90-day time frame, and yield curve inversion fears set in.
We don’t make changes to portfolios based on these short-term market events — which are nearly impossible to predict — but we realize they can be unnerving. During periods of market turbulence (like we have experienced this year), we proactively evaluate portfolios to see if there are opportunities to harvest losses and improve after-tax returns. As 2018 comes to an end, and to provide some context around this volatile year, it may be helpful for you to understand what has been happening in the economy and the market.
Let’s Start With the Economy
Volatility in the stock market notwithstanding, the U.S. economy has been extremely strong this year. In the third quarter, U.S. GDP grew by 3.5% on an annualized basis, declining from a record 4.2% growth rate in the second quarter, and GDP growth is on pace to reach 3% for the year.1 GDP growth was spurred by strong consumer spending and an increase in government spending because of fiscal stimulus. Despite last week’s job report, which showed that hiring slowed down in November, unemployment remains at a multi-decade low of 3.7% and wage growth is up 3.1%.2 Backed by the tailwind of tax reform, companies received an immediate boost to their bottom-line earnings with S&P 500 companies expected to report earnings growth of over 20% for 2018.3 Not only have we seen an uptick in profitability this year, but revenue for these companies also is estimated to increase by +6.7% in 2018.4
Given that economic growth has been so strong, you may be wondering: what is bugging the market? The stock market typically is considered to be a leading indicator of the economy, whereas GDP numbers and statistics are backward-looking. The market assimilates investors’ expectations of what companies’ prospects are for the future. While the good news on the economic front is welcome, many of the pullbacks we have seen this year have been associated with concerns around future growth prospects.
World Stock Market Performance5
MSCI All Country World Index with selected headlines from past 12 months
Short Term (January 1, 2018– December 7, 2018)
Tariffs and Trade
This year’s first big pullback in the global markets came in March, when the U.S. administration announced tariffs on key trade partners. The objective of these tariffs is to reduce the trade deficit. Many economists and market participants worry about the friction that tariffs cause in global trade and the hindrance to economic growth from an all-out trade war. Encouragingly, over the course of the year, the U.S. administration achieved breakthroughs and reached a revised trade agreement with Mexico and Canada, two of its largest trading partners. Last week’s market declines came as concerns surfaced over the ability of the U.S. and China to reach an agreement during a 90-day trade truce that was determined at the G-20 summit. During this 90-day period, both parties have agreed not to impose additional tariffs and will work toward negotiating an agreement on trade.
The Fed and Yield Curve Inversion
Another fear that has been plaguing the U.S. market is the possibility of a yield curve inversion. A yield curve inversion occurs when short-term bond yields are higher than long-term bond yields. Why is this considered a bad omen? Many investors often interpret an inversion as a sign that companies don’t have enough confidence in their long-term prospects to borrow money and invest in their future growth, which is a signal that the economy is going to slow down or contract.
A yield curve inversion can also happen if the Federal Reserve “overshoots” and raises rates too quickly (or by too much) to slow down the economy, while yields at the longer end of the curve don’t go up by as much.
The 2-year to 10-year Treasury yield curve has not inverted (even though it has flattened considerably); if it does invert, a recession is not a certainty. The Federal Reserve is watching all signals closely and has cautiously raised rates over the past few years. But recessions do happen as a normal part of economic cycles and, while we can’t say when the next one will occur, we do know the U.S. economy has always recovered from recessions and market returns can become positive even before a recession officially ends.
What About Bond Returns?
In a period of lackluster equity returns, most investors rely on the bond portion of their portfolio for stability. As the Fed has raised rates over the past few years, the short end of the yield curve has felt most of the impact; however, intermediate-term rates have risen over the past year, resulting in negative returns within intermediate bonds. Bond yields and prices move in opposite directions — i.e., as rates go up, prices go down. Despite the short-term pain experienced in bonds — as bond prices decline in a rising-rate environment — the silver lining is that you are reinvesting at higher rates so, going forward, the expected returns to fixed income should be higher.
2018 Through a Long-Term Lens
With 14 trading days left in 2018, it is difficult to say where the stock market will end the year. While we understand that concerns about slowing global growth can make some investors nervous about the future, many of these fears already may be priced into the current market prices. The evidence shows that most professional investors are unable to accurately forecast the right moment to make changes based on short-term events, which is why we take a long-term, strategic investment approach backed by research.
60% MSCI ACWI/40% Bloomberg Barclays U.S. Agg. Index6
Growth of $100,000 Invested
There are some calendar years when market returns are negative and this could be one of them. Over the past 30 years, the returns of the MSCI All-Country World Index (a globally diversified index of stocks) were negative in eight calendar years and positive in 22 calendar years. If you include a bond investment and look at a 60%/40% portfolio (i.e., 60% stocks and 40% bonds), the return was negative in seven years and positive in 23 years. The total return to the 60%/40% portfolio over this period was about 800% — in other words, if you invested $100,000 at the beginning of this 30-year period, the number would have grown to $899,000 at the end of it. It is also worth noting that the U.S. experienced three recessions over this time period. Our focus is on maintaining an investment strategy that best positions portfolios to succeed over the long term, which requires discipline and tuning out the short-term noise — as distracting as it can be.
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 audited or verified. Historical performance results for investment indices and/or categories have been provided for general comparison purposes only. Indices are unmanaged and unavailable for direct investment. 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.