October 2018

Third Quarter 2018

U.S. Economic Boom

Do you find it difficult to remember back to five years ago when the economy was moving along slowly, and the unemployment rate was very high?  The unemployment rate is now the lowest since 1968 and the number of job openings exceeds the number of people looking for jobs. This situation is putting pressure on companies to raise salaries as well as to form training programs for new employees. Companies are also finding they have a need to make capital expenditures to be both competitive and to reduce the need for hiring new employees. Even with all the added corporate expenses, the booming U.S. economy and corporate tax rate cut, are resulting in rising corporate profits.

At the same time, the job opportunities are growing. Workers seem to be more confident about their job situations and the possibility of obtaining new jobs if they so choose in many parts of the country. With higher wages, consumers are more willing to spend more and borrow more, resulting in greater demand and higher prices for goods and services. These increases in turn put upward pressure on inflation.

FED Mission

To help keep the economy from growing too quickly, the Federal Reserve (FED) has stepped up the Federal Funds Rate Target. At the end of the second quarter, the target was 1.75% to 2%. In September, this target was adjusted upward to 2% to 2.25%. At the beginning of the year the target was 1.25% to 1.50%. This new target will likely be raised again in December, by another quarter of a point.

The FED is increasing rates to slow down the economy, by setting interest rates higher for borrowing. The result is that the cost of mortgage interest has gone up from 3.75% at the beginning of the year to 4.74%, tending to slow down the housing market. Corporate borrowing costs have also gone up, as the interest paid on new bonds has been increasing, tending to slow down business growth. For consumers, the rise in credit card interest also tends to hold down the use of credit cards carrying debt. The FED must be careful in how quickly rates are raised, since they want the economy to grow in an orderly fashion, but a sharp rise in rates can cause the economy to stumble.

Market Review

Let’s look at the numbers for the third quarter of 2018. The quarter began with the S&P 500 at 2718, and ended the quarter at 2914, with a gain of 196 points or 7%. For the year, the S&P 500 has gone from 2674 to 2913 or 240 points for a gain of 9% year to date. The mid-cap stocks, represented by the S&P MidCap 400 began the quarter at 1951, ending the quarter at 2020 for a gain of 69 points or 3.5%. For the year, this index has gone from 1901 to 2020, a gain of 119 points or 6.3% year-to-date. Small stocks, represented by the S&P SmallCap 600, began the quarter at 1017 and ended at 1062 for a gain of 45 points or 4.4%. For the year, they have gone from 936 to 1062, an increase of 126 points and a gain of 13% year-to-date. International markets, represented by the DJ Global ex US index, began the quarter at 254 and ended the quarter at 253 for a loss of 1 point. Since the beginning of the year, this index is down from 267 to 253, a loss of 14 points or -5.2%.

Interest on the 10-year Treasury Note rose during the quarter from 2.847 to 3.055 for a negative return of -1.07%. For the year to date, the note has gone from 2.49 to 3.055 for a loss of -1.23%. The Bloomberg Barclays US Aggregate Bond Index went from a yield of 3.3% at the beginning of the quarter to 3.46% at the end, giving a negative return of -1.05%. At the beginning of the year the index stood at 2.97 and is now down -1.17% year-to-date.

What’s the Overall Picture

The U.S. economy is doing very well. We live in a global economy, and events in the U.S. can impact the economy of other countries. By the same token, events in foreign countries can impact the U.S. For example, the rise of interest rates in the U.S. has brought foreign money into the U.S. Some are looking for a safe place to invest and/or a higher interest rate than in their countries. The infusion of these funds into the U.S. economy results in the value of the dollar becoming increasingly stronger than foreign currencies. This means that the earnings we are obtaining in international markets are declining in value because the foreign currency has less value. In the case of large foreign countries, this decline in value is not as steep as it is in emerging countries. The devaluation in relative value of foreign currencies has had a big impact on both foreign equities and bonds. We are seeing losses in most international investments.

As noted above in Market Review, the value of most bonds was also negative for the year. Bonds are an important element of a diversified portfolio and when interest rates rise, the value of bonds declines. The shorter the duration of the bond, the less it tends to fall, and the greater the opportunity to reinvest the proceeds, at maturity, into higher-paying bonds.

The combination of negative results from international investments and U.S. bonds has provided a drag on overall performance so far this year for many portfolios. Being diversified is very important and there are times, like now, when its benefits can be masked.

Volatility

We have experienced a great deal of volatility in the U.S. markets this year. In January, the stock market was up about 7%. This was followed by a downturn of about 10% by the end of March. Prior to the end of the third quarter, we had a rally in stocks that lifted them up, as noted in the Market Review section, with the S&P500 up 9% for the year. As I am writing this in the middle of October, the S&P 500 is now up only 3.6%, for the year. A reason for diversification is to reduce volatility in portfolios. While we want U.S. stocks, they can only be one element in our strategy. I have been saying since the beginning of this year that I expected a great deal of volatility leading up to the mid-term elections. This often happens. Once the election is over my expectation to see a reduction in market volatility. We shall see! 

Ed Mallon