by Thomas Dillman
During the first half of 2018, most equity markets around the world posted flat or negative returns, with a few isolated and unique exceptions representing a tiny percentage of overall global market capitalization. Most U.S. equity markets, on the other hand, generated positive returns. Mutual of America Capital Management LLC explores the financial markets' behavior during the first six months of 2018 and whether the bull market in stocks will resume its advance, endure a correction, or shift towards a bear market.
The total return for the S&P 500® Index for the period was 2.9%, while price returns for the Nasdaq and both the S&P 500 Growth index and Russell growth index topped 10%. Value indices, however, came in slightly negative. The key driver of positive U.S. results was the performance of technology and consumer discretionary stocks. The Nasdaq is heavily weighted to technology stocks, while the technology and consumer discretionary sectors of the S&P 500 each advanced 12% for the period. The only other S&P 500 sector to outperform the overall index was Energy, up 5% for the period. Value indices have relatively small exposure to technology stocks. In other words, even the generally positive performance of U.S. stock indices was based only on a narrow set of stocks.
It is important to remember that the S&P 500 advanced almost 40% from the beginning of 2016 until peaking on January 26 of this year in an almost uninterrupted, low-volatility advance. In fact, the Index was up 7% during the first three weeks of the year before correcting 10% over the following two weeks. Since then, the Index has moved sideways within an increasingly narrow range. While earnings expectations increased dramatically following the passage of the Tax Cuts and Jobs Act at the end of 2017, price/earnings ratios declined in response to rising uncertainties regarding the impact of rising interest rates, rising inflation, a strong U.S. dollar, slowing or stagnating growth outside the U.S., and the imposition of tariffs on imported goods—despite the fact that the U.S. economy is actually accelerating.
While first quarter Gross Domestic Product (GDP) registered a lackluster 2.0%, that was largely expected because data on personal expenditures released prior to the first quarter GDP Report indicated anemic consumer spending. This was especially so for autos because of the comparison to very strong auto sales in the fourth quarter of 2017 due to replacement demand following devastating hurricanes during the third quarter. However, second quarter expectations for GDP growth are in the mid-3% to 4-plus% range. The markets' behavior during the first six months of 2018 can be viewed as a tug-of-war between a very strong U.S. economy and corporate earnings and questions about how the array of current uncertainties will impact the domestic and global economies in the future.
The U.S. Treasury bond market has been a mirror image of the U.S. equity market. The price of the 10-Year Treasury note fell rapidly during the first two months of the year but traded sideways for most of the rest of the first half. When bond prices fall, yields (the interest rate on the bond) rise. In this case, the yield on the 10-Year note rose from 2.4% to 2.9% in the beginning of the year, fell slightly to less than 2.8% over the following two months, moved above 3% over the next month-and-a-half, and then fell back to the 2.8% range. Just like equities, U.S. Treasury note prices initially fell dramatically and then stabilized in a narrow range over the remainder of the period. In this case, the driver of performance was the realization of the accelerating economy and the Federal Reserve's unexpected increased commitment to keep raising short-term rates in response.
In contrast, corporate bond yield spreads, both investment grade and high yield, remained tight throughout the period, only just recently widening a bit. Investors in corporate bonds remained focused on the strength and anticipated durability of the economic expansion and the health of corporate cash flows and balance sheets. The difference in viewpoints between the corporate bond market on the one hand and the Treasury and equities markets on the other can be interpreted as a reflection of the uncertainties facing all investors. No one is quite sure how these various factors will affect future economic and profit growth. A unified consensus has not formed thus far. Markets are on hold awaiting greater clarity. Such episodes are not unusual when the future becomes cloudy. However, when the sky begins to clear, markets move. The question is, in which direction? Will the bull market in stocks resume its advance, endure a correction or shift towards a bear market?
The answer depends on the sustainability of the economic expansion. It is already 108 months old, approaching the record of 120 months set during the 1991–2001 expansion. But age is not necessarily a determining factor of how long an expansion can be sustained. In the case of this expansion, the more important factors include answers to the following questions:
- Will the Federal Reserve raise short-term interest rates too much or too quickly and precipitate a recession, or can it be nimble enough to contain inflation and help moderate tightness in labor markets?
- Will the program to aggressively raise tariffs upset global growth to the extent it plunges the U.S. and the global economy into recession, or will the plan be moderated before too much damage is done?
- Will the economies of Europe and China slide into recession, thereby dragging the U.S. economy with them, or can policy responses enable the maintenance of growth?
This is not an exhaustive list of potential outcomes. Nor can the various interactions between and among these scenarios be ignored, even though at this point they cannot be clearly discerned. We continue to be cautiously and conservatively optimistic, but must admit that the risks that the expansion is approaching an end have risen.
Thomas Dillman is the former President of Mutual of America Capital Management LLC.
The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.
Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.