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Market Commentary

Earnings and economy drive market recovery in Q2  

June 25, 2018

Following a turbulent First Quarter, which saw volatility spike and the first 10% correction since 2016 fueled by rising interest rate fears, the US market spent the Second Quarter in recovery mode repairing the damage and investor confidence. Despite troubling headline news like trade tariffs and geopolitical storms, the US markets grinded higher on strong corporate earnings and economic growth. It was less of a positive story overseas as foreign markets slid in Q2.   

The Second Quarter was again led by growth companies, namely technology, as the Nasdaq Composite fully recovered from the Q1 set back to push to New All-Time Highs in June. Nasdaq jumped 6.3% in Q2 to finish up 8.8% at the mid-way point of 2018. However, the biggest story in Q2 was the resurgence of small-cap stocks, which have benefited from the strong US$ in reaction to rising interest rate fears. Small-caps have less currency risk than most of their multi-national large-cap counterparts who are more directly impacted by trade tariff concerns. The Russell 2000 also fully recovered from the Q1 downturn to hit New All-Time Highs in June posting a Q2 gain of 7.4% and finished up 7.0% for the year. Mid-caps also outpaced the benchmark S&P 500 in Q2 posting a gain of 3.9% and setting a New All-Time High as well, versus the solid 2.9% gain for the S&P. Mid-caps, as measured by the S&P 400, finished the first half up 2.7%, while the S&P 500 gained 1.7%. While they have recovered nicely from the Q1 setback, the benchmark S&P 500 and the Dow Jones Industrials remain below their All-Time Highs. The Dow managed to eke out a 0.7% Q2 gain but remained in negative territory for the year at -1.8%. Strong corporate earnings fueled the recovery, though the market was tough on companies that lowered forward guidance, even if they beat Q1 earnings estimates. S&P 500 earnings grew 24.8% in Q1, according to Factset, and early estimates are 20%+ for Q2. Sector standouts in Q2 besides technology, were Energy +12.7%, Consumer Discretionary +9.4% and REITs +8.9%.

The Second Quarter brought sharp distinctions between the US and foreign markets. The synchronization of global economies was a leading theme last year and heading into 2018, with many institutions recommending overweight allocations in foreign stocks. During Q2, divergence in relative economic strength was revealed in foreign market performance as well as currency valuations. The benchmark MSCI EAFE index slipped 2.2% in Q2 and is now down 4.5% for the year. Emerging markets were hit particularly hard in Q2 falling 8.5%, as concerns about the strong US$ and trade tariffs unnerved investors. The US$ index surged 5.1% in Q2 and is now up 2.7% for the year; the US$ strength is largely attributable to the rise in expectations for higher US interest rates. The US$ index fell 10.2% in 2017 and contributed to much of the foreign market returns. While we have been increasing foreign exposure in stair steps from a very underweight position since May 2015, as relative valuations remain attractive, we remain 25% underweight our full foreign target allocation. We will continue to weigh risks and reward going forward.

Interest rates remained in the spotlight during the second quarter, whipsawed by market expectations about the Fed raising interest rates and geopolitical concerns sparking a flight to quality, as well as low foreign sovereign rates. US interest rates spiked to 2.95% for the 10-year Treasury Note in Q1, a four-year high, which sent stocks into a tailspin, as the market recalibrated its Fed expectations for a fourth rate hike in 2018. We saw interest rates continue higher in early Q2 the 10-year hit a high of 3.11%. This was an important move for the 10-year, which has failed to break through 3.00% multiple times, and the market’s view on interest rates changed. It was short-lived, however, as geopolitical concerns in Italy as well as signs of slowing economic growth in the Eurozone and China spurred a flight to quality back into Treasuries by quarter-end. Despite 24.8% earnings growth and unemployment dipping to 2.8%, the 10-year settled at 2.85%. As some have noted, the US economy is outperforming our foreign counterparts by such a degree, that their underperformance is weighing our government bond yields down.  US and foreign bond yield spreads are near their widest in history. And speaking of spreads, the difference between the 10-year Treasury and 2-year Treasury yields is the lowest since the summer of 2007, as are the 30- and 5-year, and the 30- and 10-year. That reflects the flat yield curve we’ve been witnessing. Many have discounted the current flat yield curve to historical measures due to confluence of other current factors. However, we believe it is still important to monitor as an inverted curve (short-term rates are higher than long-term rates) has been a precursor to past recessions (though not all). The Fed raised interest rates at is June FOMC meeting, for the second time this year, and upgraded its economic assessment as well as its expectations of a fourth rate hike by year end. 

The Outlook

As the Second Half of 2018 begins, there are a number of reasons to remain optimistic on the markets. However, given the volatility in the first half, we are cautious as well with many moving pieces.

The following are our thoughts going forward for the Second Half: 

Positive Catalysts

  • Positive Individual, Small Business and Corporate effects from the Tax Cuts and Jobs Act
  • Repatriation of foreign earnings continues
  • Less business regulations
  • Corporate earnings remain solid at 20%+ quarterly growth
  • Positive fundamentals and technicals remain but some technical bear watching• Low unemployment
  • Upside catalyst from trade negotiations 
  • Investor and consumer confidence remain solid
  • Pullbacks still seen as buying opportunities

Negative Concerns:

  • Protectionist trade policy moving from negotiation tactics to global trade war
  • Global economic synchronization is weakening 
  • Geopolitical risks, namely North Korea, Russia, Italy and United Kingdom government cohesion/Brexit transition
  • Fallout from NATO summit• Trump administration Russian investigation fallout   • Rich but not overvalued market valuations
  • Stronger US dollar a headwind for US multi-national corporations 
  • Volatility risk
  • Fed raising rates too aggressively, including its Policy normalization and potentially inverting the yield curve

We believe the positives outweigh the negatives for the Second Half of 2018 and beyond and encourage investors to remain committed to their investment programs. It is easy to get whipsawed in markets with a lot of headline news, especially when the markets react so negatively one day and just the opposite the next. The markets are still learning how to digest information in a President Trump news world.

With Summer upon us, it’s a great time to review your portfolio with your Nelson Advisor. Call today to make an appointment at 800-345-7593.

Sincerely,

Your Nelson Securities Team