Market Data for the quarter ending June 29, 2018:
• S&P 500 Stock Index: 2718, up 2.9%
• Ten-year Treasury Note Yield: 2.85%, up .11%
• Gold: $1,327 per ounce, down 5.4%
• Oil: $74 per barrel, up 13.8%
Stocks saw modest gains in the second quarter of 2018 as investor enthusiasm for large tech stocks, such as Facebook, Amazon, Netflix, and Google (FANG), was able to buoy the market in the face of broader weakness. Interest rates crept higher driven by tightening monetary conditions, (more on that below), and oil continued to advance on strong demand and supply disruptions. (Venezuela, Libya, and, moving forward, Iran.) Gold sagged as the dollar strengthened in response to tight money, as well.
We are cautious on the stock market going into the second half of the year. We see three primary risks. To begin with, as referenced above, monetary conditions are becoming more restrictive. The Federal Reserve is raising short-term interest rates, while at the same time it is effectively selling Treasury bonds it acquired under its quantitative easing program (QE). Additionally, the recent tax cut and an increase in federal spending have flooded the market with new debt to finance the resulting deficit. The upshot of all this is that there is less money available to invest in stocks, which on balance, means lower valuations. In addition to immediate market impact, tighter monetary conditions will steadily pressure capital investment and consumption, thus weakening the economy and corporate earnings. If the Fed moves too aggressively in further raising interest rates, the economy could be tipped into recession, and the stock market would sell off significantly.
Moving on, the first shots of a global trade war and threatened escalation are an additional threat to economic growth and earnings. While perhaps aiding select domestic industries, such as steel, on balance, tariffs raise prices and reduce growth. Global supply chains are highly integrated, and tariffs on foreign goods, rather than helping US firms, damage them. Retaliation from foreign countries adds further complications. General Motors stated that the administration’s trade policy will result in reduced investment, production, and employment. It is highly concerning that the administration seems to not understand basic economics. If the trade war escalates with both China and our erstwhile allies in Europe, Canada, and Mexico, expect weakness in stocks and, ultimately, the economy.
Finally, the trade hostilities cited above have increased risks to the Chinese economy, the world’s second largest. We have said many times in previous market commentaries that the Chinese economy is built on a mountain of debt. Belatedly, Chinese authorities have recognized the need to get lending under control or risk a significant crisis. As the Chinese government has restricted credit growth, their economy has inevitably lost momentum. A threatened trade war adds additional pressure. As a result of these developments, Chinese stocks have fallen into a bear market (a 20%+ decline), and its currency, the yuan, has weakened. Given the importance of China to the global economy, weakness in China reverberates around the globe, ultimately washing upon US shores. Emerging market stocks have been broadly pressured this year, and that has oftentimes in the past led to weakness in US markets. This is a development that bears close scrutiny.
Moving into the second half of the year, we do not expect strong gains in stocks. In addition to the risks cited above, the market has exhibited characteristics of market tops such as heightened corporate indebtedness, mergers and acquisitions activity, and speculation in “can’t lose” glamour stocks such as the FANGs cited above. It would not surprise us at all if the market were to close 2018 with an outright decline in share prices. We feel we are well positioned for such an environment as our portfolios are tilted toward more defensive sectors relative to the broad market, and should hold up well in the face of market weakness. For the remainder of the year, we see the stock market, as represented by the S&P 500 stock index, trading in a range of 2550 to 2900. It closed the second quarter at 2718.