Q3 2018 Market Update

State of the Markets

After peaking in late January, the U.S. stock market experienced a tough first quarter but has been on a slow and steady upward trajectory through the close of the third quarter. The Russell 3000, a good representation of the entire U.S. stock market, closed at an all-time high in late September. Our economy is doing well. Unemployment is at record lows. Tax cuts have increased corporate profits, capital spending, and shareholder yield (the combination of dividends and buybacks). It is no surprise the U.S. stock market has been thriving (until recently).

The same is not true outside of the U.S. International developed markets (represented by MSCI world ex USA) are up slightly for the quarter but down slightly for the year. Emerging markets stocks (represented by MSCI Emerging Markets) have experienced a significant pullback from the high reached in January of 2018 and are down 7.7% year to date.

A rising interest rate environment can have a negative effect on bonds, real estate, and other income producing investments, so it is not surprising that the U.S. bond market (Barclays Aggregate Bond) and the REIT market (S&P Global REIT), while flat for the quarter, are slightly negative for the year.

The total returns for major asset classes are below.

Since the close of Q3 2018, there has been a significant pullback in markets around the world. Stock markets are always climbing the wall of worry, and sometimes concerns about politics, trade, and the rising interest rates can cause a slip on that climb, but ultimately it is corporate earnings and fundamentals that drive returns.

Fundamentals are Still Strong

2017 was a year of global expansion, which was reflected in positive performance in stock markets around the world. Global expansion continues in 2018 (with the exception of outliers like Argentina and Venezuela), but the markets have delinked from that progress. The current administration’s tariffs and trade negotiations (more on that later) has affected currencies and investor sentiment, but it has not yet affected economic progress. The chart below illustrates that the pullback in international and emerging markets through the end of the third quarter are the result of currency declines and valuation changes, not economic fundamentals. In some ways, that reinforces our opinion that markets outside of the U.S. may be more attractive going forward.

Rising Rates and Flattening Yield Curves

The Federal Reserve has been steadily raising short-term rates over the last two years. (The current Federal Funds Rate target is 2.0-2.25 %.) The good news is you can finally earn decent interest on money markets funds. The bad news is that the rising rate environment has resulted in a loss for bond holdings in 2018. As of this writing (10/5/18), the U.S. bond market (Barclays Aggregate Bond) is down about 2.5% for the year. This is what a bad year for bonds looks like – a slight loss in the short-term with the promise of higher interest rates going forward.

One of the results of rising short-term rates is a closing of the gap between short and long-term rates. This is referred to as a flattening yield curve and is illustrated in the chart below, which compares 2-year and 10-year treasury yields (and their difference) over the past two years. We believe rising short-term rates will put continued pressure on longer-term rates, which could result in more losses. This is why shortening the duration of a bond portfolio (essentially shifting to shorter-term bonds) can be helpful. It allows you to capture the upside of rising rates while limiting exposure to interest rate sensitivity, which is higher for longer-term bonds.

Tariffs and Trade

The current administration is showing unprecedented determination to challenge existing trade agreements. President Trump delivered on his promise to renegotiate NAFTA, which is now referred to as the United States-Mexico-Canada Agreement (USMCA). The actual changes to the original agreement revolve mostly around auto manufacturing, environmental and labor regulations, and intellectual property. It is not surprising that they were able to negotiate this win quickly. The U.S. held significant leverage in these negotiations as exports are a significant portion of Canadian and Mexican economies and the U.S. is by far their largest trade partner.

China may be a different story. Remarkably, exports are a smaller part of the Chinese economy (19%) than Canada and Mexico (25% and 36% respectively). China also has a broader base of trade partners. The administration has put in place significant tariffs as a means of pressuring the Chinese government to come to the table for negotiations. China has so far pushed back, and it’s not clear if this will end with positive or negative outcomes.

The tariffs, which are essentially a tax on imported goods paid in part by manufactures and in part by consumers, are not likely to have a significant impact on our economy as a whole, but they can have significant impact on specific industries and businesses. In the meantime, it has put continued pressure on foreign currencies and international markets. Since the end of the quarter, all markets have reacted to the increased risk associated of these trade tensions.

Free Mutual Funds!?

Fidelity recently launched a series of zero-fee mutual funds. Specifically, they are index funds that provide broad exposure to U.S. and international stock markets. Is this a game changer for the industry? Yes and no.

It is great to have providers of commodity products compete for your business. LendingTree was one of the first online platforms for mortgage shopping. A mortgage is basically a commodity, as it doesn’t matter who loans you the money if the terms are the same. Their tag line back in the late 90s was “when banks compete, you win.” They were spot on.

Index fund are commodity products, as well. If you buy an S&P 500 fund, it shouldn’t matter which one you buy because they should all provide the same investment returns. Price may be the only differentiator. Vanguard, the leader in the index fund space, has been offering some of the lowest cost mutual funds for decades, which has pushed down prices in the mutual fund business across the board. Vanguard has always provided great products at reasonable fees and will continue to do so. Vanguard was the original game changer, and we are a fan.

Schwab, Fidelity, Blackrock, and others have been competing aggressively for market share by underpricing each other, and now Fidelity has brought the fees down to zero. The zero-fee Fidelity funds are only available on Fidelity’s platform, and it would be no surprise if, after meeting market share goals, Fidelity closes these zero-fee funds and moves on to a more profitable model. In the end, these zero-fee funds may be more of a loss leader than a game changer. Time will tel