- US reaches trade deal with Canada. New “USMCA” deal to replace NAFTA.
- Yields back up as 10-year U.S. Treasury over 3%. Fed raises short rate while inflation creeping up as well.
- Oil surges higher once again, due in part to OPEC and Iran sanctions.
- As we approach the midterm elections, history favors strong returns in 6 months following election.
What Piqued our Interest
Just when the relationship with our northern neighbor appeared to be reaching an all-time low, the U.S. and Canada finally reached an agreement for Canada to join the U.S. and Mexico in a revamped free trade deal. While skeptics claim that the new deal makes only marginal improvements to the old NAFTA deal, this clearly removes some uncertainties and shows that the President is willing to compromise on some of the key protectionist issues which he essentially created. A few highlights of the deal include a rule that mandates that 75% of automobiles must be manufactured in North America (up from 62.5% in NAFTA), a provision to raise the minimum wage for auto workers in Mexico, access for U.S. farmers to the Canadian dairy market, extended protection for intellectual property and other provisions for the digital economy, as well as a 16-year sunset clause. This sets the stage for future trade negotiations, most notably with the Eurozone, Japan, and eventually China. Regarding the latter, as promised, President Trump imposed a 10% tariff on $200 billion of Chinese imports last month and threatened to raise the tax to 25% by year end and eventually apply tariffs to the remaining $267 billion of Chinese imports.
In other news, the Fed raised their target rate in September (as widely expected) as rates on the long end of the curve have crept up in recent weeks as well. The yield on the U.S. 10-year treasury reached 3.19% on October 4 and is now at its highest level since 2011. Driving the rise in rates has been an increase in inflation measures, along with expectations for strong corporate earnings and GDP growth in the third quarter. The core Personal Consumption Expenditure (PCE) index, which is the Fed’s preferred measure of inflation, is up to 2.0% annual growth, which is in-line with their long-term target. Evidence of wage growth is finally starting to surface, as average hourly earnings increased to $27.24 in September, a 2.8% increase versus last year. Meanwhile, the Atlanta Fed’s GDPNow model is calling for 4.1% annualized growth in the 3rd quarter, up from 3.6% on September 28. The Wall Street Journal noted that analysts for stocks in the S&P 500 are looking for growth in earnings of 21.6% versus a year ago. This is slightly lower than the 24.9% growth realized in the second quarter, but very strong nonetheless.
U.S. equities overall enjoyed yet another positive month, despite September being one of the worst months historically for the market. The S&P 500 increased by about ½ a percent for a total gain of about 10% on the year. The gains were not distributed equally however, as large cap stocks did significantly better than small cap stocks, which declined 2.4%. As the chart below shows, in 2018 the performance of small cap stocks has been largely in-line with the U.S. dollar index (which is a collaboration of the U.S. dollar versus the currencies of our major trading partners). This of course is intuitive given that a strong dollar hurts large companies more so than small companies which have higher percentages of domestic revenue. While the greenback has been particularly strong this year, it pulled back last month before rallying in the last week after the Fed’s rate hike announcement. However, small caps are still up 11.2% on the year, outpacing large caps, and are still more expensive on a valuation basis as they trade at 22.3 times forward earnings compared to 16.8 for the S&P 500.
In overseas markets the MSCI All-Country World ex-US index gained 0.46% in September, but developed international countries fared better than emerging markets which continue to struggle. Emerging market stocks, plagued by continued trade war fears and higher U.S. interest rates, lost another ½ percent and are now down 7.68% on the year. Case in point, just as the strength of the dollar has been a tailwind for small caps, it has been a burden for emerging markets which have a disproportionate amount of dollar denominated debt which becomes more expensive to service. Developed international stocks outpaced the U.S. last month but are still negative on the year. Most of the performance came from Japan (+3%) while developed Europe edged higher by 0.3%.
Fixed income indices were mixed last month, with the broad US bond index falling by 0.6% and high-yield and short treasury indices inching higher. Municipals also fell, roughly in-line with their taxable cohorts. To be noted, these results are as of September month end, and do not account for the additional run up in yields in the early days of October. As we have mentioned in the past, with rates on the rise, it will be a struggle for fixed income indices to finish the year in positive territory. High yield bonds along with floating rate bonds, which take on additional credit risk to enhance their yield, are likely to end 2018 with returns in the low single digits.
Crude oil increased significantly in September, rising from about $70 to $75 during the month, and is now trading at its highest level since 2014. As the market adjusted to the supply drop due to U.S. sanctions on Iran, Saudi Arabia and other OPEC nations have declined to ramp up output to compensate for the decrease in supply. Of course, this has prompted criticism from President Trump who has called out the cartel for price fixing, however for now it appears that even higher crude prices may be forthcoming as demand remains strong.
As the midterm election approaches, all eyes are on crucial house and senate races which could determine the political landscape for the next two years. It seems likely that Democrats have a good chance at recapturing the House, while the Senate is more of a toss-up at this point. Depending upon the result, hot political topics such as infrastructure spending, another round of tax cuts, Obamacare replacement, as well as the ongoing Mueller investigation into the Trump white house, will all be affected by the outcome. Regardless of who wins however, we may be in store for another strong equity run, if history is any guide. Looking at U.S. equity returns going back to 1945 and breaking up each year based upon which year of the presidential cycle it falls, we can observe that in the six months following the midterm election the average return was 14.6%! This represents a 15.1% improvement over the average return in the six months leading up to the midterm election and is significantly higher than any other six-month period based upon the election cycle. Of course, past performance is not necessarily indicative of future performance, but the markets are already on sound footing, and given the strong fundamentals along with historical precedent, it seems probable that we could see even higher stock prices.
Here at AEPG, we continue to be constructive on equities in general, while favoring U.S. over international, growth over value, and a slight tilt towards small and mid-cap stocks relative to the benchmark. From a factor perspective, most of our models incorporate exposure to both momentum stocks as well as high-quality, which typically do well in mid-to-late stages of the business cycle. Some of our more conservative models have begun to increase their value exposure, primarily to help mitigate risk in case of a sudden market correction. Our fixed income outlook is largely unchanged, as we favor low duration, moderate exposure to credit risk, and we are underweight high yield bonds. Cash proxies such as money market funds and ultra-short fixed income funds are becoming more attractive, as they now generate yields around 2%.
It is hard to ignore the many distractions which have the potential to derail the longest bull-run market in modern history. Trade war tensions are clearly the most formidable concern, but issues surrounding central bank policy, crises in emerging markets, and political drama here in the U.S. all could force another correction as we trade near all-time highs. We will be closely monitoring the 3rd quarter earnings season, where admittingly analysts have set a very high bar for corporations to surpass. However, at the time of this writing, the U.S. unemployment rate is now 3.7%, which is the lowest level since 1969, which bodes well for economic growth in the coming months. We may see some additional volatility around election time or if interest rates continue to climb at an accelerated pace, but the economy is still supported by a plethora of positive indicators, which supports our positive outlook for the 4th quarter.