August 2018 Market Commentary

The S&P 500 reached a record high in August, responding positively to statements by the Fed about the strength of U.S. economic growth, the pace of inflation and what that means for Fed rate hikes. Non-U.S. developed market and emerging market equities lost value over the month as investors reacted negatively to a variety of issues. These include flattening growth in Europe, growing threats to global trade, a strengthening dollar and country-specific issues in several emerging markets. U.S. bonds produced positive returns as investors concerned about rising trade tensions sought safety in Treasury bonds, leading 10-year U.S. Treasury bond prices to rise and yields to fall.

The following table contains a summary of August and year-to-date market performance:

Index August YTD Index August YTD
S&P 500 (Total Return) +3.26% +9.94% All Country World Index (Net) +0.79% +3.38%
MSCI EAFE (Net) -1.93% -2.28% Barclays Aggregate +0.64% -0.96%
MSCI Emerging Markets (Net) -2.70% -7.18% 60/40 Blend* +0.76% +1.88%

* 60% All Country World Index/40% Barclays Aggregate

Equities surpassed their earlier record highs following comments by Fed Chair Powell. He noted that a gradual approach to rate hikes is the best way to navigate the risks of raising rates too fast and “needlessly shortening the expansion” and moving too slowly and risking an overheated economy. Powell also said that the Fed does not expect inflation to accelerate beyond 2%, meaning it does not foresee a need to step up its rate hikes.

In reaching its high, the S&P 500’s current rally became the longest bull market on record. Since bottoming on March 9, 2009, the S&P 500 has gone over 3,450 days without a 20% correction, gaining over 300% during that time. The S&P 500’s climb this year has not been uninterrupted, however. After reaching its previous high of 2872 in late January, the S&P 500 fell 10% over nine days in February (on concerns of rising inflation and higher interest rates), touching a 2018 low of 2581. Over the past seven months, the S&P has slowly climbed and is now up nearly 10% year-to-date as investors weighed robust corporate earnings growth against evolving trade disputes with major U.S trading partners including Canada, Mexico, Europe and China. While the S&P 500 reached a new high of 2914 in August, stocks are slightly less expensive than at the start of the year. The S&P 500 price-to-earnings ratio has fallen from over 18x to under 17x, as the nearly 10% increase in its price trails the 23% growth in earnings from a year earlier, but remains slightly above its long-run average.

Investor sentiment has also been supported by continued strong economic data. Second-quarter GDP growth
was revised higher to 4.2% and economists now forecast the U.S. to grow at its fastest pace since 2005, with
a second-half expansion of 3% or more (annualized). U.S. manufacturing activity accelerated to a 14-year high
in August, significantly beating estimates. It was boosted by a surge in new orders both in the U.S. and from
abroad. While real wage growth has been modest, rising employment and a rising savings rate (6.7%) has
supported strong consumer confidence.

Domestically, risks to this positive outlook include fallout from a potential inversion of the yield curve that
historically signals an impending recession and would likely hurt investor sentiment. The 10-year Treasury
bond yield fell from 3.01% to 2.83% during August while the two-year Treasury bond yield was essentially
unchanged at 2.63%, leading the curve to flatten to +20 basis points. There are a number of potential causes
for the decline in the 10-year bond, including lower expected growth and inflation, but August’s decline has
been attributed to weakness in several emerging markets that have led foreign investors to seek the safety of
U.S. Treasury bonds.

The threat of U.S. tariffs on imported goods and the implications of Fed policy appears to have had limited
impact on U.S. growth and equity prices. The same can’t be said for non-U.S. developed and emerging market
equities, which have also been hurt by higher U.S. interest rates and a stronger dollar. European
manufacturing slowed in August as new orders fell, but overall remains in growth mode. Overall European
GDP growth remains near 2% with a rise in services offsetting the slowdown in manufacturing. German
manufacturing has peaked, blamed in part on concerns over the potential impact of Brexit and worries about
trade. A survey by the German Chamber of Commerce revealed that trade tensions between the U.S. and
China is hurting German firms with nearly half of all imports from German companies directly or indirectly
affected by new tariffs. Forty-one percent of German companies surveyed said they were already affected by
higher tariffs when exporting to the U.S., while 46% reported higher costs when importing from the U.S. Some
57% of firms said they faced negative effects when exporting to China and 75% reported higher costs when
importing from China.

Emerging market equities lost 2.7% in August and 7.18% year-to-date despite continued solid economic
growth and attractive equity valuations. While in general, as goes China so goes the rest of the emerging
markets, other factors are driving the selloff, specifically Fed policy to unwind its balance sheet and its effect
on global liquidity. The Fed’s policy has led investors to rebalance away from higher yielding emerging market
debt, hurting their currencies. To slow capital outflow, many emerging market economies have been forced
to raise their interest rates in response. The impact on returns has not been uniform, as the countries with
the weakest fundamentals (budget deficits, current account deficits, higher inflation) experiencing the
steepest declines, highlighted by Argentine, Brazil, Turkey and most recently South Africa, which is facing a
recession. Brazilian equities are down 18% and Chinese equities 9.4% year-to-date over moderating growth
tied to trade concerns, however Mexican equities have gained 3% and Taiwanese stocks are up 6%.
Interestingly, while the selloff in emerging markets has been mostly driven by sellers of emerging market
debt, data show that equity managers remain overweight to emerging markets, drawn by attractive valuations and earnings fundamentals. The risk to this strategy is that investors begin to treat all emerging markets the
same and sell the fundamentally sound and robust markets along with the bad.

Caprock continues to observe evidence that global economic and earnings growth will extend into 2019. We
also believe that as long as the trade war does not worsen, it should not impose permanent long-run damage
to economic fundamentals. We also note that U.S. equities, despite strong earnings growth, are fairly to
slightly overvalued at current levels. Meanwhile, emerging market equities are attractively valued relative to
fundamentals but subject to considerable near-term volatility as U.S. interest rates rise relative to those in the
rest of the world. This underscores the importance of rebalancing and perhaps even beginning to underweight
U.S. equities for clients with more sensitivity to market risk. Based on fundamentals, equity markets
are still positioned to move higher from current levels; however, the upside opportunity relative to the
downside risk is becoming increasingly less attractive. As a result, our recommendations emphasize a
conviction that rebalancing to target allocations remains a smart discipline at this stage of the market cycle.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but Caprock makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.