September 2018 Market Commentary

U.S. equities reached another all-time high in September but finished the month up only slightly as investors were largely indifferent to positive economic events and the Fed’s decision to raise interest rates. The S&P 500 did gain 7% for the third quarter, its largest quarterly gain since 2013 and is now up over 10% year-todate, after falling 7% earlier in the year. Developed market equities outside the U.S. produced positive returns, but emerging market equities continue to struggle, losing value for the month as retail investors continue to exit over earlier losses. The bond market lost value as 10-year Treasury yields climbed +0.2% to over 3% by month’s end.

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

Index September YTD Index September YTD
S&P 500 (Total Return) +0.57% +10.56% All Country World Index (Net) +0.44% +3.38%
MSCI EAFE (Net) +0.87% -1.43% Barclays Aggregate -0.64% -1.60%
MSCI Emerging Markets (Net) -0.53% -7.68% 60/40 Blend* +0.00% +1.66%

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

The economy generated lots of positive news in September including confirmation of robust economic growth, rising consumer sentiment, a record high for small business confidence, a surprising durable goods order, and continued confidence from the Fed in the resilience of the recovery. Only a slowing housing market and continued concern over global trade were drags to the view of sustained growth.

Domestic output grew at a 4.2% pace in the second quarter, the best performance since the third quarter of 2014, fueled by higher spending in both the public and private sectors as well as business investment. The ISM index of national factory activity dropped 1.5 points from August’s reading of 61.3, which was the highest since May 2004. The drop was attributed in part to trade tensions leading to rising prices of imports and falling export orders. A level above 50 indicates growth in manufacturing, which accounts for about 12% of the U.S. economy. A measure of future production, U.S. durable goods orders rose 4.5% from a month earlier (beating expectations of 2%) and 8.6% quarter over quarter.

Sentiment among consumers and businesses remains strong. The University of Michigan’s monthly survey of consumers hit 100.1 in September, its highest level since 2004, suggesting that household expectations remain very optimistic for improved personal finances in the year ahead. The survey considers 500 consumers’ outlook on economic prospects, accounting for sentiment on personal finances, inflation, unemployment, government policies and interest rates. The NFIB Small Business Optimism index reached the highest in its 45-year history. The survey revealed that 38% of small business have job openings, 26% plan to increase employment, 34% expect the economy to continue to improve and another 34% believe it’s a good time to expand their business. Inventory investment and capital spending plans are at their highest levels since 2007.

Two areas of weakness have been the housing sector and slowing global trade. Pending home sales fell 1.8% from a month earlier and were down 2.3% compared to a year earlier on rising prices and mortgage rates. That was the fourth monthly decline in the past five months and the slowest sales pace since January. Regionally, sales dropped 11.3% annually in the Western U.S., where prices are highest. Total home sales for the year are forecast to be 1.6% lower in 2018. The tariff battles between the U.S. and China have led many economists to predict slowing trade will be a drag on third quarter growth. Trade was responsible for 1.2% of the second quarter’s 4.2% growth primarily due to a rush in soybean purchases ahead of tariffs.

As was universally expected, the Fed raised the fed funds rate 25 basis points to a range of 2%-to-2.25% at their September meeting. The decision was followed by new language about the Fed’s thoughts on the economy and its plans for interest rates over the next two years. The Fed expressed a more optimistic view of the U.S. economy over the next year than previously, raising its estimate of 2018 GDP growth from 2.8% to 3.1%. The Fed’s forecast for 2019 was raised to 2.5%, but still reflects its view that growth will slow as the positive impact of tax cuts end. The Fed also projected raising rates one more time before the end of the year and three more times in 2019. Possibly the biggest piece of news coming from the Fed’s announcement was their decision to drop language saying that “the stance of monetary policy remains accommodative.” The move suggests markets should anticipate rising real interest rates in 2019.

After climbing nearly 12% in 2016 and 37% in 2017, emerging market (EM) equities have fallen almost 8% year-to-date (measured in dollars). The asset class rallied strongly to start the year (up 10% in January) before falling 20% from its peak over the next eight months. Investors have overlooked strong economic and corporate earnings growth and the fact that EM equities are attractively priced at 10.5X P/E, down from 14.5X to start the year. The factors that have hurt EM equity prices include (1) rising U.S. interest rates and the dollar’s appreciation (EM currency depreciation); (2) rising trade tensions that have affected market sentiment; and to a lesser extent, (3) country-specific political and macro imbalances.

Rising U.S. interest rates, which encourages capital outflows from EM, contributed to EM currencies losing 7.5% of their value year-to-date, explaining nearly all of their decline when measured in dollars. The growing threat of an expanded trade war between the U.S. and China has weighed heavily on Chinese equities, which make up 32% of the MSCI EM index. Chinese equities have declined 13% since the start of the year but are down 22% since their peak in late January. The fall in Chinese equities accounts for almost two-thirds of the roughly 7% MSCI EM decline since the second quarter.

Caprock’s outlook remains unchanged from one month ago. We continue to observe evidence that global economic and earnings growth will extend through 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 following the market’s recent rally, U.S. equities are fairly-to-slightly overvalued at current levels despite strong earnings growth. 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 under-weight 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.