Summary of 2Q/2018: Trade Wars and a Flattening Yield Curve

Cheri Franklin |

 

The second quarter saw healthy gains for most segments of the U.S. equity market and losses for the foreign equity markets. Bonds suffered a small overall loss with inflation-protected bonds reversing their first quarter loss. While the volatility of the first quarter abated, it was still higher than what we had become accustomed to in recent prior years. It seemed that every day brought another headline of a new tariff followed by retaliation. The targeted countries went well beyond our longtime rival of China to include our traditional allies like Canada and Germany. Companies in the U.S. have already started to plan accordingly. The most recent prominent example is Harley-Davidson which, much to the chagrin of President Trump, announced a plant to be built in Thailand.

The Federal Reserve, as expected, increased the federal funds rate to 2.0%. The 10-year Treasury yield, despite breaching 3% several times during the quarter, ended the quarter at 2.85%, up only 0.11% from where it began. The second quarter continued the trend of the flattening of the yield curve. In other words, there is now less of a return premium for taking on term risk by buying longer maturity bonds. To be clear, this does not mean that term risk should be minimized or avoided. Nobody can say authoritatively that a 2-year Treasury yielding 2.52% is a more prudent investment than the 10-year Treasury yielding 2.85%, especially for an investor with a long-term time horizon.

The table below summarizes the estimated returns for various asset classes based on the performance of Vanguard index funds. Please note that they do not represent the returns of the funds or portfolios utilized by Clarity Capital Advisors.

Asset Class           Ticker Used          2Q/2018 Return    Year-to-Date 6/30/2018

US Total Market        VTSAX                       3.9%                          3.3%

US Large Growth      VIGAX                        5.9%                         7.1%

US Large Value         VVIAX                        1.3%                        -1.1%

US Small Growth      VSGAX                       7.3%                          9.6%

US Small Value         VSIAX                        5.3%                          3.1%

International              VTMGX                     -1.6%                        -2.7%

Emerging Markets     VEMAX                     -9.1%                        -7.2%

US Real Estate           VGSLX                       8.8%                          0.0%

Int’l Real Estate         VGRLX                      -3.2%                        -2.8%

US Bond Market        VBTLX                      -0.2%                        -1.6%

US TIPS                     VAIPX                         0.8%                        -0.1%

 

Once again, growth beat value thanks in part to the information technology sector (up 6.3% based on VITAX). Value stocks were dragged down by the financial sector (down 2.3% based on VFAIX) which has been adversely affected by rising short-term interest rates. In a reversal of first quarter results, one of the stronger areas of the US market was real estate investment trusts (REITs) with an 8.8% increase which exactly cancelled out the 8.1% decline in the first quarter. The increase in interest rates also shows up in the negative bond returns seen above. The dollar reversed its weakening trend, gaining about 5% relative to a basket of foreign currencies, which would completely explain the 1.6% decline in international equities. The remainder of the 9.1% decline in emerging markets equities may be attributable to a decreased ability to access U.S. markets.

Spurred by tensions with Iran and Venezuela, crude oil prices have become highly volatile. They ended the quarter up about 16%, but with President Trump’s talk of an agreement with Saudi Arabia to pump more oil, perhaps they will stabilize.

We continue to see signs of a US and global economy that is operating at full employment. Aside from political risks, the biggest risk to investors still appears to be unexpected inflation. For now, inflation appears to be under control with the 10-year breakeven inflation rate holding around 2%. As for whether we expect volatility to return to its first quarter levels, we look to the CBOE Volatility Index (VIX), which ended the quarter just over 16 which is about 20% lower than where it began the quarter but over 40% higher than where it began the year.

 

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