Three themes for the second half of 2018
US Investment Strategist Mona Mahajan takes a closer look at the three factors likely to shape the US economy through the rest of 2018: trade tensions, midterm elections and the Fed’s road to normalization. Read what she also thinks may help power client portfolios.
While volatility and global uncertainty were hallmarks of the first half of this year, we see three themes that could drive the last half of the year: trade tensions, midterm elections, and the Federal Reserve's ongoing normalization.
US markets set a steady pace
Starting the second half of 2018, US risk assets, despite facing mediocre returns on an absolute basis, have demonstrated robust relative performance. The S&P 500 Index, one of the few global equity markets with returns in the green, was up 1.7 percent as of the second quarter of 2018.(See Exhibit 1.)
Exhibit 1. There’s plenty of good in seeing green
US equity market returns (year to date) have been robust relative to their global peers.
And this resilience runs beyond equity markets: the US dollar has strengthened, US high yield bonds have moved upward, US treasuries are starting to reverse higher and, notably, US small caps, as represented by the Russell 2000 Index, are outperforming the S&P 500 by nearly 6 percent for the year.
The positivity around US risk assets began as the global growth story faded somewhat earlier this year, particularly as economic momentum stalled in Europe and for some emerging-market countries. While economic momentum now seems to have stabilized abroad, escalating trade tensions have once again increased global uncertainty as markets in Asia decline on tariff and inflation fears. However, the US economy remains relatively closed, with 70 percent of GDP coming from consumption (and only 12 percent of GDP from exports), which continues to be a boon for US small-cap companies. In addition, as the Federal Reserve (Fed) confirmed its normalization course, indicating four potential rate hikes in 2018 compared to a more gradual path reaffirmed by global central banks, risk assets like the US dollar continued to strengthen(See Exhibit 2.)
Exhibit 2. The greenback continues to build muscle
The US dollar has been outperforming developed-market currencies, including the Chinese renminbi.
As we enter the second half of 2018, we are now watching several key markets and events, and are particularly focused on three areas:
1. Trade tensions remain a critical tail risk:
Trade tensions with China have escalated and continue to be a source of uncertainty for markets. While the implemented tariffs are, thus far, not economically significant (the $34 billion implemented on both sides as of July 6 amounts to less than 0.5 percent of either economy), the risk of escalation remains a looming unknown. If the US administration pursues close to $400 billion in tariffs, for example, China could retaliate, and perhaps use strategies beyond tariffs on US imports, which only amounted to $130 billion in 2017. While this is certainly a risk, we see the sell-off in Chinese equities, combined with recent statements from the Chinese government around intending to keep its currency stable, as indications that China does not prefer a trade escalation or other retaliatory measures.
2. Midterm elections could provide an inflection point:
As we continue through 2018, we see the US midterm elections on November 6 as critical to the market path. Historically, the period before midterm elections has been volatile for markets, and the period afterward has been robust, regardless of party winners, as marketplace uncertainty is lifted. We see the potential for a strong year-end in the markets as well, particularly as we would continue to gain clarity around policy and the current administration. Furthermore, sidelined bipartisan issues such as infrastructure reform could re-emerge as a focus area as we get closer to midterm elections, which may also boost market sentiment.
3. The Federal Reserve is on a normalization path:
Even if we remove trade tensions and politics, one key driver of the US economy over the next 1-3 years remains: the Fed. The Federal Open Market Committee has been clear that it intends to continue its normalization path, with its median “dots” now indicating four rate hikes in 2018, pushing the US economy toward later cycle. With Fed Funds rates moving higher and the Fed balance sheet shrinking, the Fed is removing liquidity from the financial system; the implications for this include elevated volatility and limited multiple expansion in equity markets. In addition, we have seen the yield curve continue to flatten, approaching multi-year lows. (See Exhibit 3.) (Although our analysis shows that a flat or even inverted yield curve is not uncommon toward the end of a Fed tightening cycle.) And while the inversion of the yield curve is historically a recession indicator, we typically do not enter a recession until 6-18 months after inversion has occurred. Nonetheless, we continue to monitor Fed movements and the downward trajectory of the yield curve as part of our in-house late cycle monitor.
Exhibit 3. Is the yield curve riding down a one-way street?
The yield-curve has moved in one direction over the past five years: down.
How the rest of the year may unfold
Overall, we believe that the S&P 500 Index should offer positive returns for the year, albeit with more volatility and below the 20 percent return we saw in 2017. We continue to see this as a peak year in terms of the economy and earnings, with US GDP approaching 2.9 percent and S&P 500 earnings topping 20 percent in 2018. Thus certain themes that have been working this year – small-cap stocks, energy, and high yield – all could have legs, particularly as we approach a potentially robust year-end.
However, we remain more cautious as we head into 2019 and beyond, as we are clearly approaching a more late-cycle environment driven by the Fed and fraught with new and emerging tail risks; we encourage investors to remain diversified, active and consider increasing exposure to uncorrelated assets where possible.
Four to watch
Looking ahead, these opportunities could help power portfolios:
1. US small caps may have legs:
This area of the market has had a strong first-half performance and we see continued potential for the asset class likely as we round out the year, particularly if trade rhetoric remains ongoing, which seems likely over the near term. In addition, tax reform benefits should also lift small caps over the next several quarters.
2. Energy can pick up late-cycle steam:
Historically, commodities tend to perform well in a late-cycle, above-potential growth environment. Given the positive supply-demand fundamentals of the energy sector, combined with the notable underperformance of energy stocks versus actual oil prices, investors could see continued outperformance in the sector.
3. US high yield could offer more alpha:
The high-yield market, particularly lower-rated segments, has performed well during the first half of the year. Given that we do not see a recession or substantial default cycle on the horizon, higher-quality high yield could remain attractive this year considering the relative carry and still favorable technical outlook. High yield is also an area where investors may especially benefit from active management with the idiosyncratic nature of the bonds and the attractive opportunity for out-of-index positions.
4. Increased exposures to alternatives
As we approach a late-cycle environment in the US, we continue to feel that investors could benefit from gradually increasing exposure to alternative assets, including private credit, infrastructure debt and equity, and absolute return opportunities. These types of investments tend to be less correlated to equities over time, and thus provide an additional source of diversification and potential protection for a portfolio.