Quarterly Client Letter – Q2 2018
- July 17, 2018
- Investment Insight
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Dear O’Brien Wealth Partners Investor,
During the second quarter the threat of tariffs and a potential “trade war” stole center stage while simultaneously throwing cold water on an economy heated by the new tax bill and increased government spending. In simple terms, a tariff is a tax levied on imports or exports between sovereign states. Most economists see them as destructive, as any tax impedes the “free hand” of the market, reducing supply and ultimately raising prices as the tax is passed on to consumers. This Administration’s commitment to tariffs has largely been criticized by both economists and politicians for its anti-cooperative properties. Political agendas aside, their effect on economies and markets is O’Brien’s primary concern. Curiously, it seems at the moment that tariffs may be just what the doctor ordered for an economy on the verge of overheating. What is potentially worrying about tariffs as a de-facto brake pedal is the amount of pressure the driver decides to apply and the timing of the foot coming off the pedal. It requires a deftness of foot to navigate the balance.
U.S. and Chinese tariffs came into force on July 6th, covering $34B of both U.S. and Chinese goods, hand-picked by each side for maximum political effect. The U.S. claims as justification that China is stealing America’s intellectual property and engaging in unfair industrial policy. China’s response has been that the American tariffs are a unilateral violation of global trade rules and has lodged a complaint with the WTO. While China/U.S. trade tensions have been brewing for decades, new and more troubling is the addition of our allies into the administration’s cross-hairs. In addition to levying tariffs on China, the U.S. has imposed tolls of 25% on steel and 10% on aluminum on some of our closest allies: Europe, Canada, and Mexico. Each has reciprocated with tariffs of its own on items near and dear to the heart of America: motorcycles, bourbon, cigarettes, denim and cheese. In each case, the skirmishes are widely seen so far as opening moves in a political game of chicken, having little effect on the economy at large but potentially undermining effects on specific industries. We continue to watch how these negotiations proceed and remain in frequent contact with our active managers on steps they are taking to reposition their portfolios as warranted.
Relegated to background news in the second quarter has been the continued resilience of the global economy. GDP growth for the second quarter in the U.S. is estimated to be around 5%, pushed higher by increased trade action prior to the official commencement of tariffs. Earnings of companies comprising the S&P 500 are expected to grow 20% (year over year) in Q2 2018, the second fastest growth rate in nearly eight years. Despite trade fears the S&P 500 finished the second quarter up 3.43%, bested by U.S. small companies as measured by the Russell 2000 Index, which finished the quarter up 7.75%. The outperformance by smaller companies is due to their largely domestic markets and their relative insulation from global trade barriers. Outside the U.S., a stronger dollar weighed on returns as developed market equities (as measured by the MSCI EAFE Index) finished the quarter down -1.24% and emerging market equities (as measured by the MSCI Emerging Markets Index) finished down -7.96%. The emerging markets decline was led by Brazil, where a trucker strike in protest of higher diesel prices literally ground the economy to a halt for 10 days. The strengthening dollar hurts the emerging markets the most as it increases the prices of commodities and other goods priced in U.S. dollars. It also makes debt service on loans denominated in U.S. dollars more costly. We still see opportunity in international and emerging market stocks as they currently sport cheaper valuations than can be found domestically, but we continue to maintain a portfolio overweight in U.S. stocks as we wait for European political stabilization. The second quarter saw yet another political crisis in Europe as two Eurosceptic parties in Italy nearly assumed power. This caused a spike in Italian bond yields and a correction in the Italian stock market. The ECB, Europe’s central bank, had announced plans to wind down their bond-buying program by the end of this year, but were forced to hedge that comment in light of the Italian situation.
Within the fixed income markets, the yield curve remains relatively flat as the spread between shorter-term treasuries and longer-term treasuries narrowed. Many eyes are watching this spread as an inversion in short- and long-term rates can be a predictor of an impending recession. With the dual mandate of the Federal Reserve achieved-full employment and 2% inflation-Fed Chair Jerome Powell hiked the Fed Fund’s rate for the seventh time in three years and alluded to additional hikes in 2018 and 2019. The market is enjoying a historically low unemployment rate that touched on 3.8% before rising to 4.0% as more workers entered the labor force than new jobs were created. We also saw in the second quarter that for the first time since 2000 there were more job openings than unemployed people, showing just how far our economy has come from the depths of the financial crisis.
What does this mean for your portfolio?
We believe that any effect tariffs are currently having on the stock market is sentiment driven as they have not yet affected broad fundamentals in a substantive way. The ongoing addition and subtraction of tariffs should create winners and losers as different industries are affected. This should give our active managers an edge as they have the flexibility to over and underweight companies and industries opportunistically. Our exposure to the small cap segment of the U.S. equity market proved to be a boost in the second quarter as the market rewarded small companies for their domestic consumer base and their relative insulation from the global “trade wars”. Specific to China, we are largely insulated from trade concerns as our manager focuses on companies tied to China’s domestic consumption rather than on industrial companies tied to exports. On the fixed income side we continue to believe that returns will be driven by Federal Reserve policy, both in their decisions to hike rates and the pace of the unwinding of their balance sheet. In this type of environment, bond selection is paramount and our active managers have done an excellent job of finding value in a low-yield world. Each of our active bond managers added value over their benchmarks in the second quarter and continue to be positioned well for the coming quarters.
As always we maintain our longer-term focus and do not let the political sentiment distract us from finding long-term value for our clients. We continue to monitor the trade situation for signs of escalation, but we believe that our portfolios, as well as our active managers, are well positioned to weather these trade skirmishes that will continue to dominate headlines into the months ahead.
If you have any questions or would like to discuss the specifics of your portfolio, please contact your O’Brien Advisor.
Your O’Brien Wealth Partners LLC Investment Team