WE’VE JUST CLOSED the books on the second quarter, and what a ride it’s been. Let’s take look back at the first half of 2018, and what we think lies ahead for the economy as we begin the third quarter.
The economy continues to grow at a faster than expected pace, having been revised up from initial first quarter estimates, and we expect good news when initial Q2 reports are issued in a few weeks. Many economists estimate that second quarter growth could exceed a 5 percent annualized rate, which would mark an impressive improvement over the slow growth we’ve experienced for most of this bull market. Corporate earnings continue to exceed expectations, and guidance so far seems to indicate this rate of growth will only accelerate as we continue through the year. The first major company to report Q2 earnings will be Alcoa (AA), on July 18, and then we’re off to the races!
Inflation is not expected to be a problem this year. In some corners, there is fear that increasing wages will necessarily drive inflation higher. While this may eventually come to fruition, it has not yet – at least not in any meaningful way. Some inflation, perhaps counter-intuitively, is fundamentally good for the economy. When we expect goods and services to be more expensive tomorrow than they are today, we make purchases today, which means inventories need to be replenished, which puts people to work and gives them money to spend on the things they want and need. Without some inflation, the economy stagnates.
The Fed increased interest rates again in June, as expected. This is being done for two reasons. First, interest rates are one of the primary levers the Fed has to help buoy the economy during a recession. With interest rates so low for so long, the Fed was missing the most important tool in its toolbelt because, if a recession were to occur with rates near zero, it would have no way to lower rates further. So, reloading for the next economic slump gives the Fed the ability to take appropriate action when the time comes.
The second reason to increase rates (and currently the lesser of the two) is to reign in a runaway economy. When an economy is growing “too fast,” the Fed can raise rates, which increases borrowing costs, as a way to throttle growth.
Investors in 2018 have had a fairly bumpy ride. From the beginning we expected 2018 to provide overall returns on US equities of approximately 10-15 percent. January saw returns of 6 percent in the S&P, only to give it all back in February. For all of the ups and downs, the broad US indices are roughly flat YTD. That is not to say that there haven’t been areas of the US markets which have performed well.
For the first half of 2018, the NASDAQ has returned roughly 6 percent, while other indices have been flat. Technology continues to be an area of the market which is outperforming. With unemployment rates at near-historic lows, companies cannot easily hire new talent as a way to increase productivity. Luckily, innovations in technology and the adoption of these innovations in the private sector are allowing corporations to increase productivity without expanding their workforce.
Consider that the US comprises roughly 4 percent of the world’s population, yet we product nearly 25 percent of the world’s goods and services. Compare that to India and China which, combined, account for roughly 40 percent of the world’s population, yet, together, only produce as much as the US. Technology allows one US worker to be as productive as the next ten Chinese and Indians combined! From where we sit, we can only see the advantage expanding as US companies continue to drive the world in innovative technological solutions.
We believe that investment portfolios can, and often are, too broad. Diversification is a basic tenet of investing, but, being too diversified means diluting growth and missing opportunities. Consult your investment advisor. However, we believe that a portfolio which includes a diversified core of holdings while overweighting stronger areas of the market, and underweighting weaker ones, generally allows an investor to capitalize on growth trends while reducing exposure to areas in retreat.
Areas of the market we think show potential for growth in the third quarter include technology and US small/mid-sized companies. The US continues to outperform most of the rest of the world, and we do not see enough potential for outperformance elsewhere to justify the additional risk associated with investing in most international markets.
Areas we are avoiding in growth portfolios include long-term bonds, most emerging markets, and utilities.
There has been a lot of talk of recession on the horizon. Frankly, the same talking heads have been focused on the subject incessantly since 2009, when the market rebounded. Eventually they will be right; however, we do not believe that now is their time. With the exception of a major unexpected geopolitical event, we do not see any fundamental reason to believe a recession in the US is due for at least another 18-24 months.
Remember that this is an election year, and there is a lot of emotion involved in the outcome. An exceedingly strong economic environment, increasing wages, reduced taxes, full employment, and high consumer sentiment are not typically signals of an impending regime change. Voters do not typically choose to upset the apple cart when their bellies and purses are full. Regardless of the outcome, prepare yourself for increased rhetoric, vitriol, and venom from every direction. Before allowing emotion to control your investment decisions, remind yourself that, in spite of it all, the US economy is as strong as it has been in a very long time, and only growing stronger each quarter.
No matter what the talking heads say, nor what the outcome of the election is, your goals remain the same. What may change is the path you take toward achieving them.
Last week, I sat next to US Senator from California, Kamala Harris, on a flight from Washington to Los Angeles. Being from Upstate New York and California’s Bay Area, respectively, we are worlds apart in many ways. When the subject of my profession came up, however, we agreed instantly that proactive planning and professional advice are crucial for anyone hoping to retire. As company pensions become more rare, and with the Social Security system in need of repair, individuals carry more of the burden of planning for their futures than ever before. A sustainable retirement is no longer a foregone conclusion for many.
The second half of the year is likely to be as choppy as the first half. There are areas of opportunity, so work closely with your independent investment advisor, continue to hold your regular strategy meetings, and make changes as appropriate when your needs or the economic environment dictate. We believe this bull market still has plenty of room to run, if you can
hang on for the ride.
Stephen Kyne is a Partner at Sterling Manor Financial in Saratoga Springs and Rhinebeck.
Securities offered through Cadaret, Grant & Co., Inc. Member FINRA/SIPC. Advisory services offered through Sterling Manor Financial, LLC, an SEC registered investment advisor or Cadaret Grant & Co., Inc. Sterling Manor Financial and Cadaret, Grant are separate entities. This article contains opinion and forward-looking statements which are subject to change. Consult your investment advisor regarding your own investment needs.
