THE SKINNY THIRD QUARTER 2018

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2 THE SKINNY THIRD QUARTER 2018 THE RECORD-BREAKING U.S. EQUITY BULL MARKET CHARGED AHEAD IN Q3, POWERED BY AN ECONOMY FIRING ON ALL CYLINDERS. U.S. stocks rallied in the third quarter, boosted mainly by strength in healthcare and information technology stocks. Those areas offset weakness in the real estate sector which has come under some pressure from rising interest rates. In terms of category and style, large caps topped small caps, and growth continued to lead value, although gains were quite broad. Looking at the major indices, the Dow Industrial Average jumped 9%, the S&P 500 and Nasdaq Composite each advanced more than 7%, and the Russel 2000 Index added 3.26%. Overall, it was the best quarterly performance for the S&P 500 since 2013, and all four benchmarks finished near their all-time highs that were achieved during the period. INDEX Q3 YTD 9/30 CLOSE HIGH CLOSE DJIA 9.01% 7.04% 26, , S&P % 8.99% 2, , NASDAQ 7.14% 16.56% 8, , RUSSEL 2K 3.26% 10.49% 1, , The Q3 rally was impressive considering the macro risks surrounding markets, but perhaps not surprising given the domestic economy which Federal Reserve Chairman Jerome Powell recently described as spectacular. 2

3 Confident consumers make for confident businesses too. In September, the Institute for Supply Management (ISM) Non-Manufacturing survey Index registered 61.6, a record high since inception of the measure in Meanwhile, beneath that, the New Orders component also came in at 61.6, the Employment component was 62.4 and the Business Activity Index increased by 4.5% to Numbers above 50 are believed to be expansionary. Most impressively, not one of the 17 Non-Manufacturing industries included in the survey reported a decrease in September activity. That bodes well for businesses heading into the holiday season. Considering recent data, spectacular IS an appropriate adjective for describing the U.S. economy. On the heels of 4.2% GDP growth and double-digit corporate profits in the second quarter, unemployment has remained anchored below 4% and wages have begun increasing. Consequently, according to the Conference Board Consumer- Confidence survey index, Americans are the most they ve been in the U.S. economy over the past 18 years. In September, the index hit 138, that is just slightly below it s all-time high of 144, reached in October of

4 On the Fixed Income front, strength in the U.S. economy is ushering interest rates higher. In light of positive economic progress, the Federal Reserve proceeded tightening monetary policy by increasing shortterm interest rates by 25 basis points in September and provided forecasts that suggest more hikes are likely to come. In addition to raising rates, the Fed adjusted its official policy statement by removing the term accommodative in describing its rate policy. While the change in policy guidance may seem innocuous, the Fed s accommodative posture has kept rates low and been a pillar of support for stocks and other risky assets since the Great Financial Crisis. Suddenly that may not be in place going forward. U.S. dollar strength has contributed to weakness in emerging market equity currency and bond markets. Emerging markets were under pressure again last quarter, particularly Turkey and Argentina which have the greatest U.S. dollar debt vulnerabilities. The Turkish lira and its local currency bonds both plunged due to mounting concerns about high levels of dollar and rising inflation. In an effort to stem those declines, Turkey s central bank recently hiked its benchmark interest rate to an astronomical 24%. Meanwhile, in Argentina, the peso plummeted 29% amid an escalating fiscal crisis there which prompted the government to ask the International Monetary Fund (IMF) to accelerate funding of an agreed bailout package. Overall, the MSCI Emerging Markets Index fell 1% quartering the third quarter, putting its yearto-date loss at 8%. However, it remains about 20% below its January high. Chinese stocks, which are a large constituent of the index, also fell last quarter as trade uncertainties remained high. Overall, we ve seen the U.S. yield curve shifting higher and flattening over the course of the year. The Fed has been pushing up the short-end through rate increases while the long-end has been responding to modestly rising inflation expectations. The U.S. 2-Year Treasury yield ended the quarter at 2.82% with the 10-year yielding 3.06%, maintaining a 24bps premium. The 30-year Treasury yield has also been moving up. At 3.20% it remains low by historical standards, but is apparently being felt in the housing market which showed signs of cooling in Q3 Interest rates have a direct impact on foreign exchange. U.S. rate hikes this year have contributed to strength in the dollar which rallied against the euro, the Japanese yen and most other currencies last quarter. 4

5 U.S. stocks have diverged dramatically from the rest of the world in 2018 reflecting bets that the U.S. Economy will maintain its growth edge, but markets may be nearing an inflection point. Looking ahead toward the final quarter of the year, U.S. equity investors remain encouraged by the prospects of soaring U.S. corporate profits, low unemployment, rising wages and oncoming fiscal stimulus. They are also relieved by the way markets have shrugged off trade tensions, disruptions in emerging markets and rising interest rates. Because we do not see those headwinds abating anytime soon, it is important that confidence of consumers and businesses remains high. Thus, in order for the U.S. markets to maintain momentum through year end, the burden falls squarely on domestic economic data and corporate earnings in Q4 which may both disappoint to some degree. First, from a growth perspective, the one-time boost to U.S. growth in Q2 from exports (foreign demand ahead of tariffs) means growth is likely to tail off a bit in the 2H of the year. Second, according to FactSet, 74% (74 of the 98) of S&P 500 firms that have provided Q3 earnings guidance so far have provided negative guidance. If that pace persists, it would take luster off the 21.2% earnings growth rate that is expected. While still strong, a slowdown in the U.S. economy and profits could lead investors to begin shying away from relatively expensive U.S. growth shares and seek better value elsewhere. They may also be more inclined to lean toward fixed income which now offer more competitive returns, especially if volatility were to return to markets. With October historically being the most volatile month for stocks, plus mid-term elections and a December rate hike on the horizon, we would pay close attention to U.S. economic data, corporate earnings, and of course macro developments, for indications as to whether confidence and markets remain in an uptrend or have temporarily peaked. If we are indeed approaching an inflection point, where U.S. equities are no longer the only game in town, diversification will be more critical than at any point in the past decade. 5