ACG Market Review Second Quarter 2018 Global Highlights: Economy Announced tariffs have so far failed to slow down economic activity Equities U.S. equites turn positive for the year backed by strong corporate earnings growth while foreign equities experience turbulence amidst strength of U.S. Dollar Fixed Income The 10-Year Treasury hits 3% for first time since 2014 led to flattening yield curve resulting in volatile quarter while yields across the globe remain low 309 East Paces Ferry Road, Suite 600 Atlanta, GA 30305 T 888.317.2810 F 470.823.3178 theatlantaconsultinggroup.com
U.S. Equity Markets Rebound Despite Escalating Trade Tension U.S. Equity Markets bounced back during the second quarter after a misstep to begin the year. The S&P 500 index has now experienced positive returns for 10 out of the last 11 quarters. First quarter earnings, coming in significantly higher than consensus expectations, are a clear sign that the impact of tax cuts are flowing through to corporate balance sheets. Many companies are using these profits to buy back shares and/or increase dividends as a record high of $650 billion worth of stock is estimated to be repurchased during 2018. The strong year over year growth in corporate earnings however, will likely cause an environment where future earnings growth slows due to very strong comps in 2019. The S&P 500 ended the second quarter with a gain of +3.43%, lifting YTD returns positive to +2.65%. Energy, Consumer Discretionary and Information Technology led all sectors during the quarter returning +13.48%, +8.17% and +7.09%, respectively. Industrials and Financials were the two largest detractors for the quarter losing -3.18% and -3.16% respectively. Small Cap stocks, as measured by the Russell 2000 Index, ended the quarter up +7.75%, leading YTD returns to +7.66%. Escalating trade tension and announced tariffs between the US and China resulted in increased volatility towards the end of the quarter. The Fed Continues to Balance Renormalization and the Yield Curve At the June FOMC meeting, the Fed announced another 25 basis point rate increase, the seventh hike since December 2015. One to two additional increases are expected for the remainder of 2018. This upward move in the short end of the yield curve has caused many of the bond proxy stocks to sell off during the second quarter as the 3-Month Treasury Bill now has a higher yield than the S&P 500. The Fed continues to unwind its balance sheet as they increased the rate to $40 billion per month on July 1st and plan another $10 billion per month increase on October 1st. Fixed income posted a negative quarter as the Bloomberg Barclays Aggregate Bond Index lost -0.16%, bringing the YTD return down to -1.62%. The 10-year Treasury rose above 3% for the first time since 2014 in April, but ultimately ended the second quarter at 2.85%, up over 11 basis points from the end of the first quarter. While rising yields have had a negative effect on bonds year-to-date, the good news is that higher starting yields have historically resulted in subsequent higher future returns. In other words, despite the negative short-term effects of interest rate hikes on fixed income, higher rates of reinvestment in the future eventually wins out. Duration management can be a useful tool in mitigating the negative short-term effects of rising rates. For institutional client use only not for distribution
A flattening of the yield curve added to June s volatility, increasing uncertainty about the markets going forward. In the past, the inversion between the 10-year and 2-year treasury spread has signaled a looming recession. While that spread is still positive, it is nearing inversion territory. Hiccup in International Equities Developed international equities, as measured by the MSCI EAFE Index, ended the quarter down -1.24%, bringing YTD returns down to -2.75%. The overall effect of foreign currency on developed international returns during the quarter was negative -4.65% as renewed strength in the US dollar impaired overall returns. International small cap, as measured by the MSCI EAFE Small Cap, lost -1.57% during the quarter dragging YTD returns negative to -1.33%. Emerging Markets took a big hit during the second quarter as the MSCI Emerging Markets Index lost -7.96%, bringing YTD returns down to -6.66%. Recent renewed strength of the US dollar, coupled with rising oil prices and U.S. interest rates, negatively influenced emerging markets during the quarter despite continued strength in underlying fundamentals. Despite predictions to the contrary, Emerging Market equities have actually outperformed U.S. equities during the last three US rate hiking cycles. Since the Fed began hiking rates in December 2015, the MSCI EM has outperformed the S&P 500 by approximately 350 basis points. Furthermore Emerging Markets tend to outperform when the underlying economic growth differential vs. the developed world is high. The Emerging Markets to Developed world growth differential bottomed out during the end of 2016 and the IMF expects the differential to continue to expand over the next few years. Economy U.S. economic indicators remain mixed as U.S. GDP for Q1 2018 came in at +2.0% but is expected to accelerate above +3% for the second quarter. In addition, the unemployment rate has declined and payrolls have now been positive for a record long 93 consecutive months. For Q2 2018, analysts are projecting S&P 500 earnings growth of +20.0%, with all eleven sectors expected to report positive earnings growth, led by the Energy, Materials, Telecom and Information Technology sectors. If 20% is the final growth rate for the second quarter, it will mark the second highest year over year growth rate since Q3 2010 trailing only Q1 2018 s growth rate of 24.8%. The Q2 2018 revenue growth is projected at 8.8% and would be the highest level since Q3 2011. The current 12-month forward P/E ratio is 17.2x vs. a 10-year average of 14.4x. Seven sectors (all but Energy, Financials and Telecom) continue to have forward P/E ratios above their 10- year averages. The U.S. manufacturing sector remained on its upward trend with an ISM reading of 60.2, the 22nd consecutive month of strong growth in manufacturing led by sustained expansion in new orders, production and employment. Conversely, inventory growth levels are beginning to show weakness as deliveries from suppliers are slowing down. For institutional client use only not for distribution
The price of oil continues to rise. Oil traded in the $65 - $75 dollar range during the second quarter and ultimately ended the quarter at $74.15, up almost $10 from the previous quarter and up approximately $30 from one year earlier. Risks Major risks continue to be monetary policy uncertainty, geopolitics, global trade tensions, the fragmentation within Europe and terrorism. Credit quality on both the institutional and retail levels are beginning to deteriorate. More than 77% of outstanding first-lien bank loans are considered covenant-lite, which offer less protection to creditors. Subsequently, the average length of a loan for a new car purchase is 69 months. Auto owners are increasingly falling behind in their car payments. Furthermore, delinquencies of subprime auto loans are now at levels higher than experienced during the global financial crisis. Another risk to consider is the increased regulation within the technology sector. An examination of past bubble suggests that increased regulation could be one reason for a bubble to burst. Both biotech stocks and tobacco names experienced broad drawdowns as compared to the S&P 500 after regulations in each sector were passed. Recent fears regarding privacy has sparked global regulation among tech names. Comparatively, the technology and e-commerce industries have the fewest regulations currently across all sectors. For institutional client use only not for distribution
Market Index Review June 2018 Market Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years International Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years S&P 500 0.62 3.43 2.65 14.37 11.93 13.42 10.17 MSCI Emerging Markets -4.15-7.96-6.66 8.20 5.60 5.01 2.26 Dow Jones Industrial Average -0.49 1.26-0.73 16.31 14.07 12.96 10.78 MSCI Europe -0.67-1.27-3.23 5.28 4.22 6.21 2.36 NASDAQ Composite TR 0.98 6.61 9.37 23.60 15.96 18.54 13.87 MSCI Pacific -2.22-1.35-2.02 9.91 6.37 6.93 3.96 MSCI EAFE -1.22-1.24-2.75 6.84 4.90 6.44 2.84 MSCI ACWI ex USA -1.88-2.61-3.77 7.28 5.07 5.99 2.54 Russell 2000 0.72 7.75 7.66 17.57 10.96 12.46 10.60 MSCI EAFE Small Cap -1.95-1.57-1.33 12.45 10.09 11.32 6.81 Dow Jones U.S. Total Stock Market 0.66 3.87 3.25 14.79 11.56 13.22 10.28 MSCI Frontier Markets -3.54-15.19-10.86 1.69 2.15 4.55-2.52 Russell Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years Bond Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years Russell 1000 0.65 3.57 2.85 14.54 11.64 13.37 10.20 Citi 3mth Treasury Bill 0.15 0.44 0.79 1.33 0.64 0.39 0.31 Russell 1000 Growth 0.96 5.76 7.25 22.51 14.98 16.36 11.83 BBgBarc US Municipal TR 0.09 0.87-0.25 1.56 2.85 3.53 4.43 Russell 1000 Value 0.25 1.18-1.69 6.77 8.26 10.34 8.49 BBgBarc US Aggregate TR -0.12-0.16-1.62-0.40 1.72 2.27 3.72 Russell MidCap 0.69 2.82 2.35 12.33 9.58 12.22 10.23 BBgBarc US Govt/Credit TR -0.19-0.33-1.90-0.63 1.83 2.29 3.78 Russell MidCap Growth 0.39 3.16 5.40 18.52 10.73 13.37 10.45 BBgBarc US Govt/Credit Int TR -0.07 0.01-0.97-0.58 1.16 1.60 3.08 Russell MidCap Value 0.81 2.41-0.16 7.60 8.80 11.27 10.06 BBgBarc US Corporate High Yield TR 0.40 1.03 0.16 2.62 5.53 5.51 8.19 Russell 2000 Growth 0.78 7.23 9.70 21.86 10.60 13.65 11.24 BBgBarc Global Aggregate TR -0.44-2.79-1.46 1.35 2.58 1.49 2.58 Russell 2000 Value 0.61 8.30 5.44 13.10 11.22 11.18 9.88 Citi WGBI -0.29-3.35-0.94 1.90 2.81 1.11 2.07 Sector Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years Other Indices MTD QTD YTD 1 Year 3 Years 5 Years 10 Years S&P 500 Materials 0.34 2.58-3.08 9.90 8.49 10.86 5.71 HFRI FOF: Diversified Index -0.26 0.80 0.87 5.40 1.81 3.34 1.45 S&P 500 Consumer Discretionary 3.61 8.17 11.52 23.55 14.44 15.97 16.41 HFRI FOF: Conservative Index -0.13 0.96 1.52 4.05 1.88 2.99 1.21 S&P 500 Consumer Staples 4.50-1.54-8.55-3.93 5.52 8.17 9.94 HFRI FOF: Strategic Index 0.03 1.27 1.67 7.09 2.66 4.31 1.70 S&P 500 Energy 0.71 13.48 6.81 20.99 3.68 2.22 0.96 Wilshire Liquid Alternative TR USD -0.26-0.63-1.61 1.27 0.73 1.31 1.30 S&P 500 Financials -1.92-3.16-4.08 9.65 12.46 13.13 7.05 FTSE EPRA/NAREIT Global TR USD 0.60 3.45-0.01 7.25 6.90 6.77 5.53 S&P 500 Health Care 1.63 3.09 1.83 7.11 5.68 14.31 12.99 Alerian MLP TR USD -1.54 11.80-0.63-4.58-5.93-4.09 6.46 S&P 500 Industrials -3.31-3.18-4.69 5.34 11.30 12.66 9.70 Bloomberg Commodity Index TR USD -3.50 0.40 0.00 7.35-4.54-6.40-9.04 S&P 500 Information Technology -0.35 7.09 10.87 31.30 22.59 21.91 14.65 S&P 500 Real Estate 4.44 6.13 0.81 5.02 -- -- -- S&P 500 Telecommunication Services 2.37-0.94-8.35 1.39 3.86 3.71 6.15 S&P 500 Utilities 2.77 3.74 0.32 3.41 11.68 10.57 6.64 Returns include dividends; 3-year, 5-year and 10-year returns are annualized. Indices are unmanaged. You cannot invest directly into an index. Past performance is not indicative of future results
Q2 2018: Tariffs and Trade Wars Source: Hedgeye, ACG
Economic Activity Still Positive Despite a low print in Q1 2018, U.S. GDP growth is averaging near 3% and is forecast to accelerate in Q2 according to most estimates In addition, the unemployment rate has declined and payrolls have now been positive for 93 consecutive months the longest streak since data has been compiled Source: Bureau of Economic Analysis, WSJ, CNBC, Atlanta Federal Reserve, Standard & Poor s, ACG
And Earnings Have Been Very Strong Strong corporate earnings, driven partially by a positive tailwind from the tax cuts and repatriation, have S&P 500 earnings projections up significantly for calendar year 2018 Effect of Tax Reform & Repatriation (% change in 2018 Expected Earnings) Increasingly, corporations are using these profits to repurchase shares and boost dividends which creates a positive feedback loop in the equity market Source: Standard & Poor s, ACG
Bond Yields Continue to Rise 10 9 8 7 6 5 4 3 2 1 Stock vs. Bond Yields Yield Curve Spread (10-Year minus 2-Year Treasury Yields) 0 1985 1988 1991 1994 1997 2000 2003 2006 2009 2012 2015 S&P 500 2 Year Treasury 3 Month T-Bill After a decade of abnormally low rates, cash is again yielding more than the S&P 500. This has caused many of the higher yielding so-called yield proxy stocks to sell-off during Q2 2018 One worry for investors is the increasing likelihood of an inverted yield curve. In the past, an inversion of the 10-Year / 2- Year Treasury spread signaled a looming recession Source: Bloomberg, Thomson Reuters, Federal Reserve, ACG
But, Rising Rates Not all Negative Starting Yield vs. Forward Return (Bloomberg Barclays U.S. Aggregate Index) Cumulative Return Scenarios (Various Rate Regimes)* Scenario A - No Rate Hikes (Starting yield of 3.0%, duration of 6.0) Scenario B - Rate Hikes (Starting yield of 3.0%, duration of 6.0) Scenario C - Rate Hikes (Starting yield of 2.5%, duration of 3.0) 55.0% 45.0% 35.0% 25.0% 15.0% 5.0% -5.0% 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Rising bond yields have had a negative effect on bonds year-to-date. The good news is that higher starting yields have historically resulted in higher subsequent future returns Despite the negative short-term effects of interest rate hikes, higher rates of reinvestment in the future eventually win out. Lower duration can also mitigate the effect of rising rates Source: Bloomberg, PIMCO, Wall Street Journal, ACG * Note: analysis assumes starting yield of 2.5% and 8 hypothetical future rates hikes of 25 bps spread evenly over the next 4 years
Strong Dollar Slows Foreign Returns, but Discount Remains 160.00 150.00 MSCI EAFE & MSCI EM vs. US Dollar (Index Performance) 135.00 130.00 P/E Ratios (2018 Calendar Year) 17.2 140.00 130.00 125.00 120.00 12.2 14.3 13.4 120.00 115.00 110.00 110.00 100.00 105.00 90.00 100.00 80.00 95.00 70.00 12/2012 3/2013 6/2013 9/2013 12/2013 3/2014 6/2014 9/2014 12/2014 3/2015 6/2015 9/2015 12/2015 3/2016 6/2016 9/2016 12/2016 3/2017 6/2017 9/2017 12/2017 3/2018 MSCI EAFE MSCI EM USD 90.00 EM Europe Japan USA The U.S. Dollar s strength in 2018 has had a negative impact on foreign equity returns to U.S. investors so far in 2018 As a result, the price-to-earnings ratio of foreign equities remains at a large discount to the United States Source: MSCI, Federal Reserve, Standard & Poor s, ACG
Risks: Will Fed Rate Hikes Derail the Emerging Markets? Despite prognostications to the contrary, Emerging Market equities have actually outperformed U.S. equities in the last three US rate hiking cycles The Emerging Markets tend to outperform when the underlying economic growth differential vs. the developed world is the highest. The IMF expects this differential to expand over the next few years Source: Goldman Sachs, Federal Reserve, Haver Analytics, Bloomberg, Factset, IMF, ACG
Risks: Increased Regulation in the Technology Sector Past Bubble Performance (Pre & Post Regulation) # of Federal Regulations (By Industry) An examination of past bubbles suggests that increasing regulation can be one reason for a bubble to burst Technology, the main target of recent increased government regulation, also happens to have the fewest current regulations across sectors Source: Bank of America Merrill Lynch, ACG
Risks: Deteriorating Credit Quality Covenant-lite Share (% of Outstanding Bank Loans) Auto Loan Delinquency (60+ days Delinquency Index) More than 77% of outstanding first-lien institutional loans are now covenant-lite. Many worry that these deals, which offer less protection to creditors, could negatively impact recoveries when the current credit cycle turns Auto owners are increasingly falling behind in their payments. In addition, these loans are typically bigger with longer repayments terms and on depreciating assets Source: Standard & Poor s, ACG
Risks: Earnings As Good as it Gets? Year-over-year growth in corporate earnings following the tax cuts has been so strong that it will likely create an environment where future earnings growth slows due to very strong comps next year Source: Thomson Reuters, I/B/E/S, ACG