The second quarter of 2018 was characterized by numerous news events that drove volatility in markets. The news stories we digest each day are presented by media channels as earth moving events which will change the world as we know it: the China trade war, North Korea, stocks at peak earnings, inflation returning, global economic slowdown. Meanwhile, the U.S. economy is surging and so are corporate earnings.
Based on key economic measures, the U.S. economy is not yet showing signs of trouble ahead. Of course, as in any period of economic history, there are high points and real concerns economically. But more signals are indicating favorable economic conditions than red flags for concern currently.
In the short run, news events that create uncertainty can trigger sudden and dramatic price swings for equities. Such events, and the market volatility that follows, get a lot of attention. However, in the long run, the key driver of equity values is company earnings. Today U.S. equity markets are near record highs, driven by a surge in corporate earnings and favorable economic conditions.
Short term market volatility cannot be avoided, but the risk of being harmed by it can be managed by employing a disciplined investment management process, and integrating your investments with your financial planning.
Today’s Economic Perspective
The U.S index of leading economic indicators surged in 2017-18. The GDP growth forecast is +3%, as compared to post-recession +2.2% average. The labor market is near full employment, meaning the economy is operating at its full potential.
On the positive side of the economy:
- U.S. families are in good economic shape (higher net worth, better credit standings, higher personal income, and lower household obligations)
- Record high job openings and low unemployment rate
- Rising housing starts and strong vehicle sales
- Small business optimism is high
Economic question remaining:
- What impact will the imposition of trade barriers have for the U.S., other countries, and U.S. consumers?
- Will the Fed’s plan to gradually step up interest rates slow the economy?
- When will the next economic recession occur and what will cause it?
Today’s Market Perspective
The U.S. equity markets suffered a small setback during the first quarter of the year, but the second quarter bounced back into positive territory.
The U.S. has been a haven of stability in a very messy world. Large U.S. company stocks (as measured by the S&P 500 index) posted a gain of 3.4% in the second quarter. Small U.S. companies (as measured by the Russell 2000 small cap index) posted gains of 7.87% for the quarter, erasing losses in the first quarter and posting gains for the year.
Internationally, companies in developed foreign countries (as measured by the EAFE index) and market stocks of less developed countries are not fairing as well. Developed international equities are down 4.49% for the year, and emerging market equities are down 7.68% for the year.
Fixed Income Securities
While typical discussions about market risk and returns centers upon equities, many investment portfolios include a substantial portion in bonds. Bonds are often viewed as the “stabilizer” in a portfolio. Bond values are not as notoriously volatile as equities, and they have a historically low correlation to equities (meaning stocks and bonds have generally gone their own ways).
But bonds are not without risk, it’s just different risk. Bonds are subject to interest rate risk and credit risk. During Q2 2018 bond prices were impacted by rising interest rates and the broad bond index was down 2.78% during the quarter.
As the Federal Reserve nudges interest rates up from historic lows, you may be concerned about potential volatility in the bond markets. The role bonds play is unchanged. Bonds play an important role in your portfolio as a counterbalance to stocks in a turbulent environment.
Regardless of reactions to Fed interest rate changes, it still makes sense over the long term to include bonds in your portfolio. Bonds help offset potential downturns in stocks, in part because their prices tend to rise when equity prices fall, but also because of the income they provide through their yields. In addition, in a disciplined investment process, the income is being re-invested at the new higher rates and re-balancing can direct more money into purchase of lower valued shares.
Diversifying your investments can help reduce risk, although you can never completely eliminate it. Each investment plays a role in your portfolio, and it is understood that certain types of investments will cycle through periods of being in favor or out of favor.
Volatility can be expected with each new headline, and investors who rely on investments for income should have processes in place to help reduce the risks caused by sudden changes to security values.
Remember that volatility is normal and cannot be avoided if you are investing in equities to achieve long term growth. Risk, on the other hand (best understood as the probability that you will lose money or fall short of meeting your goals or needs) can be managed through a disciplined process, and by avoiding behaviors that can impede attainment of your financial goals.
As an investor it pays to stay focused on long term appreciation, which is driven by the day to day process of companies employing their creative resources and ingenuity to produce revenue, growth and profits.
Our focus is to help clients build investment strategies driven by financial planning. We concentrate on integration with the other elements of a successful financial plan, including asset protection, retirement sustainability, and estate planning.