The environment is conducive to further gains this year. Over time, we expect stocks to follow earnings, and earnings estimates have been moving higher for both this year and next. Specifically, consensus S&P estimates have risen by 8% for 2018 (from around $146 at the end of 2017 to near $158 currently) and by 9% for 2019 ($160 to $175). Earnings growth will likely slow from the 27% rate this year as we lap the tax reform benefits, but should still move higher on an absolute basis.
With the market currently up only marginally for the year, and positive earnings revisions outpacing the gains, valuation continues to be relatively attractive at 17.2x 2018 estimated earnings and 15.5x 2019 estimated earnings. Though inflation is slowly rising, valuation usually expands to above current levels unless inflation pressure is much higher. Further, the most reliable predictor of recession, an inverted yield curve, is not present at this time.
During the second quarter, a significant federal court ruling allowed AT&T to move forward with its $85 billion acquisition of Time Warner that was first announced in late 2016. The Justice Department had sued to block the merger on the grounds that it would suppress competition and harm consumers. This ruling, while somewhat expected, is significant in that it may spark further consolidation in a rapidly changing media landscape. Companies like Netflix, Amazon, Facebook, and Alphabet are forcing older, more traditional companies to adapt, creating opportunities and risks in the areas in which they operate.
Similar to the end of the first quarter, the end of Q2 saw an uptick in volatility and a pullback in the market amid fears that a potential trade war could derail the global economy and financial markets. Our assessment at this time is that such fears are mostly overblown, as the aggressive rhetoric from President Trump is indicative of his negotiating style. Nonetheless, we continue to closely monitor the situation and consider the impact of the announced tariffs on portfolios.
Despite many threats regarding potential tariffs from the US, only three—the 25% tariff on all imported steel, 10% on aluminum, and a tariff on a portion of $50 billion of Chinese goods—have been implemented to date. The rest could take effect in September, and there have been several further statements regarding reciprocal tariffs from both the US and China, including one US proposal of additional tariffs on $200B of Chinese imports, plus another $200B if China retaliates. The total value of Chinese imports into the US was just over $500B in 2017. Some economists estimate that a blanket 10% tariff on all Chinese imports would reduce S&P 500 earnings by about 2-3%, not a significant amount in the grand scheme of things. Certain companies would of course face a larger impact, though many have already pulled back by over 20%, possibly assuming a worst-case scenario or unforeseen negative consequences.
Uncertainty about ultimate outcomes could continue to unnerve market participants. Substantial opposition to major tariffs exists from both political parties, so trade policy is likely to remain a major topic of discussion for Trump and others as November midterm elections approach. We believe it is prudent to monitor the implications of escalating trade rhetoric, but not to overreact to it.
Our expectation for an S&P 500 total return possibly approaching +10% in 2018 is unchanged from the beginning of the year. Support for this outlook continues to come from accelerating earnings growth, relatively low interest rates, and gradually rising inflation. Favorable current indicators like elevated small business optimism, low financial stress, and tight employment lend further support to the current bull market.
Correlations between individual stocks and the S&P 500 index have been coming down from a very high level in January, setting up a better environment for active management. Active management often shines in later stages of economic and market cycles when the Fed is in a credit tightening cycle and volatility increases.
Though volatility was lower in the second quarter than in the first, it generally remained above the very low levels we saw last year. We expect this pattern to continue as trade talks linger and midterm elections come into focus. We will remain disciplined in the face of higher volatility and committed to a long-term time horizon when building portfolios to meet client objectives.
Oil prices rose 22% in the first half of 2018 as inventories shifted into balance, and stronger demand raised the specter of undersupply over the next few years. Since the oil crash four years ago, the structural narrative is the lack of long-cycle investment from companies exhibiting capital discipline, against a backdrop of above trend demand and heightened geopolitical risk. We believe short-cycle projects such as US shale are not sufficient to balance global oil demand, which is driving commodity prices up to a level needed to incentivize long-cycle investment. OPEC recently agreed to increase production, however the cartel is acting more rationally than in past years and is now focused on maintaining a higher price level rather than its previous strategy of flooding markets to take share. We anticipate a more balanced market with continued global demand growth and higher prices required to fulfill supply, providing a constructive environment for energy stocks.
The Bloomberg Barclays US Aggregate bond index generated returns of -0.2% in Q2 and -1.6% year-to-date as rising interest rates have put downward pressure on bond prices. The yield on 10-year Treasuries increased from 2.40% at year-end to 2.85% on June 30th. This rise in interest rates can be attributed to higher expectations of economic growth, growing inflation, a widening budget deficit, and a Fed policy of raising rates while shrinking its balance sheet. Chilton’s fixed income portfolio has actually seen modest gains given our short duration positioning and the yield advantage provided by our overweight position in corporate bonds.
In June, the Federal Reserve hiked short-term interest rates for the second time this year and the seventh time since 2015. The Fed’s economic outlook was upgraded since its last meeting in March given the committee’s outlook for higher GDP growth, lower unemployment, and increased inflation. Financial markets are anticipating an additional 1-2 hikes later this year, however the decision to raise rates will continue to be data dependent. For instance, escalating trade war tensions have decreased the likelihood of more than one additional hike this year.
The credit markets are not indicating that recession is likely in the near-term. An inverted yield curve, when long-term rates are lower than short-term rates, has preceded each recession in the past 60 years. The shape of the yield curve remains upward sloping, albeit flatter than at the beginning of the year (see chart below). The yield curve is likely to continue to flatten or even invert later this year as the Fed moves short term rates higher (longer-term rates are unlikely to move up as quickly). It’s important to note, however, that the lag time between inversion and recession is typically 1-2 years. Corporate credit spreads (the incremental yield of corporate bonds vs Treasuries) have inched higher year-to-date, but remain well below pre-recessionary levels. If the yield curve was to actually invert and/or credit spreads began to meaningfully widen, we would gradually adopt a more defensive posture across all portfolios.
Given our view that interest rates will move higher over time, we continue to position portfolios with mostly short-to-medium duration securities. The majority of recent purchases in many portfolios have been floating rate bonds with coupons that adjust higher as interest rates rise. Our current estimate for fixed income total returns in 2018 is in the range of 2% – 3%, with the majority of return coming from interest income, offsetting a modest level of capital depreciation. Although fixed income returns may remain muted over the short-to-medium term, bonds play an important role in the asset allocation process by providing both income and stability within a diversified portfolio.
The MSCI US REIT Index (RMZ) produced a total return of +10.1% in the second quarter, bringing the year-to-date performance of the index to +1.2%. The rebound in the second quarter can be attributed to an increase in M&A activity and a positive Q1 earnings season from REITs of all property types. In particular, self-storage, industrial, lodging, triple net, healthcare, and shopping center REITs outperformed the index. In contrast, data centers/tech, residential, and office REITs underperformed; regional malls were in line.
Equity REITs entered the quarter at one of the largest discounts to Net Asset Value (NAV) in history. Similarly, the RMZ dividend yield peaked at 4.8% on April 23, and finished at 4.3%. Notably, the spread between the RMZ dividend yield and the 10-year Treasury yield declined by 46 basis points (bps) to end the quarter at 145 bps, an encouraging sign for REIT investors looking for the spread to compress to a level more in line with the historical average of 120 bps.
One of the catalysts helping to close the spread during the quarter was an increase in transaction activity as big market players looked to take advantage of historically high NAV discounts. Notably, Blackstone proposed three all-cash acquisitions of REITs, totaling $10.4 billion in enterprise value, during the quarter, and Prologis agreed to purchase DCT Industrial in an all-stock transaction for $8.4 billion. This flurry of activity is not surprising given the record amount of capital raised by private real estate funds. More activity is likely during 2018. As a result, the discount to NAV on the REIT sector went from a high of 14% on April 27 to finish the quarter at only 8%, according to ISI Research.
The Q1 earnings season was a positive for the sector as well, as 61% of companies outperformed the benchmark on the day of their earnings release according to Citi Research. Over 50% of REITs reported results above consensus estimates, while less than 20% missed consensus. Surprisingly, many REITs increased full year earnings and same store growth guidance, a move that traditionally happens in Q2 or later as companies wait for more data to validate their new estimates. The Q1 guidance increases indicate that the ‘disappointing’ 2018 guidance numbers, given with the Q417 earnings releases, may have been overly conservative. We look for more companies to increase guidance in the upcoming earnings season.
Shopping centers and regional malls were two of the top performers in the final month of the quarter thanks to several catalysts, most notably the rebound in retail sales and fewer tenants filing for bankruptcy. The annual International Council of Shopping Centers (ICSC) conference resulted in many positive notes from both retail and real estate analysts, and REITweek in New York City gave management teams the opportunity to further spread the positive news on the health of their tenants and the private transaction market. Finally, on June 21 the US Supreme Court overturned a 1992 law that exempted retailers from having to collect sales tax on cross-border transactions in states where they had no physical presence. The result is a more level playing field between online-only retailers and those with a brick-and-mortar presence. This was a significant victory for retail REITs, NAREIT, and ICSC, who had been pushing for this change for years. Retail REIT prices spiked on the news.
US markets outperformed international markets in the second quarter with the large cap S&P 500 up +3.4% and US small cap stocks up +7.8%, while developed international markets fell -1.1% and emerging markets fell -7.9%. Part of this discrepancy can be attributed to the strength of the US dollar, +5% in Q2, which is a headwind for US investors. In local currency, developed international markets rose +3.6%.
Source: Bloomberg LP
The global economic outlook points to continued growth momentum, however escalating trade tensions, a stronger US dollar, and geopolitical agitations in several countries contribute to increased volatility in international markets. Global manufacturing and consumption growth continues at above trend rates around the world, albeit with pockets of economic stress in countries like Argentina and Turkey. We continue to evaluate the potential impact of trade restrictions on global markets.
A portfolio diversified across low correlated asset classes effectively captures the returns offered by the financial markets while reducing risk. Combining lower risk assets such as fixed income and cash further reduces volatility and improves yields. As developed and emerging markets are at different stages of growth and economic development, international allocations allow for diversification across geographies as well as economic and market cycles.
Over the past 10 years, US earnings have recovered from the Great Recession to set new highs. This has translated into better performance from US markets while international earnings have stagnated due to a European recession, the fallout from the oil price crash, and the China slowdown. Now, international markets are in the early stage of a cyclical inflection, with earnings that are still below prior peaks. These markets should benefit from global economic growth that will likely outpace that of the US in coming years.
“The inevitable never happens. It is the unexpected always.” – John Maynard Keynes
Multiple studies of psychology and behavioral finance show our brains are tremendously powerful processors, yet humans suffer hard-wired cognitive biases that affect rational decision making. Witness the cycles of fear and euphoria that manifest in financial markets. The fear of losing everything at the bottom is contagious, as is the greed of missing out at the top. We are a long way from the pit of despair in 2009 and are perhaps now approaching a cycle of optimism with the market near all-time highs.
As mentioned before, we maintain a constructive view on the markets given strong underlying fundamentals. However, the late-cycle environment amidst tightening monetary policy and elevated geopolitical risks could eventually combine for an unpleasant scenario.
We believe that the best way to achieve investment goals is by implementing a long-term, diversified strategy and setting an asset allocation based on income needs and risk tolerances. A broadly diversified portfolio is the best defense against the unexpected. We recommend our clients work with us now, rather than after an emotional reaction to a market move, to ensure their asset allocation is appropriate to meet their goals.
Bradley J. Eixmann, CFA, firstname.lastname@example.org, (713) 243-3215
Brandon J. Frank, email@example.com, (713) 243-3271
R. Randall Grace, Jr., CFA, CFP®, firstname.lastname@example.org, (713) 243-3223
Patricia D. Journeay, CFA, email@example.com, (713) 243-3222
Matthew R. Werner, CFA, firstname.lastname@example.org, (713) 243-3234
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