“Opportunity is missed by most people because it’s dressed in overalls and looks like work.” Anonymous (though often attributed to Thomas Edison)
2018 got off to a bit of a bumpy start – volatility returned to financial markets and most asset classes posted negative returns in the first quarter. In the second quarter, investors continued to be buffeted by strong cross currents in the news. On the positive side, U.S. companies grew earnings by 26% year-over-year in the first quarter, the highest growth rate in earnings in seven years. Offsetting that good news, investors continued to fret over a potential trade war and the potential for slower economic growth as a result. This was all against the backdrop of the Federal Reserve continuing to slowly reduce its balance sheet and raise interest rates. From a performance perspective, the second quarter offered investors a bit of a reprieve as several asset classes bounced back vigorously from first quarter losses, though fixed income markets had a rough quarter as interest rates continued to creep upwards.
MLPs and REITs are two asset classes that benefitted from dramatic rebounds in Q2. By way of example, following a dismal first quarter of -11.12%, the Alerian Energy MLP, a benchmark for MLP investments, roared back in Q2 posting an 11.80% return. Similarly, following a -7.48% first quarter, Wilshire U.S. REIT, a benchmark for REIT investments, finished with a strong 9.73% return in the second quarter. In a quarter where stocks offered a mixed bag of returns and bond markets struggled, maintaining exposure to diversifying asset classes such as MLPs and REITs paid off handsomely for investors.
Performance in stock markets varied greatly depending upon country, market capitalization, and sector. The best performing equity asset class in the second quarter was U.S. Small Cap (Russell 2000), which was up 7.75%. U.S. Large Cap (S&P 500 Composite) was also up for the quarter, but a more modest 3.43%. Foreign stocks, however, posted losses for the quarter. Some of this loss was due to the strengthening of the U.S. dollar, which had a negative impact on U.S. investors allocating capital in foreign markets. From a sector perspective, energy stocks were the best performers for the quarter, up 10.2%, and financial stocks were the laggards, down 5.6%.
In bond markets, rising rates continued to be an impediment to returns. The Federal Reserve raised rates another 0.25% in June, staying on target for an anticipated one or two more rate hikes this year. The broad U.S. bond market (Bloomberg Barclays U.S. Aggregate) fell -0.16% in the quarter. Short-to-intermediate-term municipal bonds (Bloomberg Barclays Municipal Bond 5Y) held up better in the quarter, posting gains of 0.87%.
We have previously commented in these commentaries that forecasting is hard, and that basing one’s financial decisions on the ability to foretell the future is an often futile pursuit ending in a disappointing result. As an illustration of this difficulty, let’s briefly consider the impact of a rising U.S. dollar and its implications for investors. The dollar strengthening has been driven by several factors. The strong U.S. economy makes the U.S. an attractive market in which to invest, which draws foreign investors and increases demand for dollars. In addition, rising interest rates also draw capital from overseas, further increasing the demand for dollars. The stronger dollar increases purchasing power for U.S. consumers, but it can cause U.S. exports to be less competitive on price hurting U.S. companies that are reliant on exports. So while stock market investors benefit from having foreign investors buying U.S. assets and driving up equity valuations, they also suffer as many U.S. companies lose revenue, either from falling exports or from cheaper competition from imports. Investors buying U.S. bonds due to rising rates in turn drive up bond prices, which mitigates further increases in bond yields. These buyers may be partially responsible for the flattening U.S. yield curve. And all of this is occurring against a back drop of escalating trade tensions and rising protectionism. For anyone trying to develop an investment strategy based upon how this all turns out – good luck.
We’ll continue to do the hard work. Diversifying exposures across a broad range of complementary asset classes. Rebalancing portfolios when needed to maintain appropriate exposures. And remaining as tax-aware and cost-conscious as possible. It’s not as exciting or glamorous as predicting the future. But sometimes boring and reliable, even when dressed in overalls, is best.