Investor Insights - June 2018

By Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA

Bobby Moyer, CFA, CFP®, CAIA Director of Research Senior Portfolio Manager

See our recap of May's key statistics and market commentary below. 

investor-insights-numbers - June red 41The spread, or the difference, between the yield on the US 10-year and US 2-year treasury bills fell to 41 basis points by the end of May. Primarily due to the drop in the 10-year yield from a peak of 3.12 percent to as low as 2.76 percent amid fears from Europe, the compression of this spread is seen as a warning sign for the US economy.  

investor-insights-numbers-june-green-6.46The S&P SmallCap 600 index of small companies in the US returned 6.46 percent during May. Small companies far outpaced larger companies during the month due to their comparative insulation from the effects of a strengthening dollar and a potential trade war.

investor-insights-numbers-june-green-6.46-1The iShares MSCI Italy ETF, a proxy for the Italian stock market, lost 11.22 percent during May after the deterioration of the country’s political situation. The ETF, now negative for the year, was up 10.53 percent for the year through the end of April. 

Our Take

The month of May was jam-packed with noteworthy developments for markets. On the domestic front, the US saw its corporations close out one of the strongest earnings seasons in several years. President Trump was back in the spotlight (if he ever left it) for his back and forth negotiating and posturing on both trade with China as well as the potential summit with North Korean dictator Kim Jong-Un. In Europe, the political crisis in Italy injected fresh volatility into markets that caused massive movements in global equities, currencies, interest rates and therefore bonds. If that weren’t enough, the price of oil rose steadily throughout the month, causing fresh concern over the cost of gasoline, and then fell sharply after comments made by a Saudi OPEC minister. Although most major indexes finished the month positive, the table has been set with a number of storylines that may create problems for investors through summer and the rest of the year.

Let’s start with the good news. In last month’s newsletter, we reported that companies in the S&P 500 were on track to see their earnings grow 23.2 percent over last year. That was with just over half of the companies in the index having reported their first quarter results. According to FactSet, as of May 25, 97 percent of companies had reported earnings, putting the latest growth rate for the first quarter at 24.6 percent. This would be the highest growth rate in earnings since the third quarter of 2010. This strong earnings growth is expected to continue, with the consensus forecast from analysts suggesting earnings growth for all of 2018 to be 19.6 percent.

Much of the daily market movement in May is attributable to headlines generated by President Trump. Investors had been watching as trade talks began between the US and China, with fears that a budding trade war could grow into a serious headwind for both the US and broader global economy. On May 19, the two countries announced that they were putting the trade war “on hold,” with China agreeing to purchase significantly more US goods and both parties agreeing to refrain from imposing new tariffs while the talks continued. This was taken as a major positive for equity markets, which began to rally significantly. The optimism was cut short, however, when on May 29 the White House announced 25 percent tariffs on $50 billion worth of Chinese goods. China quickly signaled it was ready to retaliate. The other whipsaw occurred due to the news around the US-North Korea summit. In a matter of days, President Trump canceled and then apparently re-agreed to the summit, to be held in Singapore on June 12.

The news with the greatest market impact in May came from Europe. A tenuous political environment in Italy devolved into a crisis late in the month. Italy, which has the third largest economy in the EU, has been struggling for months to form a new government. The fragile agreement that had been reached was shattered when Italy’s president refused to allow the appointment of a euro-skeptic to the head of Italy’s finance ministry. The current political dynamics are fluid and complicated. Late on May 31 the two euro-skeptic parties appeared to have formed a government with the president’s approval. If the agreement holds it will serve to diffuse the crisis, but if the coalition fails or the president interferes, it would likely lead to elections later this year. This is of great concern for the markets because the election would be seen as a de facto referendum on whether Italy should leave the European Union.

Whether it’s called Italexit or Quitaly, it would be far more disruptive for Italy to exit the EU than it was when Great Britain decided to leave. The EU is often referred to as a stool with three legs: Germany, France and Italy. Removing one threatens to topple the entire structure. While Great Britain’s economy exceeds the size of Italy’s, Italy’s role in the EU is arguably more important because unlike Great Britain, Italy is a member of the single-currency zone. And while there’s never a good time for a crisis like this, it certainly doesn’t help that this appears to be coming to a head at the same time that we’re seeing growth in Europe begin to falter. Europe’s fragile recovery looked promising in 2017, but recent economic releases show signs of a possible slump. French unemployment rose during the first quarter and the Euro Zone Composite Flash Purchasing Manager’s Index fell in May to an 18-month low. With the European Central Bank planning to end its version of quantitative easing this year and begin hiking interest rates in early 2019, the European economy is in a tenuous position even without Italy’s problems. The prospect of Italy leaving the EU, while admittedly a low probability event at this time, could have catastrophic consequences.

Markets perceived this threat, with the Italian stock market plunging 11.22 percent during the month of May, erasing the strong gains it had seen for the year through April. Yields on Italian sovereign debt skyrocketed over a matter of days, with the yield on the 10-year note surpassing three percent after starting the month at 1.8 percent. The yield on the 2-year note rose by 150 basis points.

It’s worth noting that the trouble in Europe has had its beneficiaries: specifically parts of the fixed income asset category. Fixed income investments—primarily those with higher credit quality—benefitted, as they usually do, when equities sell off and investors flock to safer assets like US treasury securities. This pushed yields down significantly, with the yield on the US 10-year Treasury falling as low as 2.76 percent on May 29 after having peaked at a multi-year high of 3.12 percent just twelve days earlier. Because bond prices move inversely to yields, this provided a tailwind for most major bond categories. The Bloomberg Barclays US Aggregate Bond Index finished the month up by 0.71 percent, providing some relief after having been negative for the year through April due to rising interest rates. The return and correlation benefits of fixed income in times like this provide a good reminder of why investors with limited risk tolerance should keep bonds in their portfolio.

While the month of May brought to light some worrying potential flash points for investors, the fact that US equity returns finished the month positive demonstrates the strength of the US economy and the remarkable contrast of good news at home compared with bad news abroad. Small Cap stocks in particular did phenomenally well, with the S&P SmallCap 600 returning 6.46 percent for the month, putting it up 8.17 percent for the year through May. Smaller companies arguably stand to gain more than they lose with heightened tariffs, and they also benefit compared with larger companies when the dollar strengthens, as it has done so significantly as a result of the flight to safety caused by the Italian Crisis.

As we close out the first half of 2018 this month, investors should continue to reflect on whether their portfolios match their tolerance for risk. 2018 began with a number of potential concerns that could upset the apple cart; except for the prospect of good news with North Korea, these concerns remain and have been joined by new threats from Europe. 

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