U.S. stock returns were robust in August. While small cap growth led the pack (up 6.65 percent), as it has much of 2018, all domestic stock asset classes across market cap were positive by more than one percent during the month. The value-growth dichotomy also continued, as growth stocks outpaced value stocks by 3.5 percent or more for the month and over 10 percent for the year, for both domestic large and small cap stocks. International returns were negative in both the developed and emerging asset classes. This was due in part to the slight strengthening of the dollar during the month, but local returns have been generally negative. The yield on the 10 year US Treasury bill came down, finishing the month at 2.87. This helped fixed income returns recover somewhat from their year-to-date losses. Cooling of trade tensions contributed to August’s results; expectations around the Fed’s pace of rate hikes appear to be holding relatively steady at two more hikes in 2018, and the markets have been content with this outlook.

Trade talks appeared to reach a breakthrough as the United States and Mexico arrived at a bilateral agreement in the last week of August. This promising news was enough to bring Canada back into trade discussions with the other two NAFTA members, with all three countries hoping for a resolution to modernize the 24-year-old trade agreement. Unfortunately negotiators were unable to reach the August 31^st deadline for a deal, but that will likely be reset to allow more time for talks. The White House has said that the U.S. will settle for a bilateral agreement with Mexico if no deal is forthcoming from Canada. This creates some legislative hurdles, however, as a new NAFTA agreement would only require a 51-vote majority in the U.S. Senate while a bilateral deal would require 60 votes—a much more difficult hurdle that would require bipartisan support.

Fed Chair Jerome Powell met with central bankers from other countries at the annual gathering in Jackson Hole, WY. Powell defended the Fed’s path of gradually increasing the Federal Funds Rate, despite renewed criticism from President Trump, who said he was “not thrilled” that Powell was continuing to raise interest rates. The Fed is legally independent from White House influence and this boundary has been respected by past presidents. It will be interesting to see if Trump continues commenting and if Powell responds.  The CME Group’s FedWatch Tool, which polls experts on the probability of a rate hike in any given month, indicates that a 25 basis point hike in September is virtually certain, with a probability of 98 percent.  The probability of an additional rate hike in December is at 67.8 percent, up from 64.7 percent one month ago. It’s worth noting that the Fed’s preferred measure of inflation, the Personal Consumption Expenditure price index, reported a year over year increase in prices of 2.3 percent on August 30, above the Fed’s percent target rate for inflation.

One area of the market that appears to be cooling is housing.  It was reported late in August that pending home sales fell in July, the seventh straight month of declines. The decline has largely been driven by the most overheated real estate markets, where prices have been driven to a point where more and more prospective buyers can’t afford to buy. Investors who remember the painful catalysts of the Great Financial Crisis (GFC) ten years ago may draw ominous conclusions about this news. However, we view this current decline as a natural correction of a long stretch of short supply in the housing market. According to JP Morgan, household debt payments as a percentage of personal income are much lower than they were in 2007 (10.3 percent now as compared with 13.2 percent in Q4 2007), and in fact are still lower than at any point before the GFC going back at least to 1980.

The last observation that we’ll leave you with is the continued flattening of the yield curve. As we have pointed out since late 2017, the spread, or difference, between the yield of a 10 year US Treasury bill and a 2 Year US Treasury bill continues to narrow. The number began 2018 at 54 basis points and hit a low of 18 basis points on August 27. We believe it is reasonable to expect this number to hit zero and go negative within the next 6 to 12 months. Historically this has been an indicator of a recession arriving within 12-18 months, though the time between when the spread hits zero and recession occurring tends to vary. We don’t want to be guilty of the famous investment delusion that “this time is different,” but we can’t resist pointing out that the tax reform bill is a significant consideration; there hasn’t been a comparable fiscal stimulus so deep into the economic cycle in modern history. Regardless of the 2-and-10 year spread’s predictive powers this time around, you can expect market volatility to pick up as it gets closer to zero. Use this current stretch of easy investing to reflect on your portfolio and whether you’re taking an appropriate amount of risk.

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