More Quarterly Investor Letters

See More

Despite heightened volatility, the major stock market indices all posted positive returns for the Second Quarter.  Leadership was provided by the tech-heavy NASDAQ and small cap Russell 2000.  The Dow Jones Industrial Average remains slightly negative for the year, and the S&P 500 realized a total return of 2.64% through June 30.  Divergence in performance among these indices reflects the perceived sensitivity of their various constituents to the concern that dominated investor activity throughout the quarter – i.e., potential for a trade war.  As we highlighted at the end of 2016, a shift away from multi-lateral trade agreements to bilateral arrangements would be favored by the new Administration.  That shift appears to be in train.

In prior missives, we have cautioned against assigning high probabilities to worst case scenarios.  The volatility of the markets during the Second Quarter suggests that certain investors have concluded that current trade tensions will escalate into far more damaging trade conflicts.  That is not our view.  We concur that global leaders have engaged in a “war of words”, and the implementation of retaliatory tariffs will disrupt certain sectors.  We appreciate that the negotiating tactics currently favored are unsettling to the markets.  However, a deleterious trade war, involving a collapse of complex agreements protected by laws and characterized by boycotts, is far from certain.  The performance of both the US stock and bond markets thus far in 2018 supports our interpretation.

That is not the case globally.  There has been a notable correction among emerging markets, the group that dominated performance in 2017.  Investors could be expressing a view that the US will fare much better than their trade partners as this process unfolds.  As several countries manage uncertain election outcomes, there is a heightened prospect for volatile trade negotiations.  Not unlike in the US, the political process in many countries has gravitated toward extremes such as populism and nationalism.  We would note as examples the recent election in Mexico, ongoing Brexit negotiations in the UK, and the likelihood that the Angela Merkel era in Germany could be coming to an end.

Attention has also shifted to indicators such as the exchange rate of China’s currency as a proxy for the potential for a trade war.  China’s surprise devaluation of its currency was the catalyst for the stock market correction from August 2015 through February 2016.  Recent economic indicators for Europe and other regions suggest deceleration.  Yet, numerous other data support the view that a synchronized economic expansion continues, although perhaps not at the same pace as 2017.  Further, the US appears to have re-asserted itself as the engine of global economic growth.

An analysis of history confirms that the economic impact of new trade rules will prove uneven.  Nevertheless, investors are attempting to identify winners and losers, an effort that is likely premature.  The rotation by investors to small caps and domestic-only businesses argues for a generally defensive posture with respect to trade – i.e., hedging against a worst case outcome.  We likewise favor an overweight to sectors less dependent on foreign sales, but we also believe the market’s rapid shifts in this regard could offer opportunities.

Lost amid the furor over trade, the US economy continues to grind higher, with New Home Sales and the labor market providing evidence of sustained growth.  We also believe recent announcements from OPEC should provide stability to the oil market.  The Federal Reserve is expected to raise policy rates twice more in 2018.  These developments are part of the process of rate normalization, which the markets believe will conclude some time in 2019.  When once it was considered the principal risk for the markets, investors now appear less concerned about Fed action.  Moreover, after ten years, investors can now earn a nominal yield from cash.  We are watching carefully, however, the shape of the Treasury yield curve as a lead indicator for a turn in the economy.  We would note that, while the yield curve has been reliably historically, the peaks of both the market and the economy have occurred with considerable lags from the date of curve inversion.