Separating the noise from what really matters: Q3 2018 market update

In August, the U.S. stock market was crowned the longest-running bull market in history (by some measures) as it marked its 3,453rd day. While some investors toasted the rally’s impressive length, many began asking, “Should I be getting out of this market?”

As investors contemplate the meaning of the new record—and the subsequent early-October pullback—a few key contextual points are important to consider. First, the bull market record has been set amid a relatively small sample size: There have been only a handful of bull markets in modern U.S. financial history. Furthermore, it is important to consider the length of the bull market within the context of a long-term investment horizon. If you’re investing with a 15- or 30-year horizon, a 3,453-day old bull market doesn’t necessarily mean you should change your investment strategy. And lastly, every bull market is different, driven and affected by varying factors.

At SigFig, we believe that there are more important reasons to assess the investment landscape than a somewhat arbitrary bull market milestone. In our view, economic strength and macroeconomic conditions, corporate earnings, trade wars, deregulatory trends, tax policy, and contagion in emerging markets are some factors worth assessing — and these are the topics we cover in our third-quarter market update. As it turns out, these were among the factors which have made October one of the most volatile months for stocks this year: Ongoing trade worries, geopolitical tensions, and rising interest rates have been counted as key drivers of the sharp declines posted in the early fourth quarter. Here we’ll summarize major developments in these areas during the third quarter, laying the foundation for a better understanding of the forces that are likely to continue impacting markets in the fourth quarter.

Trade war tit-for-tat escalates

The trade war between the U.S. and China certainly did not cool during the third quarter. President Trump announced tariffs on an additional $200 billion worth of Chinese goods, many of them consumer products. The tariffs went into effect on September 24th at 10% and are scheduled to climb to 25% on January 1st. China promptly retaliated by announcing tariffs on $60 billion of U.S. products, including farm goods, machinery and chemicals, with levies ranging from 5% to 10%. In response, President Trump threatened he would consider slapping tariffs on virtually all Chinese goods imported to the U.S. if Beijing were to take action against U.S. farmers and workers.

The consequences are mounting. The Federal Reserve reported tariffs contribute to rising input costs, mainly for manufacturers, and noted that uncertainty about trade tensions is prompting some businesses to scale back or postpone capital investment. Additionally, The Wall Street Journal reported California farmers are struggling with heavy retaliatory tariffs imposed by China as well as other big export markets, including the European Union, Canada and Mexico. As a last example, Chinese tech mogul Jack Ma, executive chairman of e-commerce giant Alibaba, has walked back his pledge to create one million jobs in the U.S., blaming trade tensions.

Despite President Trump’s “America first” policies, the U.S. trade deficit expanded for the second consecutive month in July. The latest data showed the deficit at $50.1 billion, a five-month high. In particular, the deficit with China grew to $36.8 billion, a record high.

U.S. economy remains on its strongest footing in years

U.S. stocks advanced in the third quarter as economic and corporate fundamentals remained largely healthy. GDP growth for the second quarter was revised upward to a 4.2% annual rate from an initial estimate of 4.1%, powered by strong consumer and government spending and firm business investment. Hiring also heated up in August as U.S. non-farm payrolls expanded by 201,000, marking the record 95th consecutive month of job growth. And at long last, wages showed upward momentum: Average hourly earnings grew 2.9% year-over-year, the best rate since 2009. Consumer confidence also increased in August, reaching its highest level since October 2000. Such historically high confidence levels are expected to continue to support strong near-term consumer spending.

Corporate earnings remain robust, as 80% of the companies in the S&P 500 Index reported second-quarter earnings per share (EPS) that beat estimates. Even more impressively, these EPS estimates were not lowered coming into the earnings season: Analyst expectations had actually increased in anticipation of good news, and companies were still able to beat them. In all, U.S. stocks advanced, with the Vanguard Total Stock Market ETF (VTI) gaining 7.1% during the quarter.

As the economy looked strong by most measures, the Federal Reserve raised its benchmark interest rate at its September meeting, as widely expected. The Federal Open Market Committee voted to lift the target range for the federal funds rate by 25 basis points (a quarter of one percent) to between 2% and 2.25% and continued to project one more hike before year-end and three in 2019.

Looking ahead: Keeping an eye on deregulatory trends

As the U.S. midterm elections draw closer, polls indicate that Republicans are poised to lose their majority in the House of Representatives. In the Senate, Republicans are likely to retain their slim majority but are expected to face competitive races for several seats. As such, it seems unlikely that much legislation will move forward between 2019 and 2020. Continued deregulatory efforts are now more likely to come from more conservative-leaning courts or through Presidential executive orders.

Eurozone economic growth stalls while Japan bounces back 

Overseas, stocks in developed international markets generally posted small gains in the third quarter, with the Vanguard FTSE Developed Markets ETF (VEA) gaining1.3%.

Economic growth accelerated in the U.K. in July, though the country continues to battle concerns over Britain’s withdrawal from the European Union. In late September, E.U. leaders firmly rejected Prime Minister Theresa May’s proposal for how to maintain economic relations with the E.U. post-Brexit, intensifying the pressure as Britain plans to leave the bloc on March 29, 2019. Meanwhile, companies such as Panasonic, MUFG and Nomura Holdings have decided to move their European headquarters out of London amid uncertainty surrounding Brexit.

In Japan, the economy returned to solid growth in the second quarter, expanding at an annualized pace of 1.9%, bolstered by improvements in private consumption. This follows a 0.9% contraction in the first quarter, which ended a long stretch of growth. As inflation remains well below the Bank of Japan’s 2% target, the central bank has largely maintained its massive monetary stimulus.

Emerging markets feel ongoing strains

Stocks in emerging markets faced continued headwinds in the third quarter as concerns about contagion were driven by worries about higher debt burdens, slower growth and a less favorable trade environment. In all, the Vanguard FTSE Emerging Markets ETF (VWO) declined 1.6%.

As we described last quarter, multiple emerging equity, bond and currency markets have been struggling so far this year, partially due to a strong U.S. dollar, which is helped by a positive outlook for the U.S. economy and broad expectations that the Fed will continue to hike rates this year. Higher rates and a stronger U.S. dollar are re-balancing the risk-reward equation worldwide, acting as a magnet to pull some investors out of riskier investments in developing economies. Plus, many emerging countries have large debts based in U.S. dollars — so repayment becomes more difficult as the dollar strengthens. Earlier this year, based on our observations, SigFig made some adjustments to client portfolios as a result of these debt issues. Although we cannot predict how this current stress will pan out in the near-term, SigFig continues to endorse the long-term advantages of diversifying across multiple asset classes.

Focusing on the most critical investment decision

At SigFig, our advice remains consistent, regardless of new bull market records or short-term sell-offs. In our view, the most critical decision investors can make is about their investment horizon: Once this is known, the rest can be optimized. We maintain our view that clients are well served by investing in a strategic, globally diversified portfolio that is aligned with their preferred risk tolerance and time horizon.

If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.

 

Aaron Gubin

Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

Trade War Stokes Uncertainty: Q2 2018 Market Update

At SigFig, our advice remains consistent quarter after quarter: A globally diversified portfolio across multiple asset classes helps balance risk and return for long-term investors. As we explore some of the noteworthy second-quarter developments in global economies and markets, remember that, if you have appropriately diversified your investments for a long-term horizon, it is usually better to remain invested—even when markets look volatile in the near term.

Keeping a close eye on the trade war

Investors and businesses continue to monitor the trade war closely. As protectionist rhetoric escalates, the focus remains on the dynamic between the U.S., China, and the European Union (E.U.), the world’s three largest economies. During the second quarter, the U.S. announced a 25% tariff on $50 billion of Chinese goods, about 10% of the U.S.’s Chinese import volume. Several days later, after the Chinese government indicated it would respond in kind with similar tariffs, the White House said it was prepared to impose tariffs on an additional $200 billion worth of Chinese imports.

Other countries are also involved. In late May, the U.S. moved ahead with tariffs on aluminum and steel imports from the E.U., Canada and Mexico, after a two-month exemption. The E.U. imposed tariffs against more than $3 billion in American imports as retaliation; Canada and Mexico have also enacted tit-for-tat duties against the U.S.

Investors reacted to rising trade tensions with concern that worldwide economic growth could be impacted, as volatility in global stocks increased.

While the current economic impact of announced tariffs appears minimal, the uncertainty of escalation poses a risk to business confidence and capital spending plans. A greater concern is that the trade war spirals out of control to become a significant macroeconomic disruption, with wide but poorly understood impact. Consider, for example, analysis from Nobel laureate economist Paul Krugman, which suggests an all-out trade war could lead to a 70% reduction in trade. Additionally, the International Monetary Fund (IMF) recently pointed to a trade war as the greatest near-term threat to global growth and said rising tensions could cost the global economy $430 billion. Such an escalation could lead to more market volatility—another reason to diversify and take a long-term view.

Continued strength in the U.S. economy

U.S. stocks advanced in the second quarter as economic fundamentals remained largely intact and many indicators suggest a healthy economy. Unemployment ticked up slightly to reach 4.0% in June and job creation maintained a strong pace. Inflation is a bit above 2%, very near the level the Federal Reserve (Fed) targets for its price stability and employment objectives. The revised reading of first quarter gross domestic product (GDP) clocked in at 2.0%, and the second quarter is expected to register even stronger growth, with the Federal Reserve Bank of Atlanta GDPNow model projecting a rate of 4.5%, though the economy is unlikely to sustain growth of this magnitude. Consumer confidence decreased in June, reflecting a modest reduction in optimism.

Companies revealed first-quarter earnings growth rates that remained near all-time highs. The S&P 500 reported earnings growth of 25%—the highest growth since the third quarter of 2010. Wages, on the other hand, are growing but not as quickly as earnings: Average hourly earnings have risen just 2.7% over the last year. Tax reform remained a tailwind for corporations as the benefits of lower tax bills and repatriation of cash from overseas are still unfolding. In all, U.S. stocks advanced, with the Vanguard Total Stock Market ETF (VTI) gaining 3.9% during the quarter.

As the economy looked strong by most measures, the Fed raised its benchmark interest rate during its June meeting, as widely expected. The Federal Open Market Committee voted to lift the target range for the federal funds rate by 25 basis points (a quarter of one percent) to between 1.75% and 2%. The committee’s “dot plot,” which illustrates members’ expectations for future rates, showed two more hikes are anticipated for this year.

Developed international economies muddling through

Overseas, stocks in developed international markets generally declined in the second quarter, with the Vanguard FTSE Developed Markets ETF (VEA) falling 1.9%.

The U.K. faces continued uncertainty surrounding its Brexit negotiations with the E.U., which impaired corporate and consumer confidence. Several major corporations are exploring options to locate headquarters on the European continent, rather than London, in a clear expression of this concern. Elsewhere in Europe, Italy’s new anti-establishment government stoked fears of an exit from the E.U., sending Italian bond yields soaring. Economic growth in the eurozone slowed in the first quarter, as a June report showed GDP expanded by 0.4%, the softest pace since mid-2016.

In Japan, the economy shrank at an annualized rate of 0.6% during the first quarter. The contraction marks the end of a two-year growth run in Japan as declines in investment and consumption plus weaker export growth weighed on the economy.

Emerging markets face headwinds

Emerging markets stocks faced stiff headwinds in the second quarter, as the Vanguard FTSE Emerging Markets ETF (VWO) declined 9.7%. The deteriorating global trade backdrop was a concern, along with a strengthening U.S. dollar. The WSJ Dollar Index, which measures the dollar against a basket of 16 other currencies, rose 5.1% in the second quarter, its first quarterly gain since 2016. A stronger U.S. dollar can hurt emerging markets by pushing down the value of their local currencies, making dollar-priced goods more expensive to buy and stoking inflation. At the same time, it’s worth noting that many emerging market countries prefer a stronger dollar, as it likely supports their exports to the U.S. That said, several emerging market countries worked to bolster their currencies in the second quarter by stopping rate cuts or even tightening monetary policy. The central banks of Turkey and Argentina, which were also confronting exceptional political and economic issues, were forced to take particularly dramatic action.

In China, the situation is complex, as trade war worries and increasingly problematic economic challenges—namely its sizeable debt problems—contribute to lackluster stock market performance. Markets in Brazil—Latin America’s largest economy—also lagged as a major trucker’s strike over increasing fuel prices paralyzed commerce.

Global interest rates diverge

Around the globe, monetary policies of major central banks continue to diverge as the days of synchronized “loose money” central bank policies fade into the rearview mirror. As noted above, the Fed maintained a tightening stance, while the Bank of England held steady. Meanwhile, the European Central Bank outlined plans to end its massive stimulus program by the end of 2018 and indicated that a rate hike is unlikely to come before the summer of 2019, depending on data. In Japan, the central bank maintained its ultra-loose monetary policy, especially important as their economy contracted last quarter.

A complex global economy demands a strategic, globally diversified portfolio

A core characteristic of the global economy is that it is too complex to move in a coordinated fashion. Some economies, like the U.S., are growing rapidly, with an appreciating stock market. Meanwhile, other developed nations struggle to maintain the same pace. Self-inflicted trade war talk contributes to widespread uncertainty, though major trade war affected economies appear to be shrugging off any drag caused by the tariff tensions.

As noted in our previous update, SigFig made mild adjustments in our portfolio allocations, reducing longer-term fixed income investments—which are more sensitive to a rising interest rate environment—toward shorter duration bonds and equities. On the whole, we remain reasonably bullish about the global economy and believe the prospects for long-term investors are positive.

Finally, it is important to remember that market performance and economic indicators do not always move hand-in-hand, so we maintain our view that clients invest in a strategic, globally diversified portfolio that is aligned with their preferred risk tolerance and time horizon.

If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.

 

Aaron Gubin

Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.

Quarterly Market Update: 2017 Review and Outlook for 2018

Executive Summary

Diversification is a common theme at SigFig, and with good reason. A portfolio that is globally diversified across multiple asset classes helps balance risk and return for long-term investors. That’s why SigFig diversifies its managed portfolios across thousands of companies in nearly 50 countries, ensuring a balanced mix of equities (stocks), corporate and government fixed income (bonds), and real estate.

Our advice remains consistent for the coming year: Investors should diversify their portfolios with many investment vehicles across many countries and markets. In continued support of this strategy, we are adjusting our recommended allocations, which you will see reflected in your updated portfolio.

Our 2017 review and 2018 outlook covers several points that informed these updates:

  1. The continued strengthening of the US economy
  2. A calmer U.S. legislative agenda going into the midterm elections, following tax and healthcare reform bills
  3. The continued growth of a still-uncertain global economy
  4. Rising interest rates and the slow but steady unwinding of quantitative easing by major central banks
  5. Lower expectations for long-term returns than in prior eras, as investors work to update their long-run investment strategies

A year ago, in the wake of the 2016 presidential election, we noted that although the U.S. stock market outperformed a globally diversified portfolio during the final months of 2016, long-term investors should continue to focus on a broad, multi-asset class approach. In 2017, globally diversified investors were rewarded: Though U.S. stocks had an excellent year, international markets did even better.

We remain cautiously optimistic that near-term prospects for diversified investors are positive, though long-term investment performance is expected to be lower than we’ve seen in the past 12 months.

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Strong growth continues for U.S. economy 

The U.S. economy is healthy; most statistical and qualitative measures indicate a full recovery from the Great Recession of 2008-2009, and economic data for 2018 remains encouraging:

However, it is important to distinguish between economic performance and stock market performance: A strong economy does not necessarily equate to an up market, or vice versa. It is empirically difficult to predict how markets will perform in the future. That said, the current macroeconomic climate is promising for continued market growth.

U.S. stocks had an excellent 2017. The S&P 500, a large-company index, rose 18% last year to reach record highs. It’s also worth noting that U.S. equity markets were reasonably stable — consistently marching upwards throughout the year, with few hiccups.

Chart1

(Chart illustrates the 2017 price performance of VTI, an ETF tracking U.S. stocks; source: Google Finance)

Domestic politics have not distracted the market…yet

In previous updates, we noted that although Washington’s focus was on healthcare, investors should stay focused on the Republican tax reform agenda. This proved to be a sound strategy, as the primary repeal of the Affordable Care Act faltered. Republicans ultimately shifted their attention to tax reform, resulting in two key changes that affect investors.

One was a reduction in lower corporate taxes, easing the way for business expansion. The other established rules requiring companies to pay tax on overseas earnings, though they can then bring that cash back to the U.S. without paying additional tax.

Moody’s estimated that U.S. companies have amassed $1.9 trillion in overseas holdings, which is likely to come back to U.S. shareholders. Though companies may initially report losses from this near-term tax bill, we expect U.S. investors to benefit over the coming years as companies redistribute capital in the form of higher dividends and share repurchases and reinvest in their businesses.

As Congressional campaigning for this year’s election cycle gets underway, we don’t anticipate any major challenges. The debt ceiling debate will return in March, but we anticipate that Republicans will negotiate an extension of credit through at least the November election. With legislative stability in Washington and tax reform in the rearview mirror, the coast is clear for the U.S. stock market to continue its bull run — at least until election season gets into full swing.

Developed market economies strengthen and emerging markets bound forward

A similar story is echoing across a number of international markets: As economies in Europe and Japan continue to recover from the 2008-2009 global recession, stock market growth is accelerating.

Though unemployment in the Eurozone is notably higher than in the U.S., it continues to tick down. Germany, the European Union’s largest economy, has seen its unemployment rate fall to just 3.6%. Though most of the economic news from Europe is positive, the effect of British withdrawal from the E.U. remains a point of uncertainty, which will likely to drag on medium- and long-term growth.

Stocks in developed markets outpaced those in the U.S. with an excellent year, up 23%. Similarly, international developed markets enjoyed relatively low volatility throughout the year, marching consistently upwards.

Chart2

(Chart illustrates the 2017 price performance of VTI (in blue) an ETF tracking U.S. stocks; VEA (in red), an ETF tracking Developed International Market stocks; and VWO (in orange), an ETF tracking Emerging Market stocks; source: Google Finance)

By far, the best performer among the asset classes in our recommended allocations were emerging market equities. They jumped ahead of developed countries’ stocks, soaring to 30% returns in 2017. Economic growth and low inflation in developed nations spurred an appetite for imports from emerging markets and fueled growth in emerging economies, leading to top-tier performance for emerging market stocks.

Though international economies are growing and stock markets appear poised to continue their strong performance, uncertainty should remain a core concern for any investor. Tensions on the Korean Peninsula, issues with Russia, and management of China’s slowing economic growth are but a few issues that could spark change in our positive outlook. Despite these uncertainties, we continue to recommend a globally diversified equity portfolio.

Global interest rates are on the rise

Positive performance in 2017 was not limited to equities. Though central banks in developed markets began raising interest rates, fixed income still provided modest returns for investors.

As U.S. and international economies grow, central banks around the world are raising interest rates to moderate this growth. The U.S. Federal Reserve began its rate-hike process in late 2015 and continues to slowly increase its benchmark borrowing rates in an effort to mitigate any chance of economic overheating. The European Central Bank began raising rates later than the U.S., but globally rising rates are contributing to a long-term expectation that bond values will fall.

Chart3

(Chart illustrates the 2017 price performance of AGG (in blue), an ETF tracking Investment Grade U.S. Fixed Income; TIP (in red), an ETF tracking Treasury Inflation-Protected Bonds; and EMB (in orange), an ETF tracking Emerging Market Fixed Income; source: Google Finance)

Emerging market bonds, a source of extra yield for fixed income investors, provided better returns than U.S. investment grade bonds through 2017. As global interest rates inch up, however, the search for yield will become easier, likely reducing the demand for bonds from emerging market countries.

SigFig model portfolio adjustments

In light of the changing interest rate environment, SigFig’s portfolio allocations are shifting away from longer-duration and international fixed income positions, which are more sensitive to interest rate changes, towards shorter-duration bonds.

We continue to value high-quality investment-grade fixed income for diversification and volatility balance in all of our managed portfolios. The resulting change in our allocations reduces exposure to longer-duration Treasury Inflation-Protected Securities (TIPS) and emerging market bonds while increasing exposure to U.S. Investment Grade Bonds and Short-Term Treasuries.

Meanwhile, the mix of stocks and bonds will remain consistent with our historical view that investing in a wide range of asset classes provides a balanced approach to risk and returns.

We remain optimistic about the global economy in 2018 and believe the prospects for long-term investors are positive. We continue to recommend that our clients invest in a strategic, globally diversified portfolio that is aligned with their preferred risk tolerance and time horizon.

If you have questions about what the right asset allocation is for you based on your goals, take our risk questionnaire or talk to one of our financial advisors.

Aaron Gubin

Aaron Gubin leads research for SigFig’s Wealth Management team. He holds a Ph.D. in Finance and taught investments and portfolio management to graduate and undergraduate students before coming to SigFig. His research focuses on asset allocation, behavioral finance, and investment management.