The US economy continued to hum along in Q3 with very low unemployment and optimism from consumers and businesses alike. The fiscal stimulus has helped boost 2018 consumer spending fueling goldilocks US economic growth with mild inflation, halting immediate worries of an overheating economy which could have led to overzealous rate raising from the Federal Reserve (Fed). It has also led to a decoupling of US economic expectations from the rest of the world. Trade tensions have added more uncertainty to the global growth outlook, compounding worries of US rising interest rates and monetary tightening already affecting more fragile economies.
The final estimate for 2nd quarter GDP shows that the US economy grew at an annualized 4.2% according to the Bureau of Economic Analysis (BEA). This was much stronger than the 2.2% growth in the 1st quarter and the fastest pace since Q3 2014. Sustaining that pace of growth will be difficult, as it is believed that some of that output was pulled forward from Q3 in order to preempt effects of the tariffs. Estimates for Q3 2018 GDP growth are varied, with the Federal Reserve Bank of Atlanta’s GDP estimate at 3.6% and it’s New York counterpart estimate at 2.5% as of September 28th.
Inflationary pressure has been steady, but not accelerating, as measures such as the Producer Price Index and the Consumer Price Index have reported in line or slightly below consensus estimates in Q3. The Fed’s preferred measure for monitoring inflation, Core Personal Consumption Expenditures (PCE) which excludes measures for food and energy, was up 2.0% YoY for September, and directly in line with the Fed target. The one concern, in terms of price pressure, had been the persistent strength in the US housing market outpacing wage increases, especially in the north-west US. This pressure has been leveling off, despite a lack of meaningful growth in supply of new homes, as rising interest rates have slowed the rise of mortgage originations.
The Q2 US dollar rally was supported by the relative strength in the economy and foreign investment in US securities due to the relative pace of Fed Policy versus the European Central Bank (ECB) and the Bank of Japan (BOJ). The trend looked to be running out of steam in Q3 until a spike in the US Dollar Index in mid-August (chart below). Outside of that head fake, though, the US Dollar Index is for the most part unchanged since the start of Q3. The next move is still uncertain, as the ECB ponders less accommodative policy against sluggish Euro-area core inflation.
The trade war between China and the US has escalated with the US imposing new 10% tariffs on another $200B of Chinese goods and threatening to increase the tariff to 25% on those goods in 2019, in addition to the tariffs already imposed on steel, aluminum and $50B of other goods. China has retaliated with tariffs of their own on another $60B of US goods, a larger percentage of the country’s imports from the US than vice versa, signaling China’s ability to increase negotiation leverage may be waning. The result has been a continued drop in the Chinese currency, and according to the Bank of International Settlements (BIS), a halt in China’s private sector deleveraging campaign. The Chinese central bank may be forced to inject additional liquidity via monetary policy, while the government is looking to support consumption and investment by adding fiscal stimulus if necessary.
The US and Mexico had come to a bilateral agreement regarding issues surrounding NAFTA, and threatened to move forward without Canada after a September 30 deadline. At the last minute, Trump announced that all sides have agreed to terms of a newly branded “US-Mexico-Canada Agreement”, reinforcing the strong appetite for political “wins” prior to the mid-terms. Uncertainty surrounding future policy due to the elections in November may cause unnecessary volatility with Democrats expected to take control of the House, in what could be a stark rebuke of Donald Trump’s and Republican policies.
Effects of the trade war on the US economy have yet to be fully realized and may not be fully factored into expectations, with the outlook for a US/China deal much less auspicious than that with our immediate neighbors. The US economy appears strong enough to overcome a short to medium-term continuation of the trade dispute, however, a prolonged slowdown in global growth will no doubt eventually be felt domestically.
US Equity markets ground higher in Q3 after largely consolidating during Q2. Technology and small-cap stocks started to underperform large-cap Industrial and Healthcare stocks. The Dow Jones Industrial Average led all three of the major US equity indices, gaining 9.63%, while the S&P 500 Index and the Nasdaq Composite gained 7.71% and 7.14%, respectively, on a total return basis.
There was a major change in the Global Industry Classification Standards (GICS), this quarter, that has affected the classification of some major companies within the S&P 500. The addition of the Communications Services sector led to the reclassification of 8% of the S&P 500 and pulled market heavyweights such as Google parent Alphabet (GOOG/GOOGL) and Facebook (FB) from the Technology sector, and media/entertainment giants Walt Disney (DIS) and Netflix (NFLX) into a historically defensive sector that includes AT&T (T) and Verizon (VZ).
The Healthcare sector was the best performing sector of Q3, likely due to favorable growth at relatively modest earnings multiples and repatriated-cash-induced share buybacks. The Healthcare Sector Select SPDR ETF (XLV) returned 14.45% for the quarter, with the Industrial Sector Select SPDR ETF (XLI) coming in at a distant second, gaining 9.98%. Late bounces from the two most interest-rate-sensitive sectors, Utilities and Real Estate, solidified the new Communications Services sector as the weakest performing sector for Q3, with its corresponding Sector Select SPDR ETF (XLC) down -.80%.
With the 10-Year US Treasury Note pushing up against mid-May and multi-year highs, thanks to continued strength in the US economy and the removal of accommodative policy from the Fed, market participants are focused on the next move. A technical breakout for interest rates would need to be above prior highs near 3.11% for the 10-Year or the 2015 high of 3.25% on the 30-year Treasury Bond.High yield bonds performed well during the quarter as yield spreads over Treasury securities narrowed, thanks to improving balance sheets and continued low rates of default.
Hanlon Tactical Portfolio Commentary
The large-cap equity portion of our Hanlon Tactical Models entered Q3 invested at market weight in all GICS sectors, less Consumer Staples. In early July, our research led us to re-enter the position, joining the other sectors at a full market-cap weighting, and remaining fully invested for the duration of the quarter which included a rebalance to add the Communication Services sector. Our research also led to the addition of tactical exposure to emerging market equities, where appropriate, by symmetrically reducing broad exposure to mid-cap and small-cap US equities. We believe opportunities exist to capture attractive risk-adjusted returns from emerging markets, as global markets evolve despite recent protectionist policy.
In the Managed Income portion of our Hanlon Tactical Models, we maintained our exposure in High Yield Corporate Bonds, Bank Loans, and Energy MLPs throughout the quarter. Allocations to investment grade Municipal Bonds and Convertible Bonds were replaced with Long and Intermediate Corporate Bond exposure. The Real Estate Investment Trust (REIT) allocation was eliminated near the end of Q3, while a small allocation was made to Emerging Market Bonds as we continue to look for attractive yield opportunities.
Hanlon Strategic & All-Weather Portfolio Commentary
US equity performance was dominant in Q3, dwarfing middling returns from other asset classes. Anyone who was to “sell in May, and go away” this year would be disappointed, as the typical characterizations of low volume and low returns for summer months were only half right. As such, the allocation to broad US equities led the pack of diversified investments included in Hanlon Strategic and Hanlon All-Weather portfolios, returning slightly over 7% during Q3.
The US dollar’s continued strength combined with the ebb and flow of fears surrounding trade war effects on global commerce have contributed to International equity underperformance. The allocation to International Developed Market equities was able to squeak out a positive total return for Q3 of just over 1%. China et al. faced the brunt of the Q3 selling pressure, with the allocation to Emerging Market equities, while off the lows, was still down around -1.40% for the quarter.
In what was another tough quarter for fixed income returns where the broad iShares Core US Aggregate Bond ETF (AGG) lost -.08%, the top performing fixed income holdings for Hanlon Strategic and Hanlon All-Weather portfolios were allocated to sub-investment grade or “junk” bonds. For instance, the SPDR Bloomberg Barclays High Yield Bond ETF (JNK) returned 3.03% for the quarter. The allocation to Senior Bank Loans per-formed well during the period, up over 2%, while the actively managed SPDR DoubleLine Emerging Market Fixed Income ETF (EMTL) also boosted struggling fixed income returns, up 1.52%. The iShares International Treasury Bond ETF (IGOV) was the Q3 laggard, down -2.13%, as market participants expect cessation to accommodative monetary policy from Developed Market central banks.
The JPMorgan Alerian MLP ETN (AMJ) was the clear standout among the alternative investment components with a 5.09% total return for the quarter. Allocations to Real Estate Investment Trusts (REITs), Commodities, and Liquid Alternatives had similar positive returns of less than 1%.
For the Hanlon All-Weather Models only; the tactical equity portion contributed positively to the quarterly return, gaining 7.04%, while the tactical fixed income portion finished Q3 admirably considering the difficult fixed income environment, up 1.24%.
It may be human nature, with the benefit of hindsight, to regret not being 100% invested in US equities when comparing portfolio returns with widely followed indexes reaching fresh all-time highs, like the S&P 500. However, it would be imprudent and irresponsible for most investors to be investing in such a manner. Lest we forget the tortoise and the hare analogy before dismissing the benefits of diversification and the detrimental effects of significant drawdowns on portfolio returns in reaching our long-term goals.
As always, we will do what’s in the best interest of our clients consistent with our principals of Passion, Integrity, Vision, and Care. We will continue to monitor for opportunities, look-ahead for market dangers and make corresponding defensive moves in our Tactical allocations to seek downside protection and upside participation. For investors seeking a complete portfolio asset allocation solution, our Strategic Models or dynamic All-Weather Models that combine buy-and-hold strategy with tactical protection are the answer. We sincerely thank you for the opportunity to be of service.
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