Q2 2018 Moving Parts
COMMENTARY FROM THE INVESTMENT COMMITTEE OF CORAL GABLES TRUST COMPANY
Q2 2018 - Moving Parts
The second quarter was filled with volatility due to news events on tariffs, inflation and interest rates but U.S markets managed to squeeze out a positive return thanks to a strong showing in May. The S&P 500 returned +3.43% for the quarter and is higher by +2.65% YTD. The technology heavy NASDAQ enjoyed a +6.61% quarterly return and remains ahead of the pack with a +9.37% YTD return as the obsession with the FANG names continues. On the economic front, employment data released for the quarter was strong with the unemployment rate dipping to 3.8% in May. The jobs report for June had a strong headline number while several hundred thousand people reportedly joined the labor force pushing the unemployment rate to 4% and increasing the labor force participation rate. This information caught market watchers by surprise indicating further slack in the labor force. There is no question that the U.S. economy is on firm footing with corporate profits generating impressive growth rates, operating margins at 18-year highs and elevated corporate cash levels allowing corporate executives the flexibility to engage in share buybacks, dividend increases or M&A. Considering all the good news, the bond market is telling a much different story. After easily breaking through the 3.00% level in the quarter, the 10-year treasury retreated and has remained stubbornly low which does not coincide with the positive economic back-drop. Flattening of the yield curve indicates slower economic times ahead while an inverted yield curve possibly indicates a looming economic downturn. We believe a recession is not imminent given the strong economic environment and corporate earnings story, however, investors are searching for clues as to why longer-term interest rates remain depressed. Overseas markets were much more turbulent during the quarter as the threat from tariffs affected Eurozone and Asian sentiment. Export countries that have the most to lose in a tariff battle suffered the brunt of the volatility. The Chinese markets have sold off since the tariff announcement and remain committed to retaliating against the U.S. should further tariff threats arise. The foreign developed MSCI EAFE index was down -1.07% for the quarter and is down -2.75% YTD. Emerging markets fell the most as uncertainty surrounding tariffs and dollar strength put pressure on the region.
Fixed income continues to be a game changer for investors that have enjoyed several years of declining interest rates. We have officially been in a rising interest rate environment since the summer of 2016 and all signs point to higher levels from here. Navigating the bond market going forward will require more diligence and patience as the market normalizes. The 10-year treasury ended the quarter at 2.85% increasing about 40 basis points from January. Strategies that focused on short duration as opposed to intermediate or longer-term strategies performed the best.
THOUGHTS ON ASSET ALLOCATION
Although volatile at times, we are pleased that the markets in 2018 have delivered a modest win for investors. Historically the second and third quarter in the second year of a first term president have not been market friendly according to the political calendar. If the tariff war rhetoric proves less contentious investors could be in for a positive finish for the year. Valuations remain reasonable due to the success of the "E" in the P/E equation. The tax reform benefits have barely begun to flow through to the economy so we should expect to see solid earnings growth for the balance of the year along with corporations staying active with M&A, share repurchases and dividend increases. With interest rates rising, fixed income has suddenly found itself competing for investor equity capital as evidenced by recent fixed income inflow data. However, from a valuation perspective, equities continue to present a better value proposition for longer term investors. Our asset allocation has remained steady over the first half of the year. As we write, we recently decided to adjust one of our managers in the International equity space. The Harding Loevner International equity strategy was added to enhance our international growth allocation. We are comfortable with our focus on value over growth given stretched valuations and narrow breadth in the growth space. It is concerning that the entire S&P 500 return YTD was due to the performance of a few technology stocks. Technology now comprises 26% of the S&P 500's market capitalization and remains the most crowded sector in the market residing in the 90th percentile relative to history.
The second quarter was filled with mixed results among various major asset classes. As active managers we look for investment talent that can weather tough market environments and protect capital in times of distress. Listed below is a subset of our equity manager universe that performed very well in the second quarter.
Investment Manager / *Q2 2018 Return / Q2 Manager Benchmark
T. Rowe Price Inst. LC Growth Fund / +6.77% / +5.76% Russell 1000 Growth
Oakmark Fund / +2.13% / +1.18% Russell 1000 Value
Merger Fund / +3.24% / -0.53% MS Mkt Neutral
AB Long/Short Equity / +2.58% / -0.53% MS Mkt Neutral
DFA Small Cap Core / +7.00% / +7.75% Russell 2000
*Returns are expressed as composite returns. Results may vary. Past performance is no guarantee of future returns
We look forward to speaking with all of you regarding our views and the performance of your respective portfolios. In addition, please ask about our financial planning capabilities. For additional information or questions please contact Mason Williams, Chief Investment Officer, at 786-497-1214 or Gerardo Rodriguez, Investment Officer, at 786-292-0310.