Taking Different Paths: Summer 2018 Commentary

For the last year the real challenge of summarizing the previous quarter’s investment climate and sharing our thoughts regarding the next has been finding new metaphors to describe a mostly unchanging outlook driven by two overriding factors. Comments about sunny skies, smooth sailing and good times were supported by the pillars of a brightening outlook for U.S. corporate earnings and economic growth breaking out worldwide.

During the second quarter we turned the page on that narrative and begin new more complicated and nuanced market environment with different risks and opportunities. Replacing the almost unalloyed optimism which has dominated the past year is a wariness of old monsters wearing new clothes and the uncertainty created by changing U.S. stance on global trade.

First, there has been a decided slowdown in China as its economy’s central planners try to get a handle the enormous overhang of commercial debt within its official and shadow banking system. If this sounds familiar, it was a big story 2013 and a proximate cause of market jitters during that time.

Second, the Italian election which brought a more radical and populist government into power, is reviving fears of an EU breakup as Italy, much like Greece before, seeks relief from the harsh discipline imposed by German dominated monetary policy. Fortunately, the European banking system is at least a little more robust than during those uncertain days of 2011when the markets shook at every failed Greek debt settlement attempt.

The U.S. by contrast seems set to continue its winning ways with growing corporate profits and consensus economic growth looking to top 4% in the coming quarter on the back of the extraordinary fiscal stimulus of the recent tax cuts. But as even this positive story plays out, concerns that the stimulus will fade in 2019 have already begun to creep into stock prices. Profits of companies within the S&P 500 have surged 21% but stock prices have barely moved (as we write this the S & P is positive by a mere .84% in 2018).

A market that in December of 2017 was priced at an optimistic 18 times next year’s estimate of earnings now trades at just over 16 times those estimates. The bond market has also weighed in with the 2-year Treasury yielding just .34% less than its 10-year cousin. This is the smallest difference since 2007 and represents a “flattening” of the yield curve that, while not indicating an impending recession, will be closely watched as the Federal Reserve continues to increase short term rates.

Added to this mix is the rhetoric on trade. As the U.S. declares tariffs and our trading partners threaten retaliation, the economy and corporate profits may be collateral damage. The market seems to believe that an all-out trade war will be avoided. We hope that conclusion is accurate. Certainly, this long-lived bull market has thrown off similar concerns before.

In this charged environment, no more than a neutral weighting in equities is advised. We continue to counsel that bond portfolios be dominated by high-quality, lower duration issues. Thank you for your trust in Altavista. We hope you are enjoying a relaxing summer.

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