Q2 Economic & Market Commentary

By Don Schreiber, Jr. – WBI Founder and CEO

MARKETS IN REVIEW 

The first half of the year is now behind us and it has been interesting so far. As discussed in our first quarter commentary, market volatility increased significantly when compared to the relatively calm andrising markets in 2017. In the second quarter, volatility did settle down a little, but, markets still continued to gyrate more than they have recently. The S&P 500 Index traded below its 200-day simple moving average on five days this quarter (vs. only one day in the first quarter). This moving average is considered a key technical support indicator by traders, so all eyes continue to focus on whether it will be tested again, or move even more significantly below the 200-day, which would likely cause greater concern. Furthermore, although the S&P 500 Index was up 2.93% for the second quarter, it never recovered to its January 26th high and closed the quarter -5.38% below that level. Additionally, much of the small gain that was seen in the S&P 500 YTD was due to a handful of technology stocks which have become the most overvalued sector.

Noticeably, smaller capitalization companies significantly outperformed large-caps this quarter. For example, the Russell 2000 Value Total Return Index, which tracks small and mid-cap (SMID) value stocks, produced 8.30% return in Q2. The Russell 1000 Value Total Return Index, which tracks large-cap value stocks, returned only 1.18% for the same period. The SMID outperformance is likely due to greater exposure to domestic revenue sources, which helps protect them from trade tensions. Large-caps on the other hand tend to have more revenue generated offshore and are more impacted by fallout from tariffs.

Fiscal policy continues to help perpetuate both consumer and corporate confidence levels. GDP came in at 2.0% on an annualized basis for Q1 of 2018, and current estimates suggest a number as high as 4% for Q2.¹ Corporate earnings continued to show strength with help from tax cuts and the great results are forecast to be strong again for the second quarter. In addition, inflation slowed down its pace of acceleration and is now hovering around the Federal Reserve 2% target level. Unemployment is the lowest it’s been since 2001. All of these strong data points could provide support for a continuation of the bull market trend, but the current economic expansion is now 10 years old and the bull market for equities will also soon reach that age as well. So, investors are asking themselves whether the good news will continue.

Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg, as of 6/30/18. Past performance is not a guarantee of future results. You cannot invest directly in an index. 

INTEREST RATES AND THE YIELD CURVE

The Federal Reserve increased its benchmark short-term interest rate another quarter percentage point in June which was the second hike this year. Statements from the meeting suggest another two more hikes in 2018 due to solid economic growth and declining unemployment. The Fed also implied it expects to raise rates another three times in 2019 which could put pressure on the economy and corporate profits.

One widely followed indicator is the slope of the yield curve, or specifically, the spread between the yields on two-year and ten-year U.S. Treasury notes (commonly referred to as the “2s-10s spread”). Wall Street is closely watching this 2s-10s spread that closed out the quarter at 30.7 basis points, which is the lowest spread level seen since 2007. This decreasing spread indicates a significant flattening of the yield curve and is largely due to the increases in rates from the Fed’s actions mentioned above. However, as the Fed continues to raise rates on the short end, we could eventually see a negative 2s-10s spread, and, what is known as an inverted yield curve where bond investors are requiring more yield for short-term notes than long-term notes. This inverted yield curve is in stark contrast to a “normal” yield curve where bond investors require more return for a longer duration investment.

The interesting fact about an inverted yield curve is that, historically, it has been a good predictor of recession. Every recession in the past 60 years was preceded by an inverted yield curve, although the timing of each recession occurred between 6 and 24 months following that inversion.² Furthermore, every inverted yield curve during the same time frame has been followed by a recession except for one situation where there was still an economic slowdown.³ So, although the Fed and many market participants continue to focus on current economic growth and this ten-year bull market, others, including us here at WBI, are keeping a watchful eye on the possibility of an inverted yield curve. Once the yield curve inverts, the implication is that we are soon approaching the end of the current economic growth cycle and the bull market for stocks.

Unless otherwise indicated, the source for all price and index data used in charts, tables and commentary is Bloomberg, as of 6/30/18. Past performance is not a guarantee of future results. You cannot invest directly in an index.

TRADE WAR OR NEGOTIATION TACTICS?

Much of the market volatility during the second quarter can be attributed to trade tariffs and the possibility of a full-blown trade war. These tariffs will increase import prices and will likely lead to a decline in exports. Whether the tariff threats are real or simply negotiation tactics seems to be irrelevant as the markets fluctuated most violently on those days when trade issues were on high alert.⁴

One fear that seems to be common is the belief that China may dump its U.S. Treasury reserves in addition to other retaliatory measures. However, that move would be difficult for China as any significant reduction of its current positions would immediately impact the prices of those bonds and likely cause a significant devaluation of its remaining reserves. In addition, there is probably a lack of viable alternatives for China to reallocate reserves. China’s economy is already slowing and any negative impact to its exports may further accelerate the slowdown and cause more damage than they would like.⁵ This would be particularly problematic as China’s leaders try to reduce leverage and banking risk.

CONFLICTING SIGNS

If global trade issues reconcile without further damage and the Fed is careful to avoid lifting rates too far too fast, it is possible that we won’t see a recession until 2020 or 2021. But, it is also possible that the Fed raises rates too quickly or that there is some asset class bubble burst that triggers a recession much sooner than that. Tax cuts and government spending have helped buoy corporate earnings and GDP, but that fiscal stimulus and increased economic growth rate might lead to an acceleration of inflation and cause the end of the current economic growth cycle. A full-blown trade war with China would, at a minimum, continue to impact market volatility and prevent the markets from continuing to grind higher as they did throughout 2017. The fact that the market still hasn’t recovered back to its January highs also suggests that we might be entering the final stages of the bull market trend.

OUR FOCUS AND THE DANGER OF PLAYING “MUSICAL CHAIRS”

Whether the end to the current bull market comes this year or is still several years away, it is coming. Recession indicators are being closely watched, volatility is increasing, and passive investing becomes far less attractive as the risk of a bear market increases.

For us, we think about the cyclic danger of elimination found in a game of musical chairs. We worry that many investors are still running around the circle enjoying the bull market “music” using only passive index funds without any risk controls. But that music is going to stop playing sometime soon and many investors are going to be caught without a chair to sit in as they watch their portfolios drop significantly. After 10 years of growth, the market declines could easily match either the 49% loss posted by the S&P during the 2000 – 2002 correction or the 57% loss experienced during the 2007 – 2009 correction.

Here at WBI, we remain focused on maximizing upside gains during the sustained bull market trend. But we recognize the music could stop at any time, so we simultaneously look to minimize downside losses. For that reason, our primary goal is to protect investors from significant loss of wealth so they have a larger capital base which can be compounded more effectively over time.

WBI POWER FACTORS

We’ve dedicated more than 30 years to managing the loss of investor capital. Our active and smart-beta strategies are built on our math-based or quantitative multi-factor security selection process that allows us to identify the highest yielding dividend-paying stocks that are also highest ranked by our multi-factor fundamental, technical, and trend models. We continually look for ways to refine our models and enhance performance. WBI’s Power Factor^® models have been part of our DNA for more than 25 years and recent advancements have made these models more powerful.

Once securities are selected and purchased, we apply an active risk management overlay process to manage risk and minimize loss by raising cash as market trends turn bearish. Our goal is to protect investor capital first, and to participate in market advances that capture returns second. By preserving capital, we look to compound more effectively over time which can lead to developing a larger capital base and producing more income in retirement.

Investing is never easy but sometimes an elongated bull market can make it look that way. This environment is typically when emotion and greed cause investors to chase returns with abandon, and unfortunately, it frequently coincides with the end of a bull cycle and a violent market correction. We have already responded to increasing market volatility and signs of danger by tightening our risk controls as we focus on getting out of harm’s way faster and with less loss. WBI’s process was designed to take the emotion out of investing and increase the probability of your investing success.

Important information

Past performance does not guarantee future results. The views presented are those of Don Schreiber, Jr. and should not be construed as investment advice. Don Schreiber, Jr. or clients of WBI may own stock discussed in this article. All economic and performance information is historical and not indicative of future results. This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly in this document, is suitable for all accounts or profitable all of the time and there is always the possibility of loss. Moreover, you should not assume that any discussion or information provided here serves as the receipt of, or as a substitute for, personalized investment advice from WBI or from any other investment professional. To the extent that you have any questions regarding the applicability of any specific issue discussed to your individual situation, please consult with WBI or the professional advisor of your choosing. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. Information pertaining to WBI’s advisory operations, services, and fees is set forth in WBI’s disclosure statement in Part 2A of Form ADV, a copy of which is available upon request.

Sources for price and index information: Bloomberg (unless otherwise indicated). WBI Investments pays a subscription fee for the use of this and other investment and research tools. WBI Investments and Bloomberg are not affiliated companies.

WBI managed accounts may own assets and follow investment strategies which cause them to differ materially from the composition and performance of the indices or benchmarks shown on performance or other reports. Because the strategies used in the accounts or portfolios involve active management of a potentially wide range of assets, no widely recognized benchmark is likely to be representative of the performance of any managed account. Widely known indices and/or market indices are shown simply as a reference to familiar investment benchmarks, not because they are, or are likely to become, representative of past or expected managed account performance. Additional risk is associated with international investing, such as currency fluctuation, political and economic uncertainty.

This is not an offer to buy or sell any security. No security or strategy, including those referred to directly or indirectly, is suitable for all accounts or profitable all the time. WBI Enhanced SMA® accounts are subject to investment risk, including the possible loss of principal. The ETFs in WBI Enhanced SMA accounts may invest in other ETFs, mutual funds, and Exchange-Traded Notes (ETNs) which will subject the account to related additional expenses of each, and the risk of owning the underlying securities held by each. Investment risks may include but are not limited to: market, economic, political, interest rate, currency exchange, leverage, liquidity, credit quality, model, portfolio turnover, trading, REIT, high yield stocks, nondiversification, concentration, commodities, options, new fund, and client specific restrictions. WBI’s Passive ETFs are not actively managed and WBI does not attempt to take defensive positions in declining markets. You should not assume that any discussion or information provided here serves as a substitute for personalized investment advice from WBI or any other investment professional. If you have questions regarding the applicability of specific issues discussed to your individual situation, please consult with WBI or your chosen professional advisor. This information is compiled from sources believed to be reliable, accuracy cannot be guaranteed. WBI’s advisory operations, services, and fees are in the Form ADV, available upon request.

Annualized Rate of Return is the return on an investment over a period other than one year (such as one quarter or two years) multiplied or divided to give a comparable one-year return. Dow Jones Industrial Average (DJIA or “The Dow”) is a price-weighted average of 30 of the largest and most significant blue-chip U.S. companies. S&P 500 Index is a float-market-cap-weighted average of 500 large-cap U.S. companies in all major sectors. NASDAQ Composite Index (NASDAQ) is a market-value weighted index of all common stocks listed on NASDAQ. Russell 3000 Index is a float-adjusted market-cap weighted index that includes 3,000 stocks and covers 98% of the U.S. equity investable universe. Russell 1000 Index is a float-adjusted market-cap weighted index that includes the largest 1,000 stocks by market-cap of the Russell 3000 Index. Russell 2000 Index is a float-adjusted market-cap weighted index that includes the smallest 2,000 stocks by market-cap of the Russell 3000 Index. Russell 3000 Value TR Index uses the value characteristic book-to-price ratio to create a total return style index based upon the Russell 3000 which includes the performance effect of the dividends paid by stocks in the index. Russell 1000 Value TR Index uses the value characteristic book-to-price ratio to create a total return style index based upon the Russell 1000 which includes the performance effect of the dividends paid by stocks in the index. Russell 2000 Value TR Index uses the value characteristic book-to-price ratio to create a total return style index based upon the Russell 2000 which includes the performance effect of the dividends paid by stocks in the index. MSCI ACWI Index is a free-float weighted index including both emerging and developed world markets. Barclays U.S. Aggregate TR Index is calculated based on the U.S. dollar denominated, investment grade fixed-rate taxable bond market including treasury, government-related, corporate, MBS, ABS and CMBS debt, and includes the performance effect of income earned by securities in the index. Barclays Global Aggregate TR Index is calculated based on global investment grade debt from twenty-four local currency markets including treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging market issuers, and includes the performance effect of income earned by securities in the index.

You are not permitted to publish, transmit, or otherwise reproduce this information, in whole or in part, in any format to any third party without the express written consent of WBI Investments, Inc.

SOURCES
¹https://www.bloomberg.com/news/articles/2018-06-28/u-s-first-quarter-gdp-growth-revised-down-to-2-on-services?in_source=video_page
²https://www.frbsf.org/economic-research/publications/economic-letter/2018/march/economic-forecasts-with-yield-curve/
³Ibid
⁴https://www.cnbc.com/2018/06/20/trumps-trade-fights-have-cost-the-stock-market-trillions-and-raised-volatility.html
⁵https://www.bloomberg.com/news/articles/2018-05-29/china-s-economy-is-battling-slowdown-earliest-indicators-show