- The U.S. looks terrific with strength on both the consumer and industrial sides of the economy.
- Many retail stocks performed well in the second quarter despite ever-increasing pressure from Amazon.
- Market breadth is healthy and the yield curve, while flattening, is still in a zone consistent with the market generating good returns.
Market Overview and Outlook
The stock market overcame trade frictions to rise 3.4% during the second quarter of 2018, as measured by the S&P 500 Index. Small cap companies, with a large base of U.S. sales, performed even better. Trade represents about 15% of the U.S. economy, but for other countries it is far more important. As such, emerging markets had one of the worst quarters in several years, while Europe declined as well. Expectations of superior U.S. growth resulted in 5% appreciation of the U.S. dollar relative to the euro. Oil prices rose to a five-year high owing to a multitude of factors, including strong demand, threats of U.S. sanctions against buyers of Iranian oil, outages in Venezuela and Libya and transportation constraints in the Permian basin.
Despite sustained healthy U.S. economic performance, including a modest acceleration in inflation, concerns that trade would reduce U.S. growth held back increases in U.S. Treasury yields (up in the second quarter to 2.86% from 2.74%). We continue to monitor the shape of the yield curve given the historical relationship between curve inversion and economic recession. The spread between 10-year and 2-year Treasury paper narrowed from 47 basis points (bps) to 33 bps during the quarter. While a flatter yield curve continues to bear watching, we note that stock market returns have historically been good in periods approaching and somewhat after inversion.
Energy was — by far — the best performing sector in the second quarter. Technology and consumer discretionary stocks, driven by strong earnings, also generated healthy returns. Trade concerns and the previously mentioned impact on Treasury yields resulted in considerable performance lags among financial, industrial and consumer staples stocks. Utility and real estate stocks — which had lagged earlier in 2018 and all of 2017 as interest rates rose — outperformed.
"Utility stocks, while off from their absolute and relative highs, remain expensive."
The U.S. looks terrific with strength in both the consumer and industrial sides of the economy. After dipping to a weather-constrained 2% in the first quarter, U.S. GDP growth accelerated to over 4% in the second quarter. The unemployment rate fell to 3.8% in May, the lowest in 18 years, and jobless claims ended June at a multiyear low of 231,000. Debt service, while off the 2013 bottom, is only about 10.5% of disposable income, compared with a peak of over 13% in 2009. Auto sales jumped in June to a seasonally adjusted annual rate of 17.4 million, after several months in the high 16 million range. Housing permits grew 23% in April, the most important month of the year. While permit growth slowed in May to 8%, performance was consistent with increases seen over the past year. PCE inflation is slowly accelerating and finally hit the Fed’s 2% target in June, while wage growth was 2.7%. The June ISM Manufacturing Index hit a near cycle high of 60.2. The only economic yellow flags we see are the flattening of the yield curve and a high level of corporate indebtedness.
President Trump’s trade strategy made for a choppy June. The financial markets are uncertain whether his pronouncements are a negotiating stance or actual demands. Upcoming midterm elections in November only serve to further complicate separating campaign rhetoric from reality. Thus far, foreign nations have responded with tariffs and rhetoric of their own. Noteworthy in the second quarter was that recently implemented steel and aluminum tariffs (and the subsequent European response) resulted in Harley Davidson closing a U.S. plant and relocating it to Europe.
The price of oil and energy stocks appreciated considerably in the second quarter. While we remain comfortable with our modest overweight position, compelling opportunities appear limited. Pharmaceutical stocks and biotech companies have lagged the market owing to growth challenges. That said, low valuations and re-based expectations have offered select opportunities. Many retail stocks performed well in the second quarter despite ever-increasing pressure from Amazon. Our focus in retail remains with operating models that are hard to disintermediate. Utility stocks, while off from their absolute and relative highs, remain expensive.
Our market outlook remains conflicted by the tug of war between excellent U.S. economic fundamentals and high stock valuations. We believe that the overhang from President Trump’s trade efforts will continue at least until the November elections. That said, market breadth is healthy and the yield curve, while flattening, is still in a zone consistent with the market generating good returns. The Appreciation strategy of owning large, high-quality stocks is well-suited for today’s market, offering upside participation if the economy remains robust and preserving capital should a trade war erupt or should the Fed’s tightening lead us to an inverted yield curve.
The ClearBridge Appreciation Strategy had a positive return during the second quarter of 2018, underperforming the Strategy’s benchmark.
On an absolute basis, the Strategy had gains in six sectors in which it was invested during the quarter (out of 11 sectors total). The main contributors to the Strategy’s performance were the information technology (IT), energy and health care sectors. The main detractors were the financials and industrials sectors.
In relative terms, the Strategy underperformed its benchmark impacted by stock selection and sector allocation. In particular, stock selection in the consumer discretionary sector detracted the most from relative performance. Conversely, stock selection in the IT and health care sectors helped relative performance during the quarter.
On an individual stock basis, the biggest contributors to absolute returns during the second quarter included positions in Microsoft, UnitedHealth, Apple, Facebook and Home Depot. The greatest detractors from absolute returns were positions in Travelers Companies, Raytheon, Berkshire Hathaway, JPMorgan Chase and 3M.
During the quarter, we established a position in Gilead Sciences in the health care sector and closed a position in Intel in the IT sector.