Equity Markets: Strong Returns, With U.S. in the Lead

The U.S. equity market posted solid returns in the second quarter on the back of strong first quarter earnings as well as record share buybacks fueled by the Trump Administration’s $1.5 trillion tax cut:

• The S&P 500 Index gained 3.4% in the second quarter.
• Small cap stocks, seen to be relatively immune to global trade spats, surged nearly 8% (Russell 2000: +7.8%).
• Large cap growth (Russell 1000 Growth: +5.8%) continued to dominate large cap value (Russell 1000 Value: +1.2%); for the year-to-date period growth (+7.3%) outpaced value (-1.7%) by 9 percentage points.
• Within the S&P 500, rising oil prices fueled the Energy sector (+13.5%), but Consumer Discretionary (+8.2%) and Technology stocks (+7.1%) were not far behind.
• In spite of a late quarter boost, Financials (-3.2%) were hurt by rising short rates and a flattening yield curve.
• Industrials (-3.2%) and Consumer Staples (-1.5%) also lost ground during the quarter.

The oft-quoted “FANG” stocks plus Apple and Microsoft accounted for over half of the second quarter total returns for both the Russell 1000 Growth and S&P 500 Indices. Notably, the YTD contribution from these six stocks accounted for over 70% of the Russell 1000 Growth and over 120% of the S&P 500 total returns; Amazon alone accounted for nearly half of the YTD total return for the S&P 500 Index.

U.S. stocks outperformed non-U.S. and (in particular) emerging market equities both in local as well as U.S. dollar terms. The U.S. dollar appreciated roughly 5% over the quarter (versus a basket of developed market currencies), benefiting from higher interest rates and a relatively robust economy:

• The MSCI ACWI ex-US Index lost 2.6%, with most countries posting negative returns.
• The MSCI Emerging Markets Index sank 8.0%, with many countries posting double-digit declines.
• Regionally, Emerging Europe and Latin America sank about 15% while Emerging Asia fared better with a 3% drop.

Fixed Income Markets: Rates Rose and Yield Curve Flattened

U.S. rates rose in the second quarter and the yield curve continued its flattening trend:

• The yield on the 10-year U.S. Treasury note hit an intra-quarter high of 3.11% in May but closed the quarter at 2.85%, only 11 bps higher than March 31. Concerns over mounting trade tensions and slower global growth pushed yields lower going into quarter-end.
• The 2-year U.S. Treasury note closed at 2.52%, up sharply from 2.27% as of March 31 and its highest level since August 2008.
• The yield curve continued to flatten and the spread between the 2-year and 10-year ended at its lowest level (33 bps) in more than 10 years. The Fed hiked rates in June, as was widely expected, and expects two more increases in 2018.
• The Bloomberg Barclays US Aggregate Bond Index fell 0.2%, with investment grade corporates underperforming Treasuries as heavy supply and concerns over heightened M&A activity weighed on the market.
• High yield corporates (Bloomberg Barclays High Yield: +1.0%) outperformed, and leveraged bank loans (S&P LSTA: +0.7%), which carry a floating rate coupon, posted the best returns.
• Municipals performed relatively well during the quarter; the Bloomberg Barclays Municipal Bond Index was up 0.9%.

Overseas, changes in interest rates were modest (with the exception of Italy, where yields spiked on political news) and currency fluctuations drove returns for unhedged bonds. The dollar strengthened by 5% versus the euro over the quarter and similarly relative to the yen and U.K. pound:

• The Bloomberg Barclays Global Aggregate ex-US Bond Index fell 4.8%, largely a result of U.S. dollar strength.
• Emerging market currencies suffered more as higher interest rates in the U.S. and trade concerns weighed on markets. The JPM EMBI Global Diversified Index was down 3.5% with broad-based weakness. Argentina (-11.5%) and Venezuela (-14.5%) were among the weakest performers.
• The local currency-denominated JPM GBI-EM Global Diversified Index fared even worse (-10.4%) with several countries posting double digit declines. Argentina (-34%), Turkey (-22%), South Africa (-17%), and Brazil (-16%) were notably poor performers. Countries that rely heavily on external financing were especially hard-hit.

Real Assets: Geopolitics Played Big Role in Returns

As a group, real assets performed relatively well in the second quarter:

• Energy stocks (S&P 500 Energy: +13.5%), MLPs (Alerian MLP Index: +11.8%), and equity REITs (FTSE NAREIT: +10.0%) led the way.
• The listed infrastructure sector wasn’t to be kept away from the party, as the Dow Jones Brookfield Global Infrastructure Index rose 4.2%.
• Hard commodities saw dispersed returns and a more modest +0.4% return overall for the Bloomberg Commodity TR Index.
• Gold slipped 5.5%.
• Across the hard commodity complex, the biggest gains came from lean hogs (+45%), crude oil (+14%) in both Brent and WTI, and feeder cattle (+14%).
• The biggest loser was soybeans, which fell by 18% over the quarter.
• TIPS also performed well, in relative terms, rising 0.8% for the quarter as inflation expectations rose. The 10-year breakeven inflation rate was 2.11% as of quarter-end.

Geopolitics influenced the performance of several hard commodities. The tension between the U.S. and North Korea was somewhat eased by a June 12 summit between President Trump and Kim Jong-Un, while the U.S.-Russia relationship continued to stand at a post-Cold War low.

Elsewhere, the tough rhetoric and threat of a trade war between the U.S. and China continued to weigh on several commodity sectors, soybeans chief among them (the U.S. is the largest global exporter and China is the largest buyer of American soybeans).

As for oil, robust demand and a spate of global oil supply disruptions in Venezuela, Libya, and even Canada pushed the spot price to a multi-year high of $74/barrel despite efforts by OPEC and others to open the spigot. Recent threats by President Trump to sanction nations importing oil from Iran only exacerbated concerns around this imbalance.

Inflation-sensitive assets traditionally perform well through the later stages of economic growth cycles. However, the Fed expects to hike rates up to five times between now and the end of 2019, leaving us to wonder how long some of these more rate-sensitive real asset categories can maintain this momentum.