After Markets Pause, More Upside Anticipated for Global Equities during 2nd Half of 2018
We believe that the current threat of a prolonged trade war is serving as an emergency brake to a stock market that is pressing the gas pedal as hard as it can with positive economic data reports; including, but not limited to, corporate earnings, serving as tailwinds. Once any semblance of progress is reported with respect to trade negotiations, we would anticipate this emergency brake to be lifted and for constrained stock prices to rise accordingly.
This outlook is consistent with our overall theme for 2018 which suggests that improved valuations and overall optimism around economic growth prospects are forming the basis of a new and different type of bull market. While additional short term bouts of volatility are likely, this new bull market will likely be driven by earnings growth and economic expansion as opposed to the now 9 year old secular bull market that was driven more by accommodative central bank policies and political posturing.
While the imposition of tariffs is nothing to ignore given their potential impact on global economic growth, we view the likelihood of a prolonged trade war to be low at this time. In fact, we believe that a bigger risk to the market currently, that many are not necessarily considering, is that the Federal Reserve may move quicker, or in larger increments, as it relates to interest rate hikes than is currently anticipated as a result of the growing strength of the U.S. economy.
With all of this in mind, we suggest the following portfolio management ideas for careful and thoughtful consideration for the second half of 2018.
• Small Caps are Outperforming but Look for a Large Cap Resurgence
We would not be surprised to see Small Cap continue to outperform over the course of 2018 as companies with smaller capitalizations stand to benefit more from corporate tax rate cuts (repatriation aside) and are generally less exposed to potential trade war fallout than multi-national companies with larger capitalizations. However, we also anticipate seeing some selective Large Cap performance resurgence once some positive momentum on the trade negotiation front is reported.
• Consider Lagging Sectors that are Well-Positioned to Perform Looking Ahead
One particular sector that seems compelling to us at this stage is Financials given that they have lagged thus far in 2018 along with our expectation that Financials should perform well within a rising interest rate environment where a strong, underlying economy is supportive of additional loan demand. In addition, although not associated with lagging sectors, we also see the potential for more M&A activity in the Biotech and FinTech areas during the second half of 2018 and beyond.
• Identify Companies with Strong Balance Sheets and Histories of Earnings Growth
We believe that future stock growth potential will now largely be predicated on fundamentals, including, but not limited to, earnings growth. Continued economic growth in the 3% range within the U.S., along with a more accommodative U.S. corporate tax code, should help with the expansion of earnings in the 3rd quarter and beyond for well-positioned and well-run companies with sound balance sheets. In this regard, according to FactSet, the estimated earnings growth rate for the S&P 500 is 20.0% for the second quarter of 2018.
• Don’t Discount the Value of Bonds in Income and Growth-oriented Portfolios
It has long been our contention that, for income oriented investors, bonds can provide for a dependable and consistent stream of income, and principal protection when held to maturity. Bonds, whether they are Municipal, Government or Corporate bonds, can also provide for compounded growth opportunities when the income received from the bonds is reinvested.
Additionally, for growth-oriented investors, fixed income securities can provide investors with downside protection and diversification within a growth portfolio, especially in a highly volatile market where additional, measured, short-term flights to quality are likely.
In our view at Hennion & Walsh, investors should be careful not to miss out on the income and diversification opportunities offered by bonds by trying to time future, potential changes in interest rates. History has shown us that trying to time the market, or time interest rate increases or decreases, can be very difficult. With this said, it is important to understand that when interest rates do increase, bond prices may fall and yields may rise. However, rising interest rates should not impact the interest that bond holders receive on their bond holdings nor should they change the ability of these investors to receive par value on their bond holdings at maturity. Bond fund investors, on the other hand, may see the interest they receive on their fund holdings change in a rising rate environment and will not receive par value at maturity as there generally is no set maturity on bond funds.
While allocations to bonds may vary based upon market conditions and investor objectives and risk appetites, certain types of bonds, from certain types of issuers, can still find a home in most investment portfolios throughout most market cycles.
Specifically as it relates to municipal bonds, the 30-day new issue supply of municipal bonds has recently fallen to a twelve month low. In addition, the demand for municipal bonds and their associated levels of tax-free income, coupled with the expected reduction in supply in 2018, has helped to push short-term municipal bond yields to a 14 week low according to Wells Fargo Advisors as of June 29, 2018.
• Review Relative Valuations of International Equities
The pullback in international equities in 2018 as a result of the trade and tariffs tantrum has resulted in even more attractive relative valuations and perhaps even created attractive entry points for investors. While we could also make a bullish U.S. equities case for the second half of the year given the sideways trading activity that has taken place thus far in 2018 on top of a solid and improving economic foundation, selectively adding international equities, at these valuation levels, to a global equities portfolio strategy seems worthy of consideration.
Disclosure: Hennion & Walsh Asset Management currently has allocations within its managed money program and Hennion & Walsh currently has allocations within certain SmartTrust® Unit Investment Trusts (UITs) consistent with several of the portfolio management ideas for consideration cited above.