*Article and content provided by SigFig Wealth Management, LLC.
At Connect Invest, our advice remains consistent quarter after quarter: A globally diversified portfolio across multiple asset classes helps balance risk and return for long-term investors. As we explore some of the noteworthy second-quarter developments in global economies and markets, remember that, if you have appropriately diversified your investments for a long-term horizon, it is usually better to remain invested—even when markets look volatile in the near term.
Keeping a close eye on the trade war
Investors and businesses continue to monitor the trade war closely. As protectionist rhetoric escalates, the focus remains on the dynamic between the U.S., China, and the European Union (E.U.), the world’s three largest economies. During the second quarter, the U.S. announced a 25% tariff on $50 billion of Chinese goods, about 10% of the U.S.’s Chinese import volume. Several days later, after the Chinese government indicated it would respond in kind with similar tariffs, the White House said it was prepared to impose tariffs on an additional $200 billion worth of Chinese imports.
Other countries are also involved. In late May, the U.S. moved ahead with tariffs on aluminum and steel imports from the E.U., Canada and Mexico, after a two-month exemption. The E.U. imposed tariffs against more than $3 billion in American imports as retaliation; Canada and Mexico have also enacted tit-for-tat duties against the U.S.
Investors reacted to rising trade tensions with concern that worldwide economic growth could be impacted, as volatility in global stocks increased.
While the current economic impact of announced tariffs appears minimal, the uncertainty of escalation poses a risk to business confidence and capital spending plans. A greater concern is that the trade war spirals out of control to become a significant macroeconomic disruption, with wide but poorly understood impact. Consider, for example, analysis from Nobel laureate economist Paul Krugman, which suggests an all-out trade war could lead to a 70% reduction in trade. Additionally, the International Monetary Fund (IMF) recently pointed to a trade war as the greatest near-term threat to global growth and said rising tensions could cost the global economy $430 billion. Such an escalation could lead to more market volatility—another reason to diversify and take a long-term view.
Continued strength in the U.S. economy
U.S. stocks advanced in the second quarter as economic fundamentals remained largely intact and many indicators suggest a healthy economy. Unemployment ticked up slightly to reach 4.0% in June and job creation maintained a strong pace. Inflation is a bit above 2%, very near the level the Federal Reserve (Fed) targets for its price stability and employment objectives. The revised reading of first quarter gross domestic product (GDP) clocked in at 2.0%, and the second quarter is expected to register even stronger growth, with the Federal Reserve Bank of Atlanta GDPNow model projecting a rate of 4.5%, though the economy is unlikely to sustain growth of this magnitude. Consumer confidence decreased in June, reflecting a modest reduction in optimism.
Companies revealed first-quarter earnings growth rates that remained near all-time highs. The S&P 500 reported earnings growth of 25%—the highest growth since the third quarter of 2010. Wages, on the other hand, are growing but not as quickly as earnings: Average hourly earnings have risen just 2.7% over the last year. Tax reform remained a tailwind for corporations as the benefits of lower tax bills and repatriation of cash from overseas are still unfolding. In all, U.S. stocks advanced, with the Vanguard Total Stock Market ETF (VTI) gaining 3.9% during the quarter.
As the economy looked strong by most measures, the Fed raised its benchmark interest rate during its June meeting, as widely expected. The Federal Open Market Committee voted to lift the target range for the federal funds rate by 25 basis points (a quarter of one percent) to between 1.75% and 2%. The committee’s “dot plot,” which illustrates members’ expectations for future rates, showed two more hikes are anticipated for this year.
Developed international economies muddling through
Overseas, stocks in developed international markets generally declined in the second quarter, with the Vanguard FTSE Developed Markets ETF (VEA) falling 1.9%.
The U.K. faces continued uncertainty surrounding its Brexit negotiations with the E.U., which impaired corporate and consumer confidence. Several major corporations are exploring options to locate headquarters on the European continent, rather than London, in a clear expression of this concern. Elsewhere in Europe, Italy’s new anti-establishment government stoked fears of an exit from the E.U., sending Italian bond yields soaring. Economic growth in the eurozone slowed in the first quarter, as a June report showed GDP expanded by 0.4%, the softest pace since mid-2016.
In Japan, the economy shrank at an annualized rate of 0.6% during the first quarter. The contraction marks the end of a two-year growth run in Japan as declines in investment and consumption plus weaker export growth weighed on the economy.
Emerging markets face headwinds
Emerging markets stocks faced stiff headwinds in the second quarter, as the Vanguard FTSE Emerging Markets ETF (VWO) declined 9.7%. The deteriorating global trade backdrop was a concern, along with a strengthening U.S. dollar. The WSJ Dollar Index, which measures the dollar against a basket of 16 other currencies, rose 5.1% in the second quarter, its first quarterly gain since 2016. A stronger U.S. dollar can hurt emerging markets by pushing down the value of their local currencies, making dollar-priced goods more expensive to buy and stoking inflation. At the same time, it’s worth noting that many emerging market countries prefer a stronger dollar, as it likely supports their exports to the U.S. That said, several emerging market countries worked to bolster their currencies in the second quarter by stopping rate cuts or even tightening monetary policy. The central banks of Turkey and Argentina, which were also confronting exceptional political and economic issues, were forced to take particularly dramatic action.
In China, the situation is complex, as trade war worries and increasingly problematic economic challenges—namely its sizeable debt problems—contribute to lackluster stock market performance. Markets in Brazil—Latin America’s largest economy—also lagged as a major trucker’s strike over increasing fuel prices paralyzed commerce.
Global interest rates diverge
Around the globe, monetary policies of major central banks continue to diverge as the days of synchronized “loose money” central bank policies fade into the rearview mirror. As noted above, the Fed maintained a tightening stance, while the Bank of England held steady. Meanwhile, the European Central Bank outlined plans to end its massive stimulus program by the end of 2018 and indicated that a rate hike is unlikely to come before the summer of 2019, depending on data. In Japan, the central bank maintained its ultra-loose monetary policy, especially important as their economy contracted last quarter.
A complex global economy demands a strategic, globally diversified portfolio
A core characteristic of the global economy is that it is too complex to move in a coordinated fashion. Some economies, like the U.S., are growing rapidly, with an appreciating stock market. Meanwhile, other developed nations struggle to maintain the same pace. Self-inflicted trade war talk contributes to widespread uncertainty, though major trade war affected economies appear to be shrugging off any drag caused by the tariff tensions.
As noted in our previous update, Connect Invest made mild adjustments in our portfolio allocations, reducing longer-term fixed income investments—which are more sensitive to a rising interest rate environment—toward shorter duration bonds and equities. On the whole, we remain reasonably bullish about the global economy and believe the prospects for long-term investors are positive.
Finally, it is important to remember that market performance and economic indicators do not always move hand-in-hand, so we maintain our view that clients invest in a strategic, globally diversified portfolio that is aligned with their preferred risk tolerance and time horizon.