Owners of diversified investment portfolios earned modestly positive returns in the second quarter, as good returns in the U.S. stock market were somewhat offset by negative returns in equity markets overseas. Despite widespread conviction from investors that interest rates would rise as a result of a strong economy, taxable bonds were mostly flat for the quarter while municipal and inflation-protected bonds generated positive returns.
The gains in the U.S. stock market were due in large part to better-than-expected corporate earnings. The U.S. economy has entered its ninth consecutive year of expansion, the second longest period of economic growth on record. Across the country, employers complain that they cannot find workers. Indeed, the official U.S. unemployment rate hit 3.8% in May, the lowest rate since the height of the tech bubble 18 years ago. Economics 101 teaches that scarcity of supply should lead to higher prices, but wage growth statistics have yet to show that workers have succeeded in winning noticeably higher earnings. So long as wage growth remains muted, inflation will likely also remain under control. If employers are not raising salaries but say they can’t find workers, what is going on? As ever, economists disagree, but there seems to be increasingly strong evidence that Americans previously too discouraged even to look for work (who are thus not counted as “unemployed”) are being drawn back into the labor force, helping to meet at least some of the demand for labor.
The generally positive outlook for corporate America during the second quarter came despite the stated intention of the Trump administration to impose punitive tariffs on as much as $50 billion of imports from China. Not surprisingly, the Chinese government pledged to respond in kind. The U.S. and China are the world’s two largest economies, and as such, a drawn-out and acrimonious trade dispute would be expected to affect global economic growth adversely. Muted market reaction thus far suggests investors are wary of the potential risk but optimistic that cooler heads will prevail.
The S&P 500 (an index of the largest companies in America) gained 3.4% in the second quarter after declining modestly in the first quarter. For the first half of the year, the S&P registered a gain of 2.7%. Once again in the second quarter, technology and other growth-oriented companies led the way. The NASDAQ Composite Index, heavily skewed to growth companies, was up 6.6% in the quarter for a year-to-date return of 9.4% through the end of June.
Perhaps because smaller companies conduct more of their business domestically and are thus perceived as less vulnerable to any slowdown in global trade as a result of rising tariffs, the returns for small cap stocks (as represented by the Russell 2000 Index) were strong in the quarter, up 7.8% and bringing gains for the first half of the year to 7.7%.
Developed country foreign stocks underperformed U.S. stocks during the second quarter. The pace of growth in Europe slowed a bit and Asian stock markets are trade-sensitive — both of which led to a stronger U.S. dollar (and, similarly, weaker foreign currencies.) For the quarter, the MSCI ACWI ex USA Index of foreign stocks fell 2.6%, and for the first half of the year the index was down 3.8%. The MSCI Emerging Markets Index fell 8.0% for the quarter.
In the bond market, the U.S. Federal Reserve increased the federal funds rate in June, and investors are anticipating two more rate increases later this year. The Bloomberg Barclays U.S. Aggregate Bond Index was down 0.2% during the second quarter, the Bloomberg Barclays U.S. Treasury Inflation-Protected Securities Index gained 0.8%, and the Bloomberg Barclays California Intermediate Municipal Bond Index was up 1.1%.
The Tax Cuts and Jobs Act of 2017 was designed in part to encourage U.S. corporations to repatriate more than $2 trillion of cash held overseas. The hope was that corporations would pay some taxes to help finance the tax cuts, reward their workers with raises, and, finally, increase investments in capital improvements and research and development. As noted above, the wage gains have yet to impress. Capital expenditures have expanded nicely, however, and Goldman Sachs now expects such investments to increase by 11% in 2018 to more than $1 trillion. Goldman also predicts that corporate America will increase spending on stock buybacks and dividends in 2018 by 22%, with such activity totaling more than $1.2 trillion — a record amount.
Share buybacks play a significant role in supporting stock prices because they lower the number of outstanding shares. Even in the absence of earnings growth, if a corporation buys its own shares and thereby takes them out of circulation, it will report higher per-share earnings. While this kind of activity should not seem especially commendable, companies seldom fail to delight investors when they post higher per-share earnings. On May 1, for example, Apple said it would spend $100 billion of its cash stockpile to buy Apple shares. The stock obediently rose 4.4% the following day and 13% for the full week. Apple announced plans to spend $100 billion buying its own shares and the value of the company rose by $100 billion — in the same week! Yes, there was more to it than that, but not much.
Those in support of buybacks maintain that owners of successful corporations should be rewarded with rising stock prices, management is often right when evaluating its own shares as a good value, and it is often better to send excess cash to investors rather than undertake risky acquisitions or make costly capital improvements during periods of low productivity growth, such as is the case now. Critics reject all of these notions and maintain that buybacks are seldom a function of a judicious capital allocation exercise. Rather, they argue that buybacks are a predictable and unhealthy byproduct of an executive compensation system that inappropriately ties senior executives’ bonuses to short-term movements in the stock price. Such skeptics argue that executives should be rewarded for promoting a company’s long-term growth, which cannot be measured by quarter-to-quarter changes in the stock price.
Whichever side of this debate you may prefer, there is no doubt that corporate executives are buying their own stock at a record pace and seemingly without concern for the high prices of these stocks. This activity is all the more interesting in light of the fact that mutual and exchanged-traded fund investors have been net sellers of U.S. equities recently, initiating withdrawals from U.S. stocks in excess of $29 billion in the first quarter of the year, according to EPFR Global data. Will executives now implementing share buyback programs later be seen as having made prudent judgments about the intrinsic value of the companies they manage, or will they be regarded as short-term, compensation-focused leaders who overpaid for expensive shares? Only time will tell.
Written by Jeff D.Lancaster, CFP®, Principal; [email protected]
|Index||Market||03/31/18 – 06/30/18||12/31/17 – 06/30/18|
|Standard & Poor’s 500||Large Co. U.S. Stocks||3.43%||2.65%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||1.18%||-1.69%|
|Russell 2000||Small Co. U.S. Stocks||7.75%||7.66%|
|MSCI All-Country World ex U.S.||Foreign Stocks||-2.61%||-3.77%|
|Barclays 1-5 Year Gov’t/Credit||U.S. Shorter-Term Taxable Bonds||0.17%||-0.33%|
|Barclays Aggregate Bond||U.S. Taxable Bonds (Broad-based)||-0.16%||-1.62%|
|Barclays 1-5 Year Muni Bond||U.S. Shorter-Term Tax Exempt Bonds||0.66%||0.77%|
|JPMorgan Global Ex-U.S. Bonds||Hedged Foreign Bonds||0.27%||1.74%|
Key economic indicators compiled by Jeffrey Blanchard, CFA, Investment Analyst; [email protected]
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