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The markets continued a pattern of muted returns over the past 3 months in spite of strong economic and earnings news. U.S. equity markets were slightly up, while most international markets were down. Bond returns continued to disappoint as most bond averages remain negative for the year. The markets have performed well over the past few years and this current “cooling off” period is not unusual. To date, market returns have had little congruency with the economy and earnings, as both of the latter have done extremely well.

At the year’s halfway mark, the U.S. economy is running strongly and the global economic expansion appears intact. Total net worth for U.S. households has risen to over $100 trillion for the first time and personal balance sheets have benefited. Consumer spending has rebounded and disposable income has spiked, owing to tax reform and higher wages, which should support further growth. Additionally, the market has yet to factor in the size of the U.S. fiscal stimulus package. The combination of tax reform and spending plans has the potential to create strong growth over the next few years. Whether it’s through increased capital expenditures, the repatriation of billions of overseas dollars, lower personal income taxes, or the sheer size of the spending on infrastructure projects, our economy is in better shape than it’s been in many years. So, the question is why have both equity prices and bond returns been so lackluster?

There may be a handful of reasons for muted investment returns year-to-date, but there are a couple that stand out. As the U.S. economy strengthens, a by-product of higher growth is higher interest rates, particularly when interest rates are coming from record low levels. The Fed has stated that they will continue their policy of “normalizing” short term interest rates as our economy continues to expand. So far, they have moved rates upward at a measured pace with no adverse effects to the economy. However, regardless of the justification, rising interest rates can make both equity and particularly bond markets jittery.

Trade tensions is the other issue that has caused a modest drag for our markets. For many years, the U.S. has run significant trade deficits and for the first time, this issue is materially being addressed. To date, the rhetoric has been much stronger than actual implementation, but the tit-for-tat actions will continue to make headlines and weigh on the markets.

In the short run, a variety of factors will cause markets to fluctuate, but over time it is economic fundamentals and corporate profitability that drive prices. With solid corporate health, reasonable valuations and record profits, the base case is that equity markets have plenty of ammo to resume moving higher. Bond returns will be more difficult as higher rates by the Fed present a challenge. For our fixed income holdings, we will continue to keep bond maturities short, therefore lessening the negative impact of higher interest rates.

Sincerely, Clay Parker

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