Summer has always been a fun time for me. I have always enjoyed spending time with my family, traveling, and being active during this time of the year. When I was a boy growing up in southern Florida, the season became long and the "dog days of summer" meant uncomfortable weather, life slowing down as a necessity to endure the heat, and regular thunderstorms. I reflect on that time, and how we, at our firm, think about the current capital markets and life as an investor. Now that the second quarter is behind us, it seems we must learn to live with being uncomfortable and looking out for trouble on the horizon.
But, let's enjoy the sunshine for a moment. The second quarter was a good one for the S&P 500 - or, at least, for part of it. The S&P 500 was up 3.4% in the second quarter, led by those familiar friends, the technology and consumer discretionary sectors, and joined by the energy sector. Those three sectors were up for the quarter 7.1%, 8.2% and 13.5%, respectively, driving overall stock returns. The US market's strength in the quarter brought returns for the first 6 months of 2018 back into positive territory. It seems like an endless summer for US corporations as they continue to churn out remarkable earnings, primarily driven by corporate tax cuts and record margin expansion. Earnings have been so outstanding that most valuation measures seem reasonable, with the S&P 500 trading at near 25-year averages for both forward and trailing earnings. US corporations are now flush with cash. For S&P 500 companies, cash and cash equivalents represent 30% of current assets, the highest level in 20 years. But with so much cash on their balance sheets, low cash yields and a reluctance to increase dividends, the question is, can US corporations keep investors satisfied? The second quarter was not as kind to foreign stocks, which left investors disappointed for the first half of the year. Developed markets and emerging markets are still negative on the year at -2.4% and -6.5%, respectively, through June 30.
In the Florida Everglades, as the days get long and the heat turns up, dark clouds form almost like clockwork. If you're on the water during late summer, it's best not to get too far from the safety of the shore. We feel investors should be similarly cautious. Corporate profitability may be peaking. Wages grew at 2.8% in the quarter and are likely to continue to climb after the unemployment rate hit a near 50-year low of 3.8% in May. While additional workers entered (or re-entered) the workforce in June and drove the unemployment rate back up to 4.0%, corporate profit margins will still be under pressure as companies compete for workers in the coming months.
US non-financial corporate debt has grown to 45.4% of GDP, the highest level since WWII. The Treasury yield curve is uncomfortably flat. As of June 30, the 2-year Treasury yielded 2.52% while the 10-year yielded 2.85%, a spread of only 0.32%. The Fed tightened in the second quarter and has indicated a willingness to be aggressive as the signs of looming inflation emerge. Remember, every time in the last 50 years that the spread between 10-year and 2-year treasuries turned negative, the US economy entered a recession shortly after.
And then there is the growing risk of a full-blown trade war. The topic of trade has taken center stage this year and become a fixture in the news cycle. We've heard about the Trans-Pacific Partnership (TPP) and the 11 countries who agreed to formally proceed even after the US pulled out. Negotiations of NAFTA, the 20+ year old pact between the US, Canada and Mexico, are currently stalled. And, we've heard a lot of rhetoric about tariffs including much talk and posturing - primarily between the US, Canada and China - but other countries have made reciprocal tariff announcements of their own. Recently, the European Union's retaliatory tariffs of 25% on US exports like Harley Davidson motorcycles, bourbon, orange juice and peanut butter were put into effect. That was a direct response to US tariffs on steel and aluminum. Canada has announced plans to slap dollar-for-dollar tariffs on the US. India and Turkey have already targeted US products ranging from rice to autos to sunscreen.
Of biggest concern, and potential impact, is a trade war with China. Just after quarter-end, on Friday, July 6, 2018, the US officially imposed a 25% border tax on $34 billion worth of Chinese goods including plastics and intermediate goods used in manufacturing. China immediately accused the US of starting a trade war and responded by imposing their own 25% tariff on $34 billion worth of US goods such as soybeans, automobiles and lobsters. The Trump administration is attempting to punish China for their controversial trade practices, such as forcing foreign companies to hand over technology and intellectual property in exchange for access to their market. This may be just the beginning, as an additional $16 billion worth of Chinese goods may be subject to the same border tax and President Trump is considering tariffs on another $500 billion worth of Chinese goods, depending on how China responds.
Trade is one of the reasons the global economy is now growing at the fastest rate in almost seven years. As one country's economy improves, it imports more from another country, which then grows faster and imports more from third country, and on and on in a virtuous cycle. Trade matters both in the short and in the long-term. Actions that restrict trade could put sand in the wheels of the global expansion by disrupting production, increasing prices for consumers and, ultimately, decreasing productivity.
The escalation of the trade war from rhetoric to reality is likely to ripple through global supply chains and raise costs for businesses and consumers. But while equity markets have been volatile in anticipation of a prolonged trade fight, for now the tariffs amount to a small amount of our total GDP. Every summer blockbuster movie has twists and turns and we must wait until the end of the movie to find out how the hero survives. At the current juncture, the tariff numbers are still small and should not materially alter the trajectory of US growth. However, it is a risk we're monitoring closely.
During this season we continue to advise strong diversification, patience and that you remember your investment time horizon. There are areas of the markets we find attractive. High quality bond and credit yields can be found for both taxable and tax-exempt assets. Private Equity continues to have impressive results and, we believe, provide unique opportunity. Despite our meteorological warnings, we want you to enjoy your summer. We are keeping a close eye on the horizon and investing your funds carefully. As always, please call us if there is anything you'd like to discuss. Have a happy and healthy rest of the summer.
Sincerely,
Daryl Deke
Principal and Chief Executive Officer
