April continued to be bumpy for capital markets. 2018 is the first full year of major monetary and fiscal change in the U.S., and so far the bond and stock markets are showing some growing pains. Fears of a trade war with China are perhaps overblown. Nevertheless, with increasing federal deficits and shrinking Fed stimulus, even whispers of a trade war seem to upset the fragile markets. U.S. stocks and bonds have both sold off for the first few months of the year; it is possible that at some point those two asset classes will diverge from each other.
The stock market had a bit of a respite in April. However, bonds continued to sell off, and it seems possible that rising rates will continue to challenge equities. Fueled by rising energy prices, inflation has moved marginally higher. By the numbers:
Oil prices rose another 5% in April, and for the year are up over 13%. The big story is not just OPEC, but rather the ability of OPEC to persuade non-OPEC producers such as Russia to join in their production cuts. The cuts are clearly working, and despite a ramp-up of production in American shale fields, global energy prices have been moving steadily higher for the past year or so. Gold has been buffeted by various winds; rising inflation and political uncertainty have provided some good days, but rising bond yields are a strong headwind for the precious metal. After double-digit gains in 2017, so far in 2018 the price of gold is barely positive. Also changing course in 2018 is the dollar. It lost almost 10% in 2017 against a trade-weighted basket of currencies. But after climbing almost 2% in April, it has been essentially unchanged for the year-to-date in 2018.
The ISM Manufacturing PMI in April was 57.3%, a bit lower than the March reading but still showing strong economic expansion. The non-manufacturing, or services, index came in at 59.3%, also showing continued strong expansion. The Commerce Department released its advance, or first, estimate of first quarter growth, estimating that the economy grew at an annual rate of 2.3%.
The National Association of Realtors reports that existing-home sales in April were 2.5% lower than in March, and are 1.4% lower than they were a year ago. The median price rose 5.3% to $257,900 from a year ago. Median home prices have now been rising for the past 74 months. The average 30-year mortgage rate in April was 4.47%, reflecting 7 straight months of increases, and the highest it has been in almost 5 years. Distressed sales (foreclosures and short-sales) were 3.5% of total sales in April, down from 4% month and down from 5% in April of last year.
From 2001 to 2008, as the U.S. stock market suffered from a post-internet bubble malaise, foreign stocks went on a meteoric run. In this period, the S&P 500 cumulative return was almost 0%, while many foreign stock funds doubled. Most diversified portfolios that had healthy exposure to foreign stocks outperformed a U.S.-centric portfolio. However, in 2008, that trend reversed. From 2009 to 2016, foreign stocks entered a prolonged soft, barely posting positive gains in many cases, while the S&P 500 went on a historic growth spree.
The discrepancy between U.S. stocks and foreign stocks is often explained by the currency markets. When an American buys international stock, the first thing that happens behind the scenes is they exchange their U.S. currency for the foreign currency – the peso, the euro, the loony, etc. Their investment is now subject to dual risk – the price of the stock itself, but also the value of the foreign currency. What often happens is a doubling effect – if the European stock market appreciates 10%, foreign investors often buy more Euros so they can invest in the European stock market, which could drive the Euro up another 10%. So the return to an American investor could be roughly 20%. The reverse is also true – if the European stock market declines 10%, there is often selling of the Euro as foreign investors repatriate funds to their home country, which could drive the Euro down 10%, yielding a negative 20% return to an American investor.
As the George W. tax cuts drove growing federal deficits in the U.S., several things happened. Money that would have gone to U.S. stocks instead went to U.S. government bonds to pay for the tax cuts – which was bad for U.S. stocks. The declining dollar, however, provided tailwinds for foreign stocks. So under George W., foreign stocks did well, while U.S. stocks did poorly. Under Obama, however, the federal deficit shrank year-over-year, leaving more money available for the U.S. stock market. As the dollar also appreciated, foreign stocks suffered, which made U.S. stocks even more attractive.
Going forward, it is likely that the federal deficit will continue to grow for the next 3 years, under the current tax regime. Even if a Democrat is elected to replace Trump, they are likely to face an unfriendly House or Senate. Plus, raising taxes to shrink the deficit is always a hard sell – Obama merely let the temporary Bush tax cuts expire, rather than passing completely new legislation. So it is possible that foreign stocks will be more attractive than domestic stocks over the next several years, as increased deficits could drive another prolonged period of dollar weakness.
One significant caveat: after weakening substantially in 2017 with the resumption of deficit spending, the dollar has actually rebounded somewhat this year. Currency markets are famously volatile, and even if the dollar is facing headwinds, the recent political turmoil in Italy is a great example of how the dollar can gain strength when global uncertainty rises.
Although I believe there are attractive investment opportunities overseas, this commentary is certainly not a recommendation to buy or sell any particular security or asset class. Even if an investment does well over the long-run (and there is never any guarantee of this), sometimes the short-term volatility can be too much for investors with less risk tolerance or capacity.
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