In Quarterly Reports

Steady But Sometimes Volatile, Where Will The Market Grow?

During the quarter—May 3rd, to be exact—the Kilauea volcano on The Big Island of Hawaii began erupting and has continued erupting without pause ever since. Over that time, it’s produced enough lava to fill more than 100,000 Olympic-size swimming pools.

It’s also destroyed major sections of the island’s habitat along with more than 500 homes. Amazingly—and fortunately—no lives have been lost, although lives certainly have been greatly disrupted.

But in the wake of the chaos, something truly amazing is occurring: The Big Island is getting even bigger thanks to that volcanic activity! In fact, the Big Island has been growing consistently over time due to the fact that active volcanoes sit on it.

This expansion stands in stark contrast to many other islands, which typically shrink over time due to coastal erosion and rising sea levels.

In other words, volcanic activity— including both violent eruptions and deep underground movements that we never even notice—create new growth and cause the island to expand.

The “Growing Island” of Equity Values

For just over nine years, stock prices have continually expanded in ways that are akin to the steady but sometimes volatile growth of volcanic islands like Hawaii. Since the market bottomed out on March 9, 2009 following the financial crisis:
• The S&P 500 is up 18.7% on an annualized basis.*
• The top performing S&P industry group— Consumer Discretionary—is up 25.2%, annualized, during that time.*

As seen in the chart below, the bull market’s expansion has been (by and large) a smooth journey. The “island” of stock values has generally spread out in a fairly calm, smooth and consistent manner. * Data through June 29, 2018.


Where We Are Today?

Where does that leave us today? At 9.3 years, this is the second-longest period in history without a pullback of at least 20% in the S&P 500. A decline of 20% or more typically happens about once every six years, dating back to 1928. Naturally, such facts have some investors wondering if the current bull market is “long in the tooth.”

The good news: Economic fundamentals appear to be strong enough to help the “island”—that is, equity market returns—continue to grow and expand.

That said, it’s very likely that this growth won’t be as smooth, as consistent or as wide-ranging as it has been for the bulk of the past nine-plus years. As we move into the second half of 2018, we’re seeing that market growth is starting to be channeled into specific areas of the island rather than “fanning out” across the entire landscape.

The upshot: It’s possible that some parts of the island will see many more opportunities for growth than will other sections—while some areas could even see some erosion. Simply being on the island won’t ensure continued success.

Instead, it will become especially important to be positioned on the right parts of the island as this late-cycle bull market moves forward.

Growing Uncertainty and Fears of Destabilizing Forces

There are an enormous number of forces that tie global markets together and help them generate positive returns. The complex nature of these markets is not always apparent. They exist below the surface and aren’t noticed during “easy” periods like 2017 when those forces were more or less all aligned and moving together in the same direction.

However, those complexities start to show themselves in markets like today’s—when important market forces start to diverge and take new paths that are distinct from one another. As that occurs, it can give rise to destabilizing conditions that create distinct winners and losers—on a relative and even absolute basis.

For example, consider the market environment we find ourselves in currently and some of the signs of uncertainty bubbling up to the surface:

1. Central bank shifts. For much of the past nine years, central banks around the world were largely aligned in terms of their monetary policy—with the shared goal of stimulating economic growth in their various countries. But those banks’ paths are now diverging. For example, the Federal Reserve Board during the quarter opted to raise a key short-term interest rate for the second time this year. New Fed Chairman Powell’s comments after the decision were more hawkish than expected—prompting some investors to predict that, going forward, the Fed might raise rates more aggressively than was expected prior to the Fed’s meeting. The pace of the Fed’s next moves could calm markets, or it could destabilize them.

In contrast, the European Central Bank diverged from the Fed by taking a more dovish posture with its monetary policy—stating that plans to maintain interest rates at their current low levels though at least the summer of 2019. (The ECB did say it would end its quantitative easing bond-buying program, however.) And the Bank of Japan during the quarter chose to keep its quantitative easing program in place, while also lowering its inflation expectation range.

2. Currency shifts. The U.S. dollar rose significantly relative to many other global currencies during the quarter—an about-face from the falling or stable dollar environment we saw during most of 2017. This has resulted largely from the fact that the Fed has been tightening monetary policy and looks set to continue raising rates while much of the rest of the world remains accommodative. As noted above, a strong dollar relative to emerging markets currencies can hurt equity returns in those markets—and certainly did during the quarter.

3. Trade policy shifts. After years of largely stable trade agreements with many countries, the U.S. has recently imposed (or threatened to impose) extensive tariffs on steel, aluminum, automobiles and a variety of other goods imported from foreign countries and regions—China as well as allies including Canada and Europe. This has set off a chain reaction of retaliatory tariffs from those nations on U.S-made and exported goods. Investors fear that if a full-blown trade war erupts, global economic growth could fall significantly—possibly even plunging economies into recession. Meanwhile, the U.S. is attempting to end some key multi-lateral trade agreements and instead create bi-lateral, one-on-one pacts with individual countries. This creates further uncertainty.

4. European political shifts. A right-wing politician in Italy, Matteo Salvini, is rattling investors who worry that Italy could potentially remove itself from the European Union if Salvini’s political party takes control of the government. Italian financial markets experienced significant volatility during the quarter due to such concerns, causing losses in other markets around the globe. In addition, concerns over immigration in Germany are hurting Chancellor Merkel’s ability to lead her government—creating further doubts about Europe’s overall economic conditions.

The complexity of this ecosystem is on display now— and as it true with most things in life, complexity adds uncertainty. That fact is demonstrated most clearly by the range-bound market environment we’ve seen throughout the second quarter. Example: The S&P 500 has traded in a narrow range between its high for the year in late January and its low for the year seen in early February.

Where the Island Will Grow

Given these developments and diverging paths, what parts of the island are set to generate the most growth and which parts are going to lag or stop progressing forward? We expect to see continued growth in:

1. The U.S. Strong domestic growth relative to other countries will create continued demand for U.S. investments and markets.

2. Growth stocks. In an environment of uncertain growth prospects, investors will place a premium on shares of companies that show they can grow reliably and steadily.

3. Small-company stocks. Smaller U.S. firms will benefit from strong domestic economic conditions. They also don’t face the global trade risks to nearly the extent that large, multinational U.S. companies do. Continued deregulation by the government should also benefit smaller businesses disproportionately.

Areas that may see stagnation—or even erosion— include:
1. Emerging markets. Falling emerging market currencies can be difficult to stabilize, especially as speculators enter the markets and put continued downward pressure on the currencies. Emerging markets still represent an outlet to tap into global growth—but as long as their currencies are unstable, their returns will suffer.

2. Value stocks. As noted, value sectors tend to be cyclical—their revenues and earnings often aren’t consistent or reliable. That makes them relatively less desirable in an uncertain environment with growing complexities to navigate. In addition, industrials make up part of the value style—and continued tariff and trade concerns are likely to dampen that particular sector.

3. Fixed-income. Bonds are likely to continue trading in a narrow range for the foreseeable future. Short term rates may drift higher based on Fed policy, while long-term rates should remain anchored at around 3% or so by relatively tame inflation and continued demand for U.S. government among overseas investors and retirees. This presents a combination of low yields and low potential for price appreciation among bonds. One exception could be high-yield corporates, which may continue to benefit from the strong economy and healthy corporate balance sheets.

Note: Although we are highlighting the constructive nature of volcanic activity, Horizon cannot overlook the destructive impact that Kilauea continues to have on the residents of Hawaii. Since the volcano’s explosive eruption in April, more than 80 houses have been destroyed by lava flows, with more than 10,000 people displaced by the volcanic activity. Horizon has provided a financial donation to disaster relief specifically to help those affected by Hawaii’s Kilauea eruption.