1. Market + Economic Overview
Q3 2018
Market + Economic Overview
Mario Nardone, CFA

2. Available on the
XYIS Knowledge Base

3. Positive Signals
Solid U.S. economic growth, overall domestic outlook is bright
Low unemployment
Stable inflation
Stocks often perform well when economic growth is solid and rates rise from low levels
Even with a rise in interest rates, they are still historically low
High consumer confidence
There were several reasons to be optimistic during the third quarter. Overall, the outlook for the US economy is bright. For one, unemployment is low. In fact, just after Q3 ended it was reported that unemployment hit 3.7%, its lowest levels since Inflations has also been stable, which has been helpful for the Fed as they continue with steadily raising the Feed Funds rate. All of this has led to strong consumer confidence, which reached an 18-year high during the third quarter.

4. Reasons for Concern
Rising trade tension could have impact on global growth (US vs. China)
Flattening U.S. yield curve as Fed raises short term rates; other impacts to more rate hikes (e.g. higher mortgage rates)
We are in later stages of economic cycle
Midterm election volatility
Strong $ impacts EM countries
However, there are also some reasons to be concerned. One obvious question is “when will the bull market end” as we are likely in the late innings of the current economic cycle. Similarly, with the Fed raising short term rates and with longer term rates holding steady, the yield curve has been steadily flattening. The concern is that the yield curve inverts, which means that shorter term rates are higher vs. longer term rates. Economists often site an inverted yield curve as one predictor of an oncoming recession. Finally, an escalation and expansion of a trade or tariff war can have an impact to the global economy.

5. Running with the Bulls
We are likely in the later innings of what is now the longest U.S. bull market in history. When should we prepare for the next downturn?
On August 22, 2018 ,the current bull market became the longest in US history, passing the dot-com boom of the 1990s. As we sit here in the fourth quarter the current streak has been extended even further at this point. Interestingly, one of the similarities between the current rally and the dot-com rally is the dominant role technology has played. According to S&P, the Information Technology sector currently comprises 21% of the index. For comparison, the Health Care sector is the next largest at 15% and there are 11 sectors overall. One very different aspect of the current rally is that one could argue is has been largely fueled by the easy monetary policy of the Federal Reserve, which moved short term interest rates effectively to zero, promoting risk-on behaviors which have been driving the U.S. stock market upwards.

6. The experts are not always right
●One obvious question we noted before is “when will the next market downturn occur?” As we just showed this is already the longest bull market in US history. So we don’t think we are taking too much of a stretch by saying we are in the later innings of this cycle. As this chart shows, there are many experts that are surprised that the bull market has gone on as long as it has, as several have been predicting its demise for several years now.
●As a reminder, we would not recommend trying to time the market.

7. Even if we are in the late innings of this economic cycle...
...equity returns can still be very rewarding.
●One of the reasons we would not recommend trying to time the markets is that markets can be very rewarding , even just 3 months prior to a market peak when markets have averaged 8%. It is not surprising that we see some of the worst market returns in the 12 months following a market peak.
●Obviously the magic question is when will we hit a market peak?

8. Rising tariffs in U.S. vs. China trade
“It’s amazing how many people don’t understand that tariffs on Chinese good are paid by American companies importing those goods from China…those tariffs are not paid by the Chinese…tariffs are a tax & ultimately U.S. consumers will likely be on the losing end of the trade.” - Tweet by Liz Ann Sonders, Chief Investment Strategist at Charles Schwab
●In late September, the U.S. placed another round of tariffs on $200B of Chinese goods. The chart to the left highlights the industries and products which are expected to be most impacted, namely computer and electronic products as well as electrical equipment and appliances.
●In response, the Chinese State Council (the administrative authority of the People’s Republic of China) accused the Trump administration of being a bully while Beijing applied $60B of their own tariffs.
●IN thinking about the impact of these tariffs, Fitch, a well-known rating service, believes these trade escalations will impact future global growth and correspondingly lowered their forecasts slightly to 3.1% from 3.2%.
●Finally, as we said last quarter, in its simplest form, a tariff is a tax imposed on imported goods. Going a step further was Liz Ann Sonders, Chief Investment Strategist for Charles Schwab. She tweeted “It’s amazing how many people don’t understand that tariffs on Chinese good are paid by American companies importing those goods from China…those tariffs are not paid by the Chinese…tariffs are a tax & ultimately U.S. consumers will likely be on the losing end of the trade.”

9. Consumer Confidence is high
Consumer Confidence Index hit an 18-year high in July and is close to an all-time high. Confidence is at least coming in part from a strong labor market.
●For now, it appears that trade and tariff risks are not having a significant impact, at least as it relates to consumer confidence. In September, the Conference Board’s Consumer Confidence Index hit an 18-year high and sits very close to an all-time high, due in part to a strong outlook on economic growth and low unemployment.

10. The labor market is tight
The August unemployment rate of 3.9% is well below its 50-year average of 6.2%.
Helping employers, but at the expense of workers, is that wages aren’t increasing much.
Unemployment fell to 3.9% in August, well below the 50-year average of 6.2%. In addition, in the early part of the 4th quarter, unemployment actually went lower, falling to 3.7%, a low since December (remember, this is a 3rd quarter presentation)
Unfortunately for workers but positive for employers, is the fact that wage growth has not been accelerating and remains well below historical averages.

11. Inflation is stable
The Fed prefers the Core PCE measure of inflation as its target. If inflation picks up too much, too fast, the Fed may be forced to raise interest rates quicker than they prefer.
●The Fed’s preferred method of measuring inflation is Core PCE (Personal Consumption Expenditures). As the chart shows, Core PCE is running right around the Fed target of 2%, which is something the Fed is welcoming with open arms as inflation has persisted stubbornly below this mark for the last several years. Of course, inflation measures can be a fickle thing. The Fed will be watching inflation very closely as if it climbs higher and faster than they like, they risk an overheating of the economy and will be forced to raise interest rates more quickly.

12. The Fed has been on a tightening cycle
Date
Increase (bps)
Level (%)
9/27/2018 25
2.00 – 2.25
6/13/2018
1.75 – 2.00
3/22/2018
1.50 – 1.75
12/14/2017
1.25 – 1.50
6/15/2017
1.00 – 1.25
3/16/2017
0.75 – 1.00
12/15/2016
0.50 – 0.75
12/17/2015
0.25 – 0.50
Most economists expect one more rate increase in 2018 with two more penciled in for 2019.
●In each of the last four quarters, the Federal Reserve made the decision to increase the Fed Funds rate 25 bps, which now stands at a level of 2.00% %. It is the third increase in 2018 and 8th since It is expected there will be one more increase in December 2018 with an additional two increases penciled in for Certainly, while there are other events that could change the current trajectory, like if inflation moves too high, too fast, the Fed is likely to keep its current course.
Source: FederalReserve.gov

13. The yield curve continues to flatten
The flattening of the curve continues as the Fed increases rates and inflation expectations remain stable.
●As the Fed has raised short term rates consistently, the longer term part of the curve has not moved very much. The longer part of the curve is moved by the market, including expectations for inflation, which we mentioned before were stable.
●As the yield curve is continuing to flatten, it means investors are not being compensated for taking on the risk of holding longer dated Treasuries. In addition, we will be looking out for an inverted yield curve where shorter term rates are higher vs. longer term rates, which often signals an oncoming recession.

14. 10 Yr - 2 Yr Spreads Narrow to Post-Crisis Lows
Another way to show how the yield curve is flattening. An inverted yield curve can signify a recession is on the horizon.
●Another way to look at the flattening of the yield curve is to look at the spread between 2 year and 10 year Treasuries.
●As this chart shows, the spread between 2’s and 10’s has been consistently shrinking.
●Our recommended portfolios generally eschew long-dated bonds in favor of the better risk-adjusted-yield profile of shorter-term alternatives, including corporate bonds which have performed more favorably vs. Treasuries.
●Our focus will continue to be on high quality bonds with an emphasis on short to intermediate duration Treasury and corporate bonds, where default risk is relatively low.

15. Global Fixed Income
●Fixed income investments continue to be challenged in a rising rate environment.
●Specifically, Treasury investments have been negative over the last 12 months. The picture worsens as you move further along the yield curve with 5-10 Yr Treasuries, corporates and munis posting negative returns for the prior 12 months.
●From a global bond perspective, hedged returns fell only 5 bps in Q but the category is still positive (+0.8%) over the previous 12 months. As a reminder, we recommend hedging global developed bonds to reduce the impact of currency volatility.
Source: Morningstar
Data as of 9/30/2018

16. US Equity by Size and Style
In a reversal of last quarter when small caps outperformed large caps, this quarter we saw large cap stocks outperform their small cap counterparts as trade and tariff talk dissipated. Large cap stocks are likely still benefiting from the tax cuts as well. However, on a year-to-date basis, it is still small cap stocks that have outpaced large cap stocks (R2000 = 11.5% vs. R1000 = 10.5%). In July, the National Federation of Independent Business said its Small Business Optimism Index reached its second-highest level in its 45-year history as small business owners continue to expect increased sales. Remember though, while small caps are less immune to trade wars and tariffs vs. multi-national firms, they still do have exposure. In addition, small cap stocks tend to be more volatile vs. their larger cap counterparts.
From a style perspective, the last quarter only widened the gap between growth and value stocks. On a year-to-date basis, large cap growth stocks, as represented by the Russell 1000 Growth, have outperformed large value stocks by 13.2% (17.1% vs. 3.9%).
Source: Morningstar
Data as of 9/30/2018

17. It’s not just tech leading the way
Consumer Discretionary and Health Care stocks have also led the S&P 500 higher YTD
●It is not only technology stocks driving the market higher. For example, the Consumer Discretionary (+17.0%) and Health Care (+15.4%) sectors have also led the S&P 500 higher on a YTD basis

18. Int’l Developed, Emerging, and Frontier Equity
●International equities continued to lag their U.S. counterparts in Q In fact, the MSCI EAFE was the only major international equity index we follow that earned a positive return during the quarter (1.4%). Additionally, each of the four major international equity indexes we follow have fallen on a YTD basis (range from the MSCI EAFE down -1.4% to the MSCI Frontier Markets Index decreasing -12.6%).
●The Fed rate hikes have not helped, as when the Fed raises rates, it normally leads to better investment opportunities in the U.S, which leads to outflows from emerging and frontier nations, which often have messy politics and currencies that are more negatively impacted from a strong dollar.
Source: Morningstar
Data as of 9/30/2018

19. The U.S. comprises just over half of the global market cap
Even with returns in the U.S. as strong as they have been, investing globally is still recommended.
●This chart shows, in part, why we recommend a global equity allocation. The U.S. comprises 55% (up from 54% last quarter) of global market capitalization, meaning 45% comes from outside our borders. Thus, despite occasional challenges, we believe it is important for investors to have exposure to markets outside the U.S.
Data as of 9/30/2018
Source: Factset, MSCI, Standard and Poors, J.P. Morgan Asset Management, Guide to the Markets

20. Int’l Developed, Emerging, and Frontier Equity
International stocks are currently cheaper vs. the U.S and also have a higher dividend yield.
●In addition, while returns in U.S. stocks have certainly been better vs. international stocks, the chart to the left shows two important characteristics: 1) Non-U.S. stocks are considerably “cheaper” from a P/E perspective and 2) Non-U.S. stocks are currently paying a higher dividend yield.
●It is important for investors to keep in mind that investing domestically vs. internationally should not be an all-or-nothing endeavor. We continue to believe that investing in international, emerging and frontier markets are important.

21. Maintain Your Focus On What Really Matters
Financial planning is a process, not an endpoint
Concentrate on long-term goals and objectives
Focus on reaching goals, not on beating benchmarks
Maintain a disciplined approach, in good and bad markets
Invest broadly and globally; asset allocation is key
Reduce investment and tax costs where possible
Rebalance as necessary
●Do investments matter? Of course they do; however it is not investments aloe that will help you achieve your goals. Maintaining a focus on these bullet points is what really matters in helping you achieve your goals.

22. Q+A

23. About XY Investment Solutions, LLC
Disclosures
The commentary contained herein is intended to be general and educational in nature, and is not intended to be used as the primary basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor. Nothing contained herein should be considered legal, tax, accounting, investment, financial, or other professional advice, and should not be construed as an offer to sell, a solicitation of an offer to buy, or a recommendation of any security or other financial product or investment strategy. Investors should consult with a qualified professional advisor before taking any action based on this commentary.
Investing in mutual funds, exchange-traded funds (“ETFs”), and other equity and debt securities involve risks, including loss of principal. Any performance data quoted represents past performance. Past performance does not guarantee future results and principal value will fluctuate so that an investor’s investments, when redeemed, may be worth more or less than their original cost. Performance data quoted does not account for any advisory fees imposed by XYIS or any independent and unaffiliated financial planners, or other transaction charges, expenses, taxes, or other fees and costs. Performance of an investor’s actual portfolio will differ from any performance presented.
Investing in foreign securities may involve certain additional risk, including exchange rate fluctuations, less liquidity, greater volatility and less regulation. Small company stocks may be subject to a higher degree of market risk than the securities of more established companies because they tend to be more volatile and less liquid. Bonds are subject to risks, including interest rate risk which can decrease the value of a bond as interest rates rise. REIT investments are subject to changes in economic conditions and real estate values, and credit and interest rate risks.
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About XY Investment Solutions, LLC
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