First Half Summary:
- 2018 marks the eighth consecutive year the S&P 500 has risen in the first half
- Small Caps continue to outperform
- Tech continues to outperform
- Market leadership is narrowing, with seven of eleven industry sectors lower so far this year.
- Volatility normalized following 2017’s historically low levels
- The Treasury yield curve continued to flatten
- Dollar strength continues impacting Emerging Markets
- The implied probably of a forth rate hike by year end is about 50%
The first half of 2018 is in the books resulting in very mixed returns amongst the major equity indices and underlying sectors. Despite the net positive performance by the broad averages in 2018, seven of eleven industry sectors are negative for the year, highlighting the importance of technology and energy companies (and consumer discretionary which contains two of the FAANG stocks). Looking to Q2, all of the major indexes finished in the green including some with breakouts to fresh all-time highs and double digit returns, however others remain in corrective mode like the Dow Jones Industrials which was up less than 1% in Q2 and remains in the red for the year. A multitude of ongoing factors have attributed to the diverging performance.
Index & Sector Performance
Through the 1H’18 the Russell Micro Index and Nasdaq 100 are the top performing indices with gains of 10.2% and 10.1% and both led the final month of June with returns of 1.2% and 1%. The broader based Composite gained 8.8% while the small cap Russell 2000 returned 7% through the first two quarters. The laggards have been the large cap S&P 500 which is up 1.7% through 1H’18, while the blue-chip Dow Jones Industrials Index is the only major in the red with a decline of (1.8%). The Dow Jones Transportation Index is also negative with a 1H decline of (2.5%). The negative performance of both the Dow Industrials and Transportation indices is a major red flag for Dow Theorists which bears (pun) watching throughout the 2H of 2018.
The tax reform plan is having a more profound impact on smaller size companies which historically have had a higher tax bracket than their larger cap peers. A more indirect impact from the tax code has been the repatriation of overseas cash on the balance sheets of larger multi-national companies. While this has aided the amount of buybacks which are expected to reach a record in 2018, it has also helped spur a bullish reversal in the U.S. dollar which is a headwind on exports for larger companies who have a greater percentage of revenues overseas.
Trade war rhetoric has only increased throughout Q2. Trump’s “bark” is proving to have more “bite” as the U.S. and its trading partners impose and retaliate with higher tariffs which in no way will improve trade over the near to intermediate term. Finally on the monetary policy front the Federal Reserve has as expected raised rates two times so far in 2018 with markets now pricing in ~50% odds for another two hikes in 2018. This diverging rate policy relative to global central banks is another tailwind for the dollar, particularly when combined with the increasing pace of quantitative tightening which now stands at $40B per month vs. the $10B monthly pace started back in October 2017.
The underlying sectors largely improved in Q2, yet important cyclicals like financials and industrials finished the quarter, as well as June, in the red. Through 1H’18 only four of eleven groups are in the green led by discretionary and technology with double digit gains of 10.8% and 10.2%, followed then by energy and healthcare with gains of 5.3% and 1%. Energy led all groups in Q2 with a quarterly gain of 12.7%.
What a difference a month makes. After being the top sector for the month of May gaining a little over 7% vs. the previous month, a tumultuous month of June had the S&P 500 Information Technology Index finishing 3rd from the bottom slightly negative at -0.38% for the month of June. Within the information technology sector, the software and software services sub segment was an outlier up +1.26% while the hardware and equipment sub sector finished the month negative at (-0.51%) The semi and semi equipment sub segment was deep into negative territory for the month finishing at (-6.23%) and generally keeping the sector in negative territory for the month. The importance of the technology sector and its influence on the economy cannot be overlooked. The sector now makes up more than a quarter of the total market cap of the S&P 500 index. This is its largest percentage since the peak of the tech bubble in 1999, when it topped out at over 30% of the index, and larger than any other sector in at least the last 25 year according to Bespoke Group, so there is a lot of attention paid to its performance. There was not just one element that held the sector back from continuing its strong growth for the year but a myriad of factors over the June month. The first is the ongoing trade wars between the U.S., China and Europe. The tech sector gets over 50% of its revenue from overseas sources, the second-highest out of all eleven sectors. That could leave the sector vulnerable in two ways. Recent dollar strength makes U.S. goods more expensive to foreign buyers, and could result in reduced demand and the ongoing tit for tat among the 3 nations could result in creased tariffs on U.S. tech exports. The other two factors pressuring the sector was some earnings softness and guidance from some reporting companies during the month and some sector rotation out of technology because of the weakness at the end of the month/quarter. That sector rotation out of technology or window dressing if you will can also be a testament to the strength of the sector overall and the momentum it has carried into June. So far YTD Technology has been a beast growing 10.16% so far despite a hiccup in June. The bottom line is technology is now in practically everything we do so it will remain a critical piece of the economy.
The leading sector in Q2 was Energy with a 12.7% advance, its best since Q4 2011. Bolstering the gain was a 14% increase in WTI crude oil, its fourth consecutive quarterly gain. The supply glut has mostly abated and OPEC recently agreed to relax their self-imposed production caps, but supply disruptions from Iran, Venezuela, and Libya are keeping things interesting. There is growing political pressure on the Saudis to produce even more in an effort to contain gasoline prices ahead of the November elections in the U.S., and though low prices might not be appealing for voters working in the industry, this development suggests we have moved closer to supply shortages rather than a supply glut.
Retail stocks had a strong June and a very strong Q2’18. The S&P 500 Retail Index gained over 4.4% for June and 14% for Q2’18. This, again, helped push the broader based S&P 500 Consumer Discretionary Index up 3.5% for June and up 8% for the Quarter, making it the best performing sector of the S&P 500 for 2018. Again, on the flip side, Consumer Staples underperformed the markets. The S&P 500 Consumer Staples Index gained 4% for June but is still down over 2% for the Quarter. Consumer spend is an important factor in U.S. GDP and any signs of strength there should be viewed as a positive for the economy while any weakness should be cause for concern. With Q1’18 GDP at 2% and a trade war brewing, cause for concern may be appropriate for the sector.
Another theme in 2018 so far is the return of volatility. The question for market watchers seems to be has volatility returned from 2017’s abnormally low levels. The answer, at least for the first half of the year, is “yes, but less so in 2Q’18 than in 1Q’18).”
Volatility receded in May and June after returning in February when ETFs based on short volatility bets blew up following concerns of faster rate increases. May’s Italy issue was also short lived, and the Trump tariff concerns in June showed up in the VIX but not in other volatility measures. Despite all the noise, the Dow and S&P 500 both closed higher in June.
The numbers: Overall YTD there have been 36 days in which the S&P 500 has risen or fallen by 1% or more compared to a total of eight in all of 2017. 2017 was an abnormally low year for volatility however. From February through April, the S&P 500 had a total of 29 days with close-to-close moves of 1% or greater. Over half (12) of February’s 19 trading days saw such moves. Things did not get much better in March (8) and April (9). However, since then May (3) and June (2) have been much quieter.
The June numbers seem surprisingly low considering the angst in the market over Trump’s tariffs. Market sentiment seemed to sour in the month and investors often moved to safe sectors like Staples, REITs and Utilities. Part of the answer is in sector rotation itself. Market correlations have been dropping, meaning that sectors move less in lockstep, and cancel out each other’s moves which lowers volatility.
Given the trade talk, we also measured volatility by looking at the number of days this year when the (multinational and industrials weighted) Dow had a high/low range of more than 1%. There were only four in June (two for the S&P 500) even though it felt like more. Midway through 2018 we have already seen 69 such days against only 11 for all of 2017. This bears out the sentiment that something has changed in 2018.
But, looking at just the past two months, volatility seems to be receding. The second quarter saw 13 days with S&P moves of 1% or more, in line with historical averages. The CBOE VIX Index also shows elevated volatility vs. last year but a decline from earlier in 2018. The index peaked intra-day above 50 and closed above 37 on 2/5/18 but spent much of June in the 12-13 range, before the final week saw closes in the 16-17 range, with a June close at 16.72. For 2017, the average was a little over 11.
There is plenty in the remainder of 2018 that could bring back sharp moves in stock prices especially since the markets feel jumpier after a few scares already, but the trend is that volatility is receding.
The Dow is the only broad average negative for the year:
The S&P 500 had a 1.7% return for the first half of the year, while the Dow lost 1.8% over the same period. Why? One reason is that the Dow is constructed differently, with stocks weighted by price, not market cap. For example the highest weighted Dow stock Boeing, with a $338 share price, has a 9.4% weight while Intel has a greater market cap but with a $50 price carries less than 1/6th the weight. For the year so far, Boeing added over $40.60 to its stock price and 275 points to the Dow, while 3M and Goldman Sachs cost the index over 200 points each YTD. Boeing was on pace to add 500 points to the Dow for the year but shed about $36 from its June highs to close out the month. New entrant Walgreen Boots Alliance fell 9.9% a few days after being added. Amazon’s announcement it will purchase PillPack, hurt the drug retailer space and also threw shade on the company’s first week in the Dow. WBA lost over half of its $12.61 YTD price decline on 6/28 and has “cost” the Dow about 88 points on YTD calculations*.
*WBA joined the Dow on 6/25/18, replacing GE, so calculations are adjusted.
IPOs and M&A
Strong cash levels and lower valuations are helping fuel record buyback activity. According to CNBC, Spending on buybacks, dividends, and M&A may hit $2.5T this year. The forecast is for companies to spend $700-800B on buybacks, $500B on dividends and about $1.3T in M&A in 2018, helped by a large influx of cash following the recent tax cut. The tech sector is seeing very strong buyback trends (and leading the market YTD). Buybacks have been heavily skewed toward growth stocks (which have seen ~$280B in activity). The top 20% of companies by market cap have accounted for 72% of the buybacks.
Separately, Thomson Reuters data shows global deal making has reached $2.5T in 1H’18, breaking the all-time high for the period and underscoring the intense nature of M&A activity in spite of increasingly bitter geopolitical tensions. Megadeals led by the U.S. media and telecoms sector helped to lift worldwide deal volumes 65% from the same time a year ago and the most on a nominal basis since Thomson Reuters began keeping data on M&A in 1980.
IPOs are also showing a healthy trend. So far this year, 120 companies have raised $35.2 billion via IPOs, the largest number of companies since 2014 and the fourth busiest YTD since 1995. Aided by a strong 37 deals in June alone, Nasdaq welcomed 93 IPOs this year vs. 53 at the same time in 2017.
ETF Fund flows show that money continues to move to U.S. small caps and tech stocks as well as into short term treasuries and higher grade corporate debt. According to Nick Colas of DataTrek (numbers through June 27):
- Q2 global equity ETF money flows were substantially slower than in Q1, $29.7 billion versus $47.3 billion, and ALL that capital went to U.S. equities this quarter.
- Q2 U.S. equity flows were better than Q1, at $35.7 billion versus just $4.5 billion.
- Q2 emerging market equity funds saw outflows of $7.2 billion following Q1 inflows of $12.8 billion.
- Inflows to fixed income ETFs accelerated in Q2, at $28.7 billion versus $16.4 billion in Q1
- Small cap U.S. equity ETFs saw greater inflows in Q2 ($12.1 billion) than large cap equity funds ($8.4 billion)
Are Treasuries offering a signal?
The difference between yields on U.S. 2-year Treasuries compared to 10 year paper continues to narrow. At the end of June, the yield differential was 3 basis points, down from 52 basis points at year end. The Fed is raising rates at the short end of the curve and some would argue that long term rates are too low: suppressed partly by a recent flight to quality given market turmoil and the ECB’s continued actions to keep rates low in the Eurozone. Still market watchers are concerned. History shows that once the Treasury yield curve inverts (10s yield less than 2s) a US recession is likely. One thing that might change the current trajectory is inflation brought about by a trade war as goods become more expensive. Let’s hope that is not the solution.
Among the issues investors will be watching for the balance of 2018 are further signs of a trade war escalation, a potential slowing of corporate earnings growth, economic data, the shape of the yield curve, dollar strength & its impact on multinationals, trading partners and emerging markets, Fed tightening and the risk of a “policy error”, and any return of volatility to equities.
With regards to “QT” and volatility, Bloomberg says the number of hedge fund managers expecting impending market chaos are growing, with many predicting an end to the rally in asset prices, as central banks move to normalize policies and the rise of populism threatens trade across the globe. One counterweight is the Atlanta Fed’s GDPNow model, which has a current forecast of 4.1% U.S. GDP growth for Q2, which would be the highest quarterly growth in four years.
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Charles Brown is Associate Vice President on The Market Intelligence Desk with over 20 years of equity capital markets experience. Charlie has extensive knowledge of equity trading on both floor and screen based marketplaces. Charlie assists with the management of The Market Intelligence Desk and works with Nasdaq listed companies providing them with insightful objective trading analysis.
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