Quarterly Update: October 2018

Around the Firm

Fall is a busy season for planning as we look towards year-end reviews and deadlines. Business owners often use this season to look to add or update their retirement plans and its open enrollment for health care, FSA and HSA benefits. We encourage you to be proactive as these opportunities arise and consider reaching out to your advisor to discuss possible plan savings or benefit updates. Whether you are a plan sponsor or plan participant, Integrity is here to offer holistic health and wealth reviews to ensure you are well positioned to utilize the strategies available to you next year as well as planning for the years ahead.

The change of seasons also means a return to school for many of our children and grandchildren. As they head back to class, don’t forget about saving for their educational futures. Integrity is happy to discuss the variety of college savings plans available for your children’s future or tax strategies as a grandparent wanting to help offset higher educational expenses. Contact your advisor if you are interested in learning more.

Lastly, we are thrilled to announce our new website! Along with a visual redesign, the new site provides our clients with easier access educational articles and updates as well as direct access to scheduling meetings with your advisor (see advisor Bio). Please take a moment to visit the new site and to share the site with anyone you think we might be able to serve. As always, we hope that the next quarter brings you much joy as you spend time with loved ones and we look forward to talking with you soon!

The Economy

The last few months have brought good news for the US economy and US based investors. Many economists believe that at the close of the 3rd quarter, the US economy is stronger than it has been at any point in the current expansion. The current cycle, which began in 2009, has now become the 2nd longest expansion in history and will become the longest if it continues through July 2019. Growth has been gradually accelerating thanks to resurgent consumer demand and increased business capital spending. Fiscal stimulus, in the form of tax cuts and government spending, has fueled the growth and led to increased employment, strong profit growth, and a surge in GDP growth. GDP hit an annualized rate of 4.2% in Q2, measurably higher than 1st quarter’s report of 2.2%. The current readings reflect strong fundamentals, leading most economists to believe that growth should re-main solid for at least the next few quarters. With the Federal Reserve’s target GDP growth for 2018 at approximately 3%, this goal should be met, if not exceeded, should we continue on the current trajectory.

Labor market data remains strong as the unemployment rate appears to have found an equilibrium, remaining steady at 3.9%, well below the historical average. Corporate earnings, a large driver of stock appreciation, also increased by 3% in Q3 (not annualized). Hopes at the beginning of the year of expected earnings growth translating into higher employee wages finally is beginning to materialize as well. While still modest, wages have increased year-over-year by 2.9%, up from 2nd quarter’s reading of 2.8%. All that said, inflation has remained subdued with the PCE rising 2.0%. The Fed’s 5 year forward inflation expectations remain steady at 2.15%.

Solid economic data has provided the foundation the Federal Reserve needed to continue marching forward with raising interest rates. At their September meeting, the Feds raised the target rate for the 8th time in this cycle to between 2.0-2.25%. This was in line with expectations and therefore did not materially affect markets. One more hike is expected to occur in 2018 and potentially another 3-4 in 2019. If all of these increases come to fruition, the short-term rates will be close to 3.5% at the end of next year, a substantial increase from the near 0% rates experienced prior to 2015.

The housing market has leveled off in recent months, as increased mortgage rates and reduced tax deductibility of home ownership have kept a lid on demand and prices. Inventory has increased, and existing home sales are down 1.5% year over year. Existing home prices in August were up 4.9% from August 2017. NAHB Housing Market Index, a measure of homebuilding activity, ended the quarter at 67, same reading as last month, but still at high levels. Despite softening data, homebuilders’ confidence should continue to remain strong as wage in-creases translate into heightened demand over the coming quarters.

Growth abroad has been mixed but at large has lagged the US. The disparities between the US and European economic production are widening with GDP growth in the Eurozone seemingly capped at 2%. We are still seeing aggressive monetary policy at play in many developed nations attempting to bolster growth. China’s economy has decelerated, and while largely expected, the most recent GDP rate of 6.7% is the most sluggish pace since 2016. The slowing has been led by weak investment, a decrease in industrial production, and recent trade skirmishes with the US.

Though global economic conditions are largely positive, there are risks worth noting. Trade negotiations be-tween the two largest economies, US and China, and ensuing tariffs and political posturing have potential to be disruptive to the flow of commerce throughout the world. So far these tariffs have not had a materially impact on production, but the trade deficit has been growing and is now at the largest gap in the last 6 months. As recently as the week of September 24th, the US imposed tariffs on $200B of Chinese goods. If things continue to escalate in this manner, further volatility is sure to follow. Anther risk is simply an overheating economy that produces increased wage pressure and inflation. While inflation is currently subdued, as mentioned previously, it will be more difficult to restrain prices if growth continues to accelerate and the economy remains at full employment.

The Markets

In light of the strong economic and supportive fiscal landscape, US equity markets posted solid returns in the 3rd quarter, bucking the negative seasonal trends of August and September. The markets have been more volatile in 2018 than the last few years, but have continued to march forward despite the growing length of the bull market. Similar to GDP growth, the US has significantly outpaced international markets in 2018 thus far. The S&P 500 grew by 7.7% in Q3 and is up 10.6% year to date.

Tax cuts in the US have led to significant increases in company profits and therefore have justified an increase in stock prices, without extending multiples. As of last quarter, the forward P/E ratio of the S&P 500 was 16.8x, only slightly higher than its 25-year average of 16.1x. In Q3, larger corporations outperformed their smaller counterparts by a significant margin, with the Russell 2000 (a small cap index) posting returns of 3.6% for the quarter, half that of the S&P 500. Of the major economic sectors, the strongest performers this quarter were Health Care and Industrials, up 14.5% and 10.0% respectively. The worst performers were materials and energy, with returns of only 0.4% and 0.6% in Q3. Real estate Investment Trusts generated modest gains during the quarter of 0.6%, and commodities fell by -2.0%.

International markets have been quite a different story. Economic growth has been modest in the developed world and emerging economies have struggled in the face of rising US rates. While most major US indices posted solid gains for the quarter, the majority of international markets/indices were only slightly above neutral or in the red. Developed markets led the way with the MSCI EAFE Index up 0.8% for the quarter but down -3.8% year to date. Emerging markets fell by -2.0% in Q3 and are down -9.5% year to date. China was the poorest performer falling -7.5% in the 3rd quarter.

The yield curve flattened modestly in the 3rd quarter with yields on short to intermediate-term treasuries climbing slightly more than the long-term issues. Driving the short end of the curve has been the Fed’s decision to continue increasing rates. By the end of Q3, the 3-month Treasury settled at 2.2%, up 28 basis points (bps), the 10-year Treasury rose to 3.06%, up 20 bps, and the 30-year Treasury rose to 3.21%, up 22 bps. Rising yields have put pressure on bond prices, though returns were mixed across fixed income segments. The Barclays US Aggregate Bond Index declined by -0.8% in Q3 and is down -1.73% YTD. High Yield securities, which often follow the performance of equities, rose 2.4% in Q3, and Munis fell -0.2%. Emerging mar-ket bonds rebounded somewhat in Q3, up 1.9%, but are still down -4.2% for the year.

Outlook

In summary, the US economy is experiencing a late-cycle acceleration and if growth remains positive through mid 2019, it will be the longest expansion in our history. We believe conditions remain favorable and the outlook is positive, but potential risks include: a flattening yield curve, an overheating economy, and the persistent threat of trade war. With these noted, economists believe that given the significant amounts of stimulus that have been implemented, the US economy will have a difficult time being tripped up for at least the next few quarters. In the short term, market returns are unknown, however given the height of the market, a correction will eventually be inevitable. A reminder to have a focused, disciplined, long-term approach to investing is very important at this time to protect against common investor mistakes of market timing or fear-based reactions. A thoughtful, well-diversified approach, that may include alternative and defensive strategies, should help alleviate investor anxiety. Consider meeting with your advisor to review your current risk tolerance and ensure your investments and financial strategies are meeting your short term and long term goals.