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Second Quarter 2018

We hope your summer is off to a great start. As we noted last quarter, some normalcy has returned to the capital markets following an eerily quiet 2017. We expect that the reemergence of volatility in both equity and fixed income markets, as witnessed in the first six months of this year, will continue for the rest of 2018.
US equities, as measured by the S&P 500, returned 3.43% in the quarter with technology stocks continuing to boost the index. With a positive return for the quarter, the index is now up 2.65% on a year-to-date basis. Global equities, as measured by the MSCI ACWI Index, returned only 0.53% in the quarter. US equity outperformance for the quarter can be attributed to factors such as global growth concerns and sustained bullishness on the US market despite rising interest rates. Halfway through the year global equities now lag US equities by 308 basis points.
The two primary bond indices we use to measure performance, the Bloomberg Barclays US Aggregate Bond Index and the Bloomberg Barclays Global Aggregate Bond Index, posted negative returns for the second quarter, -0.16% and -2.78%, respectively. Despite the outperformance in the second quarter, the US index still trails the global index on a year-to-date basis, -1.62% vs. -1.46%.
The Federal Reserve increased its benchmark rate by 0.25% in June, the second increase of 2018. The US central bank also signaled that more rate increases may be on the horizon in the second half of the year. At the beginning of the year we thought three rate increases were likely—enough to continue with the Fed’s normalization plan for monetary policy—without choking off growth and inflation. Now halfway through the year, we see the possibility of a fourth hike as increasingly likely, although the economic data over the next few months will need to show firming inflation. Conversely, the yield curve is the flattest it has been in a decade, and the Fed would be reluctant to invert the curve by raising short-term rates too quickly.
It is safe to say that trade tensions heated up during the second quarter and it appears market participants have begun to realize harsh rhetoric may not just be a negotiating tactic any longer. Mexico, Canada, China and the EU were the main targets of the Trump administration’s criticisms on trade practices, and all of them were clear in their response that they were not going to be pushed around. We discussed the potential negative impact of trade hostilities in previous letters and our belief on this topic is unchanged: upending global trade via tariffs and other measures with major economic players would likely cause significant harm to the real economy and put an end to the US equity bull market.
Trade with China and Europe is one area of concern for global investors, but it is
certainly not the only one. The synchronized global recovery from 2017, which provided a solid growth environment with minimal volatility, seems to be fading. A flare-up in Italy in May brought back nightmares of the European debt crisis, while emerging markets (notably Argentina and Turkey) had a brutal quarter and concerns about China’s indebtedness crept back up. These are the types of developments that markets generally ignored in 2017 but so far have appeared to
be evaluating a little more closely in 2018. So far this year investors are signaling they are beginning to get nervous on China: the Shanghai index is down 17% year-to-date.
The Chinese debt story has moved in and out of focus the last several years. As the second-largest economy in the world, China’s mid-single digit growth has propelled global growth in a time when advanced economies are expanding much more slowly. The debt cycle typically starts with Chinese entities going on a borrowing binge until the government becomes concerned that leverage is too high. Credit conditions will tighten, but only until the point where economic growth is not threatened. If concerns about growth creep up, credit conditions will ease and borrowing will resume. This carefully controlled, yet dangerous, cycle could be disrupted by a variety of factors, including a trade conflict with the US. We find it hard to believe that a combination of rising debt levels and a trade dispute between the two largest economies in the world would result in anything but serious headwinds for the global economy.
We have added a few features and made some formatting changes to the performance reports for this quarter. We hope you find these changes helpful. As always, please do not hesitate to contact us if you have any questions.
 
Sincerely,
Carl R. Hall, CFA
Chief Investment Officer
Wealth Management at Century Bank logo.
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