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Third Quarter 2018

We hope this letter finds you well. Last month marked the tenth anniversary of the collapse of Lehman Brothers and the onset of the worst financial crisis since the Great Depression. A decade later, US equity markets are at all-time highs, the domestic economy appears to be on a strong footing and the Fed continues to normalize monetary policy. The current environment is also characterized by more financial market volatility relative to last year and there are a couple of global developments that could upend the existing state of affairs: emerging market instability and increasing trade tensions with allies and major trading partners.
Compared to major equity markets around the world, US stocks have performed well year-to-date. The S&P 500 Index was up 7.71% in the third quarter compared to the MSCI ACWI Index, a measure of global equities, which was up 4.28%. While the S&P 500 Index significantly outperformed its global peer in the last quarter, the performance through the first nine months of the year has been even more striking: the S&P 500 Index is up 10.56% compared to the MSCI ACWI Index, which has returned only 3.83%.
Similar to equities, domestic bonds outperformed their global counterpart in the third quarter. The Bloomberg Barclays US Aggregate Bond Index posted a return of 0.02% in the quarter, besting the Bloomberg Barclays Global Aggregate Bond Index which returned -0.92%. On a year-to-date basis, the domestic index continues to outpace the global aggregate, although higher global rates have put pressure on both: the US aggregate is down 1.6% and the global aggregate is down 2.37%.
The Federal Reserve once again raised its benchmark rate by 0.25% in September, marking the third such increase this year. This rate increase had been widely expected and most of the analysis of the Fed’s decision has been on the potential for more rate increases over the next several quarters. With inflation holding around the Fed’s desired level and unemployment below four percent, it is now likely that the Fed will raise rates in December again and proceed with additional hikes in 2019. The flat nature of the US Treasury yield curve remains a key issue for investors and monetary policymakers alike. After spending the majority of the quarter under 3.00%, the 10-year US Treasury yield broke out in the last days of September, keeping a positive, but narrow, spread over shorter-term yields. We expect scrutiny of the shape of the yield curve to intensify over the coming quarters as the Fed pursues interest rate normalization.
One area in particular that caused some uneasiness in financial markets during the quarter emanated from a handful of emerging market countries such as Turkey and Argentina. Last year Turkey was the fastest growing G-20 economy, but those days seem distant now. The combination of large amounts of dollar-denominated debt, a weakening currency and significant geopolitical concerns have made for a challenging 2018. The Turkish central bank had to, controversially, hike interest rates to help defend the country’s currency, but this alone will not solve the country’s long-term challenges related to the debt boom of recent years.
The story in Argentina is similar. In 2017, investors were scooping up newly issued 100-year Argentinian government bonds with newfound optimism for South America’s second largest economy. This year, Argentina is being bailed out by the International Monetary Fund (IMF) once again. A lot of the focus on international economics this year has been on the largest economies (US, China, EU) but smaller, developing economies should not be overlooked. Emerging-market economies are typically smaller than their developed country counterparts, but that does not preclude them from causing havoc when things go awry at home.
On the trade front, there was some significant divergence in the last three months. The US made progress with Mexico on a NAFTA rewrite and a new trade deal was reached with South Korea. On the flip side, Canada had been sidelined in NAFTA talks until they agreed to a revised agreement with the United States and Mexico at the eleventh hour. Most notably, the big trade spat with China intensified on several different occasions. With such a strong quarter for US equity markets, does that mean the trade conflict does not matter? Our view is that the market remains optimistic that the outcome of the US-China trade dispute will be less disruptive than the rhetoric would suggest. Progress in other trade relations during the quarter likely boosted this optimism. There is no doubt that if both sides continue down the current path, with strong rhetoric turning into real action via billions of dollars in tariffs, that tangible effects will be felt in the coming months and quarters for companies, economies and financial markets globally.
From an asset allocation perspective, we continue to exhibit a domestic bias in stocks. We do remain skeptical that equities can climb even higher without some sort of pullback, but the growth profile in the US looks much more stable than abroad. The relative under performance of international stocks compared to domestic stocks does however provide an opportunity to evaluate some regions or sectors that may now be undervalued. After a rough year so far, as I noted above, emerging markets may be the best example of where pockets of value could open up.
We still favor short duration on the fixed income side for two reasons. The primary reason is that we believe rates will continue to rise over the next several quarters. Additionally, we believe inflation, whether it is caused by higher prices due to tariffs or increasingly tighter labor markets, could surprise to the upside and further chip away at bonds’ principal and interest payments. We are evaluating inflation-protected securities such as TIPs as a way to protect against a scenario like this.
As always, please do not hesitate to write or call with any questions.

Carl Hall, CFA
Chief Investment Officer

Wealth Management at Century Bank logo.

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