The first half of 2018 had plenty of drama, without much in terms of absolute returns. It was a stark contrast to the blockbuster year we had in 2017, which is now a distant memory. There were pockets of optimism, but they were largely overshadowed by the breakout of what has the real makings of an unfortunate trade war.

Fixed income took an unexpected path. The yield on the 10-year Treasury rose in Q1, but investors began to seek the perceived safety of Treasuries by the end of Q2 despite a Federal Reserve eager to normalize rates.

Below, we break down the market’s performances in Q2 and the first half.

Equity indexes: Footing found after a rough Q1

U.S. equities bounced back in Q2. The S&P 500 TR Index returned 3.43% after its first negative quarter since Q3 2015. Year-to-date, it’s up 2.65%. Abroad, the MSCI World ex USA NR USD Index decreased 0.75% in Q2 to take its negative 2018 return to -2.77%. The MSCI Emerging Market (EM) NR USD Index’s struggles continued, declining 7.96% in Q2 and down 6.66% for the first half.

The gulf between Growth and Value in large-cap U.S. stocks was wide in Q2. On the Growth side, the NASDAQ Composite Index returned 6.61% in Q2 and 9.38% on the year. Strength in the Information Technology and Consumer Discretionary sectors helped the index hit an all-time high of 7781.5 on June 20.

On the small-cap side, the Russell 2000 Index returned 7.75% in Q2 and 7.66% in the first half, outperforming the Russell 1000 Index’s 3.57% and 2.85%, respectively. Less exposure to trade uncertainties in the more domestically focused small cap world has helped performance.

During Q2, the difference in performance between Growth and Value was minimal within small caps. The Russell 2000 Value Index was the top-performing segment with an 8.30% total return, followed by the Russell 2000 Growth Index (+7.23%), Russell 1000 Growth Index (+5.76%) and the Russell 1000 Value Index (+1.18%). Thus far, it’s the Russell 1000 Value Index taking the brunt of the trade concerns.

U.S. sectors: Trade tensions affected some sector more than others

Overall, sectors flipped the script in Q2. Performance was much stronger than in Q1, when only two S&P 500 sectors had positive returns. Energy (+13.48%), Consumer Discretionary (+8.17%), Information Technology (+7.09%) and Real Estate (+6.13%) were the top-performing sectors during the quarter. Higher crude oil prices and expectations for lower crude supply got Energy off to a strong start this year, but its sensitivity to global trade dynamics and crude prices tending to retreat with every renewed trade offensive weighed on performance. West Texas Intermediate Cushing Crude Oil began 2018 at $60.42 per barrel and ended Q2 at $74.15.

Thus far, tariff fears have not hit Consumer Discretionary, which notched a solid Q2 with help from online retail and streaming companies. Technology was strong as well, with the Internet and software subsectors driving performance.

Industrials (-3.18%), Financials (-3.16%), Consumer Staples (-1.54%) and Telecoms (-0.94%) were the only sectors with negative returns for Q2. The escalating trade conflict held Industrials back, which is not surprising given the sector’s linkages to all things trade.

As for Financials, the tightening spreads between intermediate and short-term Treasury yields hurt. Deregulation not being as significant as expected was a drag too. The rollback in Dodd Frank legislation helped small and mid-sized lenders and only increased competition among larger lenders that were not able to benefit from the deregulation.

Initially, Consumer Staples were hit hard by the trade concerns and changing consumer habits; in particular, tobacco sales were down and well short of expectations. However, as trade concerns escalated, the sector’s defensive characteristics proved beneficial. Merger activity weighed on Telecoms at the beginning of the quarter.

For the first half, Consumer Discretionary (+11.50%), Information Technology (+10.87%), Energy (+6.81%) and Health Care (+1.83%) led the way. Consumer Staples (-8.55%), Telecoms (-8.35%), Industrials (-4.69%), Financials (-4.09%) and Materials (-3.08%) performed the worst.

Fixed income: Muted performance amid Treasury yield swings

Subdued would be one way to describe fixed income performance. The Bloomberg Barclay U.S. Aggregate Bond Index returned -0.16% in Q2 and -1.62% in the first half. The 10-year U.S. Treasury went on something of a roller coaster ride; it started 2018 at 2.4%, ended Q1 at 2.74%, and breached the psychological 3% level in Q2 before closing Q2 at 2.85%.

The spread between the 10-year and the 2-year U.S. Treasury began the year at 0.51% and ended Q1 at 0.47% before retreating to 0.33% at the end of Q2. That contraction led to weakness in short-duration securities. The spread between the yield on Investment Grade Corporate bonds and the 10-year Treasury measured by the U.S. Corporate BBB/Baa -10 year Treasury Index increased from 1.29% at the start of the year to end Q1 at 1.44%. By Q2’s close, the spread had increased to 1.64%.

Elevated equity market volatility earlier in the year contributed to an increase in credit default swap spreads, which had an adverse effect on the Investment Grade Corporate spread. That spread rising beyond where it started 2018 resulted in Investment Grade Corporates being one of the worst performing fixed income segments in Q2 and for the first half of the year.

By segment, High Yield Corporates was a top performer in Q2 after struggling in Q1. Higher equity market volatility contributed to elevated spreads between High Yield and Investment Grade Corporates in Q1, but the spread tightened in Q2 and gave High Yield a boost.

Fixed Rate Preferreds performed well in Q2, while Variable Rate Preferreds lagged. Emerging market debt was the weakest fixed income segment in Q2 and in the first half, due in part to USD strength and global trade uncertainty. Local currency-denominated emerging market debt significantly underperformed USD-denominated emerging market debt in Q2 and for the first half of the year.

Category: Commentary

Topics: Macroeconomic

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