Second Quarter, 2018 - Market ReviewSubmitted by Karstens Investments on August 14th, 2018
Michael Karstens, CFP, AIFA
For the most part, the second quarter could be characterized as a tug-of-war between corporate profits and political concerns. According to Factset, earnings for the S&P 500 as a whole rose 24.6% for the second quarter relative to the first quarter of 2017. Steep cuts in corporate tax rates drove most of the gain, but economic growth remained strong as well. On the flipside, political tensions remain high, and markets seem concerned about the potential tariff situation and possible trade wars. For the quarter, US stocks recorded decent gains, although the gains were not evenly mixed. The Russell 2000 index of small stocks was one of the top performers, gaining 7.75% for the quarter. The Russell is up 7.66% year to date. The technology-driven NASDAQ also performed well, gaining 6.33% for the quarter (8.79% year to date). Interestingly, the NASDAQ gains were fueled by the FANG stocks; Facebook, Amazon, Netflix, Google/Alphabet, while some of the other technology stocks posted losses. The Dow Jones Industrial Average lagged as escalated trade worries have depressed many industrial-type stocks. For the quarter, the Dow Jones was up 1.2%, and is virtually flat for the year. International stocks did not fare as well, with the EAFE down 1%, Japan down 3%, and emerging markets were down 7.86%. All of these indexes are now down for the year.
Looking ahead, it is hard not to feel bombarded with worrisome news regarding the market. We are constantly reminded that the current bull market is now 9 years old and one of the longest bull markets in history. All the while, stock prices are trading near all-time highs, government money printing is slowing, interest rates are rising, the geopolitical situation is dismal and budget deficits are out of control. Since it is difficult to argue against many of these points, one may ask, “Why own stocks in this environment?” The answer in one word may simply be, “Inflation.”
Many of you will recall the inflationary era of the 1970s. For those of you who don’t, inflation spiked to 13% per year and interest rates rocketed to 16%. Imagine purchasing a house today with a 16% mortgage rate. A $300,000 house today, assuming a 3.5% mortgage rate, sports a mortgage payment of $1,350 per month. At a 16% mortgage rate, this payment would skyrocket to $4,034 per month. In response to the double-digit inflation rate, the Federal Reserve Reform Act was passed in 1977 with a stated goal of stable prices. The following year, the Humphrey Hawkins Act was enacted. This law promoted full employment, balanced growth, productivity, and reasonable price stability. The five-year stated goal (for 1984) was an unemployment rate of 3% and an inflation rate of not more than 3%. By 1988, the 10th anniversary of the Act, the government was to achieve “a rate of inflation of 0% per annum.” That was the law then and presumably still is today. Despite this, Japan, Europe and the United States have all seemed to set an inflation target of 2%. Their objective is clearly higher prices which results in lower purchasing power of paper money.
So, what is inflation? When you see the term inflation in the newspaper, it refers to a change in the consumer price index (CPI), which tracks the cost of goods and services typically purchased by consumers. This government figure is good for measuring economic activity for the country at large but does little for individuals who consume based on their age, lifestyle and where they live compared to typical consumers. If you spend a lot on goods and services with high inflation rates, such as college and medical expenses, the CPI significantly understates the impact that inflation is having on you.
So how much does inflation erode purchasing power? Most consumers don’t understand how damaging inflation can be to their purchasing power over a long period of time. One dollar today simply doesn’t buy as much as it did in 1970 and will buy even less 30 years from now. If you long for the days when you could buy a Coke for a nickel, you know exactly what we’re talking about. Inflation has averaged about 3% annually from 1926 to 2016. 3% may not seem like much, but it can significantly erode your purchasing power over a longer time horizon. Take for example the impact that a 3% inflation rate has on a fixed annual income of $100,000 over a typical 30-year retirement. As the chart on page one demonstrates, your money would be worth 14% less in five years, and in 30 years, the purchasing power of your income would be reduced nearly 60% to $40,101. There’s a chance that the rate of inflation you will experience in retirement might exceed the long-term 3% average, simply because goods and services that you will be purchasing won’t resemble what the typical consumer is buying in the CPI index. Medical expenses are likely to be a significantly higher portion of your overall spending.
What asset classes keep pace with inflation over the long run? Despite the risk inflation can pose to retirement savings, the natural tendency for many retirees is to protect their assets by investing conservatively. Their portfolios are largely allocated to bonds, cash, and CDs with minimal exposure to stocks. History shows, however, that of these asset classes, stocks were the only one to provide significant growth after accounting for inflation. The graph below illustrates the annual returns for stocks, bonds, and cash from 1926, before and after inflation. Government bonds returned very little after inflation. Cash fared even worse. That said, you may be hard pressed to meet income needs over a 30-year retirement if your portfolio is invested primarily in bonds and cash.
In conclusion, cash and bonds may not offer great protection against inflation but they do provide some ballast to a portfolio during times of economic or stock market turmoil. Stocks on the other hand, despite their fluctuations, have provided solid protection against rising inflation over the years and we won’t be surprised if over the long run this continues to be the case. Unfortunately, it probably will not be a smooth ride.