Domestic equity markets posted solid gains in the second quarter of 2018 as strong corporate earnings and positive domestic economic data outweighed investor concerns over rising interest rates and the possibility of a global trade war. The S&P 500 index bounced back from a weak first quarter returning 3.4% during the second quarter, leaving the index up 2.6% year-to-date.
Small-cap stocks outperformed their large-cap counterparts, with the Russell 2000 index returning 7.8% during the second quarter. A generally lower dependency on global trade, a rising U.S. dollar, and increasing profitability from U.S. tax reform contributed to the small-cap rally. Within the small-cap asset category, value-oriented stocks outperformed growth-oriented stocks, while the opposite was true for large-cap stocks. The energy sector posted the largest gains during the quarter as oil prices increased sharply, followed by the consumer discretionary and technology sectors. On the other hand, trade sanctions and a flattening yield curve weighed heavily on the industrials and financials sectors, respectively, with each sector declining 3.2% during the quarter.
International equity markets generally underperformed during the second quarter of 2018, with losses for U.S. investors amplified by the strengthening U.S. dollar. Emerging markets suffered the most with the MSCI EM index falling 8.0% during the quarter. Outside of the U.S., the United Kingdom had one of the best performing markets, with the MSCI UK index gaining 3.0% due to a boost in UK exports and a further decline in the value of the British pound.
The Federal Open Market Committee (“FOMC”) lifted its federal funds’ target rate by 25 basis points to a range of 1.75% to 2.00% during its June meeting. Current market expectations are for two additional 25 basis point increases during 2018 and three more during 2019. The U.S. yield curve continued to flatten throughout the quarter, with the spread between 2- and 10-year yields
reaching its lowest point in over 10 years. The yield on the 10-year Treasury began the quarter at 2.74% and spiked to a high of 3.11% in May before finishing the quarter at 2.85%.
According to the initial estimate, gross domestic product (GDP) rose 4.1% during the second quarter, which is the highest rate since the third quarter of 2014. Robust consumer and business spending and a large increase in exports before the implementation of retaliatory tariffs helped boost growth. The global synchronized economic expansion continued during the second quarter, albeit at a slower pace, indicating that it may have entered maturity.
The unemployment rate fell to an 18-year low of 3.8% in May but rose to 4.0% in June as new entrants joined the labor force. The labor force participation rate ended the quarter where it started, at 62.9%. Another solid jobs report in June revealed the addition of 213,000 jobs during the month, with a welcome increase in professional and business services, as well as manufacturing jobs.
The year-over-year headline inflation rate increased from 2.4% to 2.9% during the quarter, with increases in gasoline, shelter and food costs identified as the largest contributors in the June report. During the same period, core inflation, which excludes food and energy, increased from 2.1% to 2.3%, with modest growth in a variety of areas contributing to the overall increase.
