The game of tug of war elicits images of schoolyard battles and Fourth of July family picnics. Images of teams pitted against each other in a clash of strength and will with little more at stake than bragging rights, but battling with the effort afforded a life-or-death encounter. However, it is really an engagement that lasts for only a few minutes with no real consequences attached. Just good, light hearted fun. Of course, it hasn’t always been that way. From 1900-1920 it was an Olympic sport and has been around far longer. While the origins of tug of war are uncertain, the sport was apparently practiced in ancient Egypt, Greece, and China, where it was held in legend that the sun and moon played tug of war over the light and darkness. The kind of tug of war going on in today’s global economy isn’t quite as profound as a power struggle between light and dark, good and evil, but it does have implications for investors and savers across the globe.
Global economies and markets appear to now be playing their own form of this ancient game. Pulling on one side of the rope we have Team Continued Economic Growth, anchored by record corporate earnings in the United States and sustainable momentum for double-digit profit growth. Pulling on the other side of the rope we have Team Inflation and the growing concerns that central banks could choke off growth and push economies into recession as they raise rates to stave off inflation and normalize policy. Also tugging on that side of the rope are anxieties over increased tariff rhetoric and the potential fallout from trade wars. Elevated trade concern is creating doubt in the market that team economic growth can continue its current trajectory. As everyone knows, confidence, not doubt, is critical in any battle of strength. And trade wars and political uncertainty are sowing the seeds of doubt in the economic growth team just as it appeared ready to win the war.
The U.S. jobs picture continues to reflect favorably on the growth story. Job growth continues while wage growth remains largely subdued as the much anticipated return of long-term displaced workers begins. The unemployment rate, in fact, has ticked back up as more and more workers return to the labor force after previously removing themselves from the job market. Over the course of the recovery many felt that unemployment figures were artificially low because so many disgruntled workers had given up looking for work, suppressing the workforce participation rate. It was felt that if the economy heated up for long enough many of these workers would return helping keep a cap on wage growth (and therefore inflation). It appears that that is finally occurring. It is like a few more people have joined one side of the tug of war game well after it started.
Often forgotten in the game is the third participant—the referee. While not actively pulling in either direction, the referee is a critical judge in the outcome. In this scenario, the referee is represented by global stock and bond markets.
In the second quarter, U.S. stocks were pulled higher by powerful corporate profit growth. Small cap stocks, as represented by the Russell 2000 Index, gained 7.8% in the period while large cap stocks leapt up by a more modest (but still very respectable) 3.6%. Unfortunately, international stocks did not fare so well in the quarter as the tug of slowing economic growth and trade war uncertainty muddied up the story for non-U.S. stocks. For the quarter, the MSCI EAFE Index of developed non-U.S. stocks dropped 1.2% while emerging markets equities plummeted almost 8% thanks to a big rally in the U.S. dollar, which muscled higher due to strong U.S. economic growth and rising interest rates.
In the United Stated, energy stocks stole the limelight from the technology sector and produced the quarter’s best returns (up 13.5% vs a 7.1% gain for the technology sector) while financials and industrials lagged the field, losing 3.2% each for the quarter.
In fixed income, the core BarCap U.S. Aggregate Index slipped 16 basis points (bps) for the quarter as the bond market digested another rate hike by the U.S. Federal Reserve and is now down 1.6% through the first half of 2018. While U.S. government bonds have been pulled down by rate hikes and rising inflation, corporate debt has hung in, with high yield bonds gaining 1% for the quarter and high-grade corporate squeezing out a few bps of return, pushed higher by investors cheering U.S. economic growth. On the other hand, global bonds, like stocks, got pulled lower for the quarter. The Global ex-U.S. Agg Index fell 4.75% for the quarter as EM debt and Italian bonds struggled in the period.
As we head into the second half of the year it appears Team Economic Growth has the slight edge in the contest but the war is far from over. If Team Inflation catches its second wind or the Team Economic Growth starts to wear down and lose its strength, it could be a quick reversal. More likely the battle will last throughout the balance of the year and beyond. And when this tug of war ends there will be new combatants pulling investors this way and that. Therefore, its best for investors to hedge for either outcome and remain diversified.