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Second Quarter in U.S. Stock Funds: Will Tariffs Derail This Market?

As trade barriers go up, so do U.S. equities--for now.

U.S. stocks showed some resilience in the second quarter, even as tariffs moved from rhetoric to reality.

The United States, China, the European Union, and others began erecting trade barriers during the quarter, causing investors to question the prospects for many multinational large-cap companies. Even so, the S&P 500 rose a modest 3.4% through June 28, 2018, led by growth stocks such as  Facebook (FB), which rebounded from the Cambridge Analytica sell-off, and  Netflix (NFLX), whose stock price has nearly doubled for the year to date. These giant caps diluted the impact of smaller index constituents such as  Harley-Davidson (HOG), which gave back all of its June gains on the news that it is shifting some production overseas to skirt tariffs.

Given the international trade disputes, investors looked to small-cap stocks, which typically do the bulk of their business in the still-strong stateside economy. The Russell 2000 Index jumped 7.9%, enjoying a relatively steady rise since early May even as trade tensions mounted. For the first time since the fourth quarter of 2016, value equities led the small-cap rally. Rising oil prices pushed energy stocks higher, and investors gobbled up U.S.-focused consumer defensives such as  Boston Beer (SAM) and  Performance Food Group (PFGC) as they sought relief from the trade turmoil.    

Winners
 Champlain Small Company's (CIPSX) valuation discipline and higher-quality bias helped it weather the quarter's choppier market conditions while positioning it well for the small-cap rally. It sailed to an 11.7% gain, landing in the top quintile of its small-growth Morningstar Category. Although manager Scott Brayman and his team aren't shy about investing in growth sectors like technology and healthcare, their attention to valuations led them to opportunities in consumer defensives. The fund's overweighting in that sector gave it an edge during the quarter, with Boston Beer and Treehouse Foods (THS) among its top contributors.

While small-cap funds posted some of the second quarter's best absolute returns in the Morningstar 500 (a list of funds in the Morningstar FundInvestor newsletter that meet or clear some fundamental hurdles),  Touchstone Sands Capital Select Growth (PTSGX) was a notable exception, rising 10.1%. This highly concentrated fund of 25-30 large-cap stocks loads up on technology, consumer cyclicals, and healthcare companies. This risky stance paid off during the quarter as the fund scored with big bets on  Amazon.com  (AMZN), Netflix, and Facebook. Manager Frank Sands, Jr. also found a diamond in the rough with Loxo Oncology (LOXO), which spiked on positive drug-trial results. 

 Hotchkis & Wiley Mid-Cap Value (HWMAX) benefited from improving oil prices in 2018's first half. It rose 7.9% in the second quarter on the back of its 25% stake in energy stocks--nearly 3 times the mid-value category average. The fund's top holding as of April 2018, Whiting Petroleum (WLL), has doubled since the start of the year. Lead manager Stan Majcher's deep-value process also opens the portfolio to smaller-caps and non-U.S. stocks, with The GEO Group (GEO) (a REIT) and  Ericsson (ERIC) performing well in those respective segments.

Losers
Trade tensions, an appreciating U.S. dollar, and another interest-rate hike by the U.S. Federal Reserve were a triple whammy for funds invested in emerging markets. The pain was particularly acute at  Lazard Emerging Markets Equity (LZOEX). The fund fell 15% during the second quarter, ranking among the worst in its diversified emerging-markets category. It suffered from having more exposure to Brazil than its benchmark, the MSCI Emerging Markets Index. Four of its top 20 holdings as of March 2018 were Brazil-based, including Banco do Brasil, Cielo, and  Ambev (ABEV)--each of which weighed heavily on performance during the period.   

 Matthews Emerging Asia (MEASX) dropped 11.2% in the quarter, but the culprit wasn't the U.S.-China sparring over tariffs that hurt many Chinese stocks. Unlike its MSCI Emerging Asia Index benchmark, the fund has little exposure to China; instead, it tilts strongly toward frontier markets such as Vietnam, Pakistan, Bangladesh, and Sri Lanka. Stocks in all four countries cooled off during the quarter (or, in the case of Sri Lanka, continued its year-to-date slide). Two jewelers were among the fund's top detractors in the second quarter: India-based PC Jeweller and Vietnam-based Phu Nhuan Jewelry.

 Dodge & Cox International Stock (DODFX) suffered another bout of underperformance at the hands of its emerging-markets holdings. The same thing happened in 2015 when its picks in developing countries languished. In 2018's second quarter, the fund sank 6.3% and didn't fare well with its financial-services names, which made up about a third of the portfolio. Political upheavals in Brazil and Italy upset top-10 holdings Itau Unibanco Holding and UniCredit SpA, respectively. Another top holding, Petrobras, lost its CEO and a third of its value in the wake of a Brazilian truckers' strike. 

For all category returns through the previous day, visit the Fund Category Performance page

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Tony Thomas has a position in the following securities mentioned above: DODFX. Find out about Morningstar’s editorial policies.