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2019 Interest rates and inflation shouldn’t represent a serious roadblock to equities.
Economic and corporate earnings fundamentals have remained relatively positive over the past few months amid increasing volatility; many stocks have entered correction territory. Investor concerns have grown as a number of issues remain unclear; trade talks, oil price declines, strengthening (U.S.) dollar and unresolved monetary policy. The year 2018 is almost in the rear-view mirror, but significant events over the last 12 months will continue to shape economic outcomes.
On the whole, we think the global economy is expanding and reasonably solid, but recent trade conflict presents a significant and serious threat.
U.S. stocks ended the week slightly lower after reaching new all-time highs last week, with the S&P 500 Index dropping 0.5%. Materials, financials and consumer staples were among the biggest detractors, while telecom, health care and technology moved higher. U.S. Treasury prices and the dollar also advanced and oil prices ended the week up 3% amid growing concerns over tightening supply as a result of U.S. sanctions on exports from Iran.
Vicissitudes in the market should not come as a surprise, equity prices simply don’t move in linear fashion. However, we are entering the fourth quarter (when markets typically post the strongest returns of the year). In theory, investors can breathe a sigh of relief during this time of year. We are not postulating a linear move higher heading into year-end, but we have analyzed data collected on S&P 500 performance from 1980-2017. The way we see it, the final quarter of the year has generated average gains of 4.59%, compared to gains of 2.34%, 2.67% and 0.3% for 1Q, 2Q and 3Q, respectively.
Stocks prices continued moving higher last week as if to say a somewhat disappointing July jobs report and ongoing trade-related tensions between the U.S. and China are not a serious threat, yet. The Dow Jones Industrial Average and the S&P 500 both climbed 0.5%, while the Nasdaq Composite inched up 0.1%. Second-quarter earnings were mostly above expectations and provided much of the direction for the week. The biggest market story, however, was the sharp rebound in tech stocks following a selloff the prior week. The momentum pushed Apple’s market capitalization to an unprecedented $1 trillion.
Friday’s jobs (non-farm) report showed that the U.S. economy generated 157,000 positions in July, well below the consensus forecast of 190,000. Moreover, the latest numbers are significantly lower than the six-month average of 219,000. The unemployment rate also ticked lower, to 3.9%, while wage growth held steady at a 2.7% annual rate. Looking under the hood, jobs were most plentiful in manufacturing, healthcare, and professional and business services. Overall, the headline jobs number, while weaker than in recent months, appears reasonable at this stage of the economic cycle. As the Federal Reserve meets this week in Jackson Hole, we are anticipating plenty of discussion about the economy’s potential for employment growth. We also expect two more rate hikes in 2018.
Last week brought modest gains for stocks and volume was underwhelming. The Dow Jones Industrial Average rose 0.4% and the S&P 500 increased 0.1%, while the Nasdaq Composite was flat. Trade-war concerns surfaced again mid-week, as the Trump administration issued a new list of tariffs on $200 billion of Chinese goods, but the market was largely in rally mode ahead of second-quarter earnings. The Dow climbed 2.3%, the Nasdaq was up 1.8%, and the S&P 500 increased 1.5%. Year-to-date, the S&P 500 is up 4.8% and the Dow has also turned positive with a 1.2% rise.
The 10-year Treasury yield ended Friday at 2.83% and remains range bound. Last week’s economic news was mixed and included a modest decline in the small business confidence index for June from May’s strong reading. Finding qualified workers appears to be the culprit for lower optimism. The consumer price index moved higher by 0.1% in June and is now at 2.9% over the past year. Medical care and autos were among the largest gainers while housing costs were flat and energy prices moved lower. The takeaway, however, is that the inflation is running warmer than the Fed would like and it has justification to pursue its continuing rate hike campaign.
Stocks spent much of Friday in recovery mode following weakness on global trade concerns as President Trump said he would impose tariffs up to $50 billion on goods from China. According to officials in Washington, China’s theft of intellectual property and technology and other unfair trade practices reignited Trump’s promise to inflict heavy tariffs. Markets opened deep in the red on Monday amid lingering trade tensions between the two largest economies in the world.
The long-term effect of tariffs is nebulous and full of speculation. On the other hand, Treasury bond yields are presenting a compelling case as they rose sharply in recent weeks on stronger-than-expected U.S. economic data. In contrast, corporate bond yields have not risen as fast — so spreads between corporate and Treasury bond yields have narrowed. The spread between AAA-rated corporate bonds and 10-year government bonds in May was 102 basis points, well below the 35-year average of 123 bps. The gap between the government 10-year bond yield and a BAA-rated bond in May was 185 basis points, also below the historical average spread of 233 bps. These spreads help us gauge the bond market’s view of corporate financial strength. Based on this premise, corporate balance sheets look solid, but corporate bonds are not as favorable to investors. From an investment standpoint, we are favoring inflation-protected securities and shorter-duration Treasuries.
Every week brings new developments that grab the attention of investors. Political and economic developments dominated headlines last week, and, in general, most investors focused on the positives. President Trump announced our withdrawal from the Iranian nuclear accord and renewed sanctions on that country’s oil exports, sending oil prices to their highest levels in 3 years. Crude has remained in a solid uptrend, supported by rising global demand, adherence by OPEC countries to production cuts, and trouble with Venezuelan exports. It is plausible that we have returned to the risk-on trade and volatility has retreated, for now. The S&P 500 Index jumped 2.5% for the week with energy, financials, technology and industrials all climbing more than 3%.
Interest rates are also making headlines as the 10-year Treasury yield ended Friday at 2.97% and climbed above 3.00% on Monday. Rising interest rates suggest inflation but Thursday’s consumer price index came in below-consensus for April and likely alleviated fears of inflation concerns. This was one more catalyst for the recent stock rally. Markets have been sensitive to inflation readings while looking for direction on whether the Fed is likely to raise interest rates two or three more times in 2018. In spite of a slower than expected first quarter, we are anticipating a total of three interest rate increases during the current year. Supporting our thesis, the Atlanta Fed sees real GDP rising to 4% over the next few months. Inflation moved higher in the first quarter, but remains at a level that should not impede growth. Finally, Fed balance-sheet tightening is expected to accelerate later this year; unwinding the Fed’s bond supply began at just $10 billion per month in (2017) with plans to reach $50 billion per month by late 2018.
Investor confidence of late has been dented but looks to be (generally) holding up. This story may be one of rotation from sectors into areas that appear to have great opportunity. U.S. equities gave back their sizeable January inflows, but flows into non-U.S. developed market and emerging market (EM) equities have more than offset the loss. U.S. investment grade, EM debt and U.S. government bonds have attracted inflows.
For now, Investors remain focused on trade issues where tensions rose near the end of March. However, last week we saw conditions improve as Chinese officials indicated they may be open to negotiating resolutions. In theory, the Chinese government has signaled that it will make some concessions. Such a move would avoid any disruption in the global trade and afford President Trump a political win. Indeed, we see a full-blown trade war as unlikely.
Most people would like to see a gain of 21.6 percent on their annual statement. That was the annual return for the Standard & Poor (S&P) 500 Index during 2017. In general, U.S. stock indexes did quite well last year – and the year before, too. For instance, the S&P 500 Index was up 11.8 percent in 2016.1
While no one can invest directly in an index (many mutual fund companies offer index based fund options) recent returns make it easy to understand why U.S. stock markets have been popular with investors. Morningstar reported record amounts of money flowed into various types U.S. stock investments during 2017.2 Was this a result of the proverbial “herd mentality”? Whenever large numbers of investors are doing the same thing, we believe a prudent course of action is to step back, take a breath, and evaluate the situation. Here are two questions that investors should consider:
Friday’s bond market sell-off was likely precipitated by a strong non-farm payroll report for January which showed 200k new jobs as well as a positive December report. Adding to inflation concerns was the report’s reading on wages, which grew at an annual 2.9% rate. The Fed left interest rates unchanged after last week’s FOMC meeting, but their statement pointed to inflation risk in 2018. They also noted that consumer spending was “solid” (versus their former description of “moderate”).