Quarterly Economic Review: First Quarter 2018


After experiencing the euphoria of the best year in recent memory, investors were jolted back to reality in the first quarter of 2018. Inflationary signals, rising interest rates, trade tensions and other geopolitical risks added to idiosyncratic events related to privacy concerns and crypto currencies in provoking investor anxiety. Despite sharp moves up and down, most investing markets only moderately declined for the quarter. The U.S. dollar continued to weaken, boosting the returns of international investments.

While the global economy is expanding at a healthy pace, the momentum has slowed. Gains in manufacturing and trade, particularly in Europe and parts of Asia, are less robust and are threatened by new tariffs and a possible trade war between the U.S. and China. Both consumers and businesses have failed to bump up spending despite high confidence levels. The recovery in select emerging markets is reaching a more mature stage as the economies in countries such as Brazil and Russia stabilize.

In the U.S. stock market, growth stocks once again sharply outperformed value stocks, as fast-growing consumer and technology companies, despite short-term swings, were favored. Real estate companies and other high dividend stocks were rebuffed by investors as rising interest rates made fixed income relatively more attractive. Energy stocks, which have yet to benefit from the upswing in oil prices, also underperformed. The valuation of stocks from developed countries has become more attractive as price levels have fallen. Emerging markets, led by Brazil and China, sharply outperformed their more developed counterparts which show signs that earnings momentum is weakening.

The “re-inflation” theme that was a popular talking point amongst investors in 2016 has morphed into fears that inflation will rise too quickly and by too much, forcing central banks to take aggressive action. U.S. inflation appears to be trending upward on the back of wage gains and tight capacity. Dollar weakness, trade tariffs and tax cuts suggest rising pressures ahead. However, other than in China, inflation remains fairly modest in most parts of the world.

Most bond markets had a negative quarter due to both higher interest rates and tighter credit conditions. High quality short-term and international bonds were the only major markets to post gains. In the U.S., corporate debt is now 70% of GDP and leverage is historically high. Rising interest rates threaten to drive up the rate of defaults and downgrades when companies that are dependent on cheap credit find their profit margins squeezed.

The sudden reversals in the stock markets have once again highlighted the benefits of a diversified portfolio. High level macro decisions made by governments and investor sentiment, two factors that are very difficult to forecast, are driving relative investment performance. As always, maintaining a longer-term focus is the best way to achieve investment goals and objectives.

Economic Review

Key Economic Fundamentals

The U.S. registered economic growth of 2.9% in Q4 of 2017.  For the full year, real GDP increased 2.3%.  Expectations for near-term economic growth in the U.S. remain tepid, but have increased recently as a direct result of fiscal stimulus.  In fact, in January, the IMF increased their U.S. GDP forecast by 0.4% for 2018 and 0.6% for 2019.

2017 growth came in ahead of expectations for most advanced economies, while results were mixed relative to expectations for large emerging economies. Current estimates call for stable growth in the near-term for most major countries and regions.  Canada is expected to soften, while a rebound is expected in Brazil.  India and China are expected to continue to expand at a relatively rapid pace.

In October 2017, the Fed began unwinding its balance sheet, which ballooned to a high of $4.52T in Jan 2015.  After nearly 6 months of “quantitative tightening,” Fed assets are down 2.7% from the high.  The Fed has telegraphed its plan for balance sheet normalization to the markets.  The process will increase the supply of bonds, which may put upward pressure on rates.

As the Fed unwinds its balance sheet, it also continues to hike the Fed Funds target rate, thus tightening monetary policy from two angles.  The current target rate stands at 1.625% (1.50%-1.75%).  As shown to the left, markets indicate the most probable outcome is an additional two hikes this year to 2.125%, though Fed members are somewhat more hawkish.

Trade conflicts dominated headlines in Q1.  China, in an act of one-upmanship, answered Trump’s initial proposed tariffs with the threat of tariffs on over 100 U.S. products.  The aggressive back-and-forth posturing between the two nations has continued.  Tensions with Mexico have abated, as a NAFTA agreement seems increasingly likely.  Nonetheless, prospects for trade wars have stoked inflation fears.

Inflation metrics have generally been accelerating.  CPI and PPI both came in above 2% in Q1.  Although the Fed’s preferred inflation gauge (the PCE deflator) has also been heading upward, the trend is less stark, and the most recent reading was below 2%.  Recent Fed minutes revealed a growing consensus that inflation will be above the 2% target in 2018.

Employment

Labor market momentum from 2017 carried over into the first quarter of 2018, as payroll growth averaged a bit above 200,000 in Q1.  Weekly jobless claims came in below 300,000 for the 161st consecutive week, the longest streak since this metric first started being tracked in 1967!  Wage growth has generally hovered around 2.5% for over a year, but a modest upward trend is observable in the longer term.  Notably, the January wage number that fueled concerns of accelerating wage inflation and roiled markets when it was first reported at 2.9% was later revised lower, thus allaying fears that the Fed may need to be much more aggressive than anticipated in tightening monetary policy.  An unemployment rate of 4.1% has become old hat, as March was the sixth month at this historically very low level.

Consumer

Despite a turbulent stock market and rising interest rates, consumer sentiment remains buoyed by continued strength in the housing market and favorable labor market dynamics.  Also serving to buttress confidence is a 7.8% year over year increase in household net worth; households are richer than ever.  Auto sales, which make up about 3% of the country’s GDP, were unexpectedly strong in March, after experiencing negative year over year growth for much of last year and in January and February of 2018.  Expectations for a sustained rebound in autos should be tempered, however, as March’s strength was potentially attributable to large incentives and anticipation of higher borrowing costs.  While the savings rate edged higher in Q1, it remains very low by historical standards.  Investors are no longer “saving for a rainy day,” which could be a threat to future consumer spending.

Business Activity

Business activity remains strong, particularly in the manufacturing sector, as illustrated by the ISM graph below.  Capacity utilization has established a clear uptrend, ascending to a 3-year high.  More capital that was sitting idle is being put to work to meet rising demand.  If the pace of increase in utilization continues, the metric could reach 80 in 2018, the level which has historically been associated with inflationary bottlenecks.  Industrial production has accelerated in recent months, indicating healthy growth in the manufacturing, mining, and utilities industries.  While early analyst estimates typically overshoot, S&P 500 company earnings are anticipated to grow at a robust 25% clip in 2018 and 11% in 2019.  However, strength could be transitory as many of the benefits to corporations from the tax legislation phase out over time.

Real Estate

The housing market has been a pillar of economic strength of late.  Existing home sales remain near decade highs, despite the constraint of low supply and accelerating price growth.  Housing starts and new home sales paint a similar strong picture.  Home builders are feeling confident, particularly in the West, where activity is very robust.  Additionally, home prices have accelerated almost in a straight line since mid-2016.  It is noteworthy, however, that most housing data that has been released is somewhat delayed, reflecting activity in February, a month during which the interest rate on a conventional 30-year mortgage rose materially.  Mortgage rates ended the quarter around 4.45%, an increase of roughly one half of one percent as compared to year-end.  It will be interesting to see how housing metrics respond in the coming months, as the specter of higher rates begins to sink in.

Capital Markets Review

Returns

Equity Markets

Fixed Income Markets

Alternatives

 

Disclaimers: This commentary was written by Noreen Johnston, CFA, Director of Research and Daniel Cohen, CFA, Senior Investment Analyst at Summit Financial Resources, Inc. and Summit Equities, Inc., 4 Campus Drive, Parsippany, NJ 07054.  Tel. 973-285-3600, Fax: 973-285-3666.  Securities and Investment Advisory Services offered through Summit Equities, Inc. Member FINRA/SIPC, and Financial Planning Services offered through Summit Equities, Inc.’s affiliate Summit Financial Resources, Inc.  Sources of Performance: Morningstar®.  Indices are unmanaged and cannot be invested into directly.  The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity.  Standard & Poor’s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general.  The Wilshire 5000 Index is a market capitalization-weighted index of the market value of all stocks actively traded in the United States.  The index is intended to measure the performance of all U.S. traded public companies having readily available price data.  The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets.  Emerging markets are considered risky as they carry additional political, economic, and currency risks.  Real Estate Investment Trusts, REITs, are securities that invest in real estate directly, either through properties or mortgages.  REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints.  The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bond, Mortgage-backed bonds, corporate bonds, and some foreign bonds traded in the U.S.  Fund Category Performance is not inclusive of possible fund sales or redemption fees.  Investment grade bond analysis included bonds with ratings of AAA, AA, A, and BBB.  Municipal and Corporate Bonds are backed by the claims paying abilities of the issuer.  TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors.  Past performance does not guarantee future results.  Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market of other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information.  Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader.  Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance.  Consult your financial professional before making any investment decision. 20180419-369

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