Quarterly Economic Review Second Quarter 2017
As the first half of 2017 comes to a close investors are faced with a shifting landscape that few would have predicated a year ago. A resurgence in Europe and emerging markets is driving a pick-up in global growth after years of U.S. dominance. Negative interest rates and deflation are in the rearview mirror in most countries. Global interest rates have moved higher as central banks debate how to unwind balance sheets built up to support monetary stimulus while minimizing disruption to the economy and bond markets.
Global stock markets soared during the quarter. Improving economies, stronger currencies and assets flows into global equity funds propelled international equity prices upward. While most U.S. stocks gained ground, a small group of large growth companies, many in the technology sector, surged. Energy stocks, hampered by the drop in oil prices and policy uncertainty amongst the major oil producing countries, were one of the few market segments to decline.
Although U.S. stock market volatility has been historically low, there was more instability beneath the surface of the broad markets. Overvaluation concerns and political news at times caused sharp reversals in high flying sectors such as technology and healthcare. Financial stocks underperformed but then rebounded. Although growth stocks dominated for the quarter, value stocks were at times strongly favored by investors.
After many years of a bull market, two traditional value sectors, energy and financials, were the only equity sectors with valuations below historical averages at quarter-end.
The fixed income markets have been difficult to navigate in recent months. The Federal Reserve raised short-term rates, resulting in a flatter yield curve, which is typical in an environment of tighter monetary policy. However, longer-term interest rates fell during the quarter, making the yield curve even flatter, and suggesting that the outlook for long-term growth and inflation has become more subdued.
Lower interest rates rewarded investors in longer-dated bonds and may be a positive for consumers who can benefit from lower mortgage and credit rates.
Like the stock market, the bond market saw rotations between sectors during the quarter. High yield bonds outperformed investment grade issues for the quarter but tighter credit spreads and increasing default rates are making the risk/reward trade-off less appealing and investors at times fled to the safety of high quality issuers.
Municipal bonds did well after a rebound in investor demand and a slowdown in new issuance. Overall state fundamentals are improving although inadequate financial cushions and unfunded pension obligations are problems with specific states such as Illinois and New Jersey. Global yields seem to have bottomed.
The global investing markets face a long list of economic and political risks. However, economic growth and corporate earnings have picked up. Currencies and most commodity prices have stabilized. Lower asset class correlations and higher return dispersion make diversification a powerful tool to protect portfolios from volatility.
Key Economic Fundamentals
Q1 U.S. economic growth was revised upward to a final reading of 1.4%. Q1 growth has historically come in lower than other quarters due to challenges in adjusting for seasonal variables. In the post-recession era, Q1 GDP growth has averaged 0.9% while growth in the other quarters has averaged 2.5%. IMF forecasts call for U.S. growth of 2.1% in both 2017 and 2018.
Though consumer spending was the largest contributor to Q1 GDP growth, it grew at its slowest pace since 2013. Fixed investment spending notched its best quarter since Q1 of 2012, but overall investment spending was dragged down by a large inventory draw. Net exports contributed positively on the heels of a weaker dollar.
Economic data proved increasingly soft relative to expectations in the United States in Q2, as the Citigroup U.S. Economic Surprise Index dropped to its lowest level since August 2011. Factors contributing to this slide were shortfalls in retail sales, job creation, and productivity. The European Index was postive in Q2, but generally trended down until a late-quarter uptick.
The U.S. dollarâ€™s downtrend continued in Q2, bringing its year-to-date drop to 5.2%. Even still, the dollar is widely considered one of the most overvalued currencies in the world. Dollar weakness should provide a tailwind for domestic multinational companies, emerging markets, and U.S investors with international exposure.
Leading economic indicators show a modestly positive trend in Europe. The uptrend in the U.S. that began in mid-2016 seems to have plateaued. Meanwhile, Chinese prospects have declined slightly in recent months. Not shown, Brazil and Russia continue to experience rapid improvement while Greece and Mexico have shown marked weakness.
Despite an improving economic environment in Europe, the U.S. is still expected to lead the way amongst advanced economies in the coming years. U.K. growth is anticipated to decline as political uncertainty looms and Brexit negotiations begin. Strong growth in India and China, and recoveries in Russia and Brazil, are expected to drive emerging markets.
The domestic labor market remains on solid footing. Payrolls continue to grow at a pace sufficient to absorb any remaining slack in the labor market, and the unemployment rate hit its lowest level in 16 years in May (4.3%). While job openings hit an all-time high in May, employers are having difficulty finding workers qualified to fill these positions due to a â€œskills mismatch.â€ Typically, such a tight labor market would lead to wage inflation, as employers are forced to offer increasingly attractive compensation to lure skilled workers away from their current positions. On the contrary, wage growth has been tepid, hovering around 2.5%, barely outpacing inflation. To be sure, the Federal Reserve will be watching wage growth closely as it charts the course for monetary policy.
U.S. consumers seem to be shrugging off significant uncertainty surrounding President Trumpâ€™s policy agenda, an array of geopolitical risks, the prospect of rising interest rates, and stretched valuations in financial markets. Focusing instead on continued strength in the housing and labor markets and a stock market near record highs, consumer confidence remains near a 16-year high. Household net worth continues to make record highs, growing 8.3% in Q1 to $94.8 trillion, 40% above pre-crisis levels. While most metrics indicate a very healthy consumer, warning signs do exist. Auto sales have registered five consecutive months of year-over-year declines, and the current pace is more than 10% below Decemberâ€™s apex. Nonetheless, sales remain above the 20-year average. The rapid rise in student debt, the second largest component of household debt behind mortgages, and relatively high delinquency rates are a growing concern. Increasing financial burdens on student borrowers could pose a headwind for the U.S. economy, with the potential to impact consumer spending, the housing and job markets, and ultimately, growth.
Business activity remains robust. The service economy notched its best quarter since Q3 2015 and its 90th consecutive month of growth. Manufacturing was strong as well, with the ISM Manufacturing Index hitting 57.8 in June, the second-best reading in five years. Recent strength in industrial production corroborates the upshot from the ISM reports. Importantly, capacity utilization picked up in Q2, indicating a decrease of slack in the industrial economy. As for corporate profits, S&P 500 earnings are expected to grow in the mid-to-high single digits in Q2 after increasing almost 14% in the first quarter, the fastest growth rate in six years.
Most housing market indicators trended sideways in Q2, albeit at relatively strong levels. Existing home sales remain near 10-year highs. Availability of homes is very constricted, and homes are coming off market at a record pace. Tight supply and strong demand have pushed the median sales price of existing homes to a record high, pricing some would-be buyers out of the market. As far as sentiment goes, the NAHB Housing Market Index shows builders have a positive outlook on market conditions. While housing starts remain at post-crisis highs, they are below long-term averages and well below highs seen in prior cycles. National home prices, as measured by the S&P/Case Shiller Home Price Index, have exhibited consistent year-over-year growth of between 5%-6% for the past 22 months. The index currently stands 4% below all-time highs.
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