Quarterly Economic Review: Second Quarter 2018


U.S. stock markets rallied in the second quarter even as other investing markets struggled. Robust corporate profits and a positive economic outlook overtook the headwind from rising interest rates. The U.S. dollar made a comeback against a broad range of currencies, paring back returns from international investments. Rising fears over trade wars and political turmoil in Europe also dampened enthusiasm for investments outside the U.S.

U.S. stock market returns were driven by a narrow range of growth stocks in the consumer and technology sectors and by energy stocks, which rebounded as energy prices spiked. Smaller companies, considered more resilient to the geopolitical risks outside the U.S., sharply outperformed larger companies. Small cap value stocks staged a resurgence, driven by double-digit returns from energy companies which make up a large portion of the value index. Another notable area of strength was real estate stocks, which had been rebuffed by investors earlier in the year due to their exposure to rising interest rates.

International stocks had a lackluster quarter, particularly emerging markets stocks which were most impacted by a stronger U.S. dollar and rising interest rates. Despite recent stock market performance, emerging markets continue to dominate global economic growth. By some measures, the U.S. dollar is now overvalued versus most other currencies. A reversal of recent currency trends would be positive for international investments.

Rising interest rates continued to batter the fixed income markets, but credit metrics were fairly stable over the quarter. The U.S. 10-year Treasury, the closely watched bellwether for economic growth and inflation, breached the 3% threshold. The yield curve flattened as the Fed once again raised short-term interest rates. Long-term rates only rose modestly, suggesting expectations for long-term growth are restrained. High yield and municipal bonds outperformed for the quarter. Despite lackluster returns, asset flows have at times favored high-quality, defensive fixed income investments, suggesting that investors are wary.

Fiscal stimulus from tax cuts and government spending has sparked an uptick in economic growth, corporate profits, and inflation in the U.S. At the same time, the Federal Reserve has taken steps to pull back on the unprecedented level of monetary stimulus supporting the economy and stock markets since the credit crisis. The long-term impact of these measures is uncertain. Inflation has reached the Fed’s 2% target despite limited wage pressure. The possibility of U.S. dollar weakness and supply disruptions resulting from escalating trade tensions are pushing inflation expectations upward.

Asset class diversification, including allocations to inflation-sensitive stocks and real assets, remains a powerful tool to protect investment portfolios from volatility and the erosion of purchasing power over time.

Key Economic Fundamentals

In the Commerce Department’s third estimate, Q1 U.S. economic growth was revised downward to an annualized pace of 2%.  As of this writing, the Atlanta Fed’s “GDPNow” estimate for second quarter growth is 4.5%. Most economists’ predictions range from 3.2% to 4.6%. For 2018 and 2019, the IMF predicts economic growth of 2.9% and 2.7%, respectively.

After a very strong showing in the fourth quarter of 2017, consumer spending in the first quarter of 2018 came in at its weakest level in five years. Investment spending spearheaded GDP growth in Q1, a phenomenon rarely seen, while government spending and net exports both had de minimis impacts.

Dollar weakness was a major theme in 2017, and it continued into the first quarter of 2018. That trend reversed sharply in Q2, as the dollar appreciated 5.6% versus a trade-weighted basket of foreign currencies.  Dollar strength was a major contributing factor to negative returns on international investments. The effect was most pronounced on EM stocks.

The Fed’s quantitative tightening efforts have resulted in a 5% reduction in its balance sheet from the January 2015 apex.  The Fed is now allowing $40B per month to “runoff.”  The target will jump to $50B in October, and will remain at that pace thereafter.  The process is expected to take 4-6 years. The target balance sheet size is expected to be $2.5T-$3.0T.

Leading economic indicators show a modestly negative trend for many of the world’s largest economies. This metric, designed to identify business cycle inflection points before they occur, portends modest deterioration in China, Japan, Germany, the U.K., France, and Canada. Meanwhile, India continues to show great strength while Brazil’s recovery continues to gain momentum.

Expectations for future growth in most large economies have risen marginally in recent quarters, despite escalating trade tensions. Economists’ outlook for the Euro Area has become significantly more positive as of late. India and China continue to power global growth; some estimate these two nations were responsible for nearly half of the growth in global GDP in 2017.

Employment

Amid the second-longest economic expansion in history, labor market strength continues apace.  Payrolls grew at an average rate above 200K for three quarters in a row, a feat that has only occurred twice since 2001.  Private payrolls have grown for 100 months straight, surpassing the next longest streak by 41 weeks!  While the unemployment rate ticked up from 3.8% to 4.0% in June, this was a result of 600K new people entering the labor force.  Job openings are just below record highs.  However, the skill set of workers seeking employment is not well-aligned with employers’ needs – a potential long-term concern.  Jobless claims remain historically low and the record duration below the important 300K level continues to extend with each week’s release.  Wage growth is trending higher, albeit slowly.  This bodes well for consumer spending, but could result in a more aggressive Fed if wage growth accelerates.

Consumer

U.S. consumers are benefitting from a strong labor market, a domestic equity market near all-time highs, increasing home values, and lower income taxes. Consumer confidence remains near a 16-year high. Despite losing momentum earlier in the year, retail sales have rebounded more recently, in part due to a strength in the auto sector. The most recent monthly retail sales figure came in 6.6% higher than last year. While this was the largest year-over-year increase in five years, a significant contributor to the strong reading was higher energy prices. Fuel costs could prove to be a pain point for the consumer down the road if prices remain elevated. At present, households are in a strong financial position. Household net worth continues to reach record highs, surpassing $100 trillion, 83% above the low point touched during the credit crisis. While most metrics indicate a very healthy consumer, the low Personal Saving Rate remains a concern. The metric has hovered between 2.4% and 3.8% for the past year and currently stands at 3.2%. These are levels last seen just prior to the Great Recession. Individuals are not “saving for a rainy day” and are thus more vulnerable should future economic turbulence materialize.

Business Activity

Both the service and manufacturing segments of the economy exhibited strong growth in the second quarter of 2018. ISM figures for both sectors remain well above 50, the crossover level that demarcates growth versus contraction. Industrial production growth has also been positive for sixteen months and has accelerated as of late. Businesses reported larger than anticipated demand in Q2, particularly from purchasers outside of the United States. Relatedly, suppliers are experiencing bottlenecks in delivering products to customers due to diminishing transportation capacity. This phenomenon is most apparent in trucking. This should be monitored closely, as transportation shortages can lead to an upward pressure on prices.

Real Estate

CAPITAL MARKETS REVIEW

Returns

Equity Markets

Fixed Income Markets

Alternatives

 

Disclaimers: This commentary was written by Daniel Cohen, CFA, Senior Investment Analyst and Noreen Johnston, CFA, Director of Research 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. 20180724-682

Download PDF