Quarterly Economic Review Third Quarter 2016
Considering the capital market violence ushered in during the first half of 2016, investment returns through the end of the third quarter were nothing short of remarkable. All major asset classes, worldwide, delivered not only positive returns, but in some cases results in excess of even the most positive prognosticators. Moreover, investments previously shunned, questioned, or doubted by investors, such as commodities, emerging markets, and international bonds, delivered the strongest returns to those investors with globally diversified portfolios.
If the first and second quarters were distinguished by their volatility, the third quarter was notable for just the opposite. In July, bonds rallied on falling interest rates, and equity markets climbed a “wall of worry.” Yields on U.S. government 10-year and 30-year debt plumbed historic lows and U.S. stocks hit new all-time highs during the month. International gains were even more substantial.
August presented the lowest investment market volatility many investors have experienced in their lifetimes. The S&P 500 index traded within its tightest 30-day range since December 1965, and the yield on the 10-year U.S. Treasury note moved in its narrowest range in over a decade. Volatility levels such as these have only been seen a handful of times over the past half century.
Central banks stirred calm waters in September, but most investments fared well. The exceptions were higher yielding investments such as longer dated bonds, real estate, and some dividend focused strategies. Even these strategies experienced only modest declines.
Looking forward, U.S. economic fundamentals look reasonable. Labor markets continue to improve and the consumer is healthy. The housing market hit an air pocket in the second quarter and price gains have slowed, but interest rates are supportive and sentiment remains positive. Most believe data for the third quarter will show a nice acceleration in GDP growth and expectations call for an overall acceleration of economic growth in the second half of 2016. Analysts also expect the fourth quarter to show corporate earnings growth following six consecutive quarters of year-over-year declines.
Aside from the upcoming election, which will likely drive some market volatility, policymakers will be front and center for some time to come. The Federal Reserve has telegraphed a rate hike prior to year-end. Most investors expect this to take place at the group’s December meeting. Eyes will also be on the European Central Bank and the Bank of Japan. Recent actions by both organizations have underwhelmed investors, leaving many to wonder if they are running out of either the will, or the capacity, to do more. Meanwhile, as austerity falls by the wayside, it appears increasingly likely that the role of monetary policy will begin to diminish while nations increasingly turn to fiscal tools toÂ coax progress out of growthÂ challenged economies.
Key Economic Fundamentals
Annualized second quarter U.S. GDP growth of 1.4% proved surprisingly tepid against original expectations of 2.6%. Married with an even weaker first quarter, it was the nation’s slowest start to a year since 2011. Expectations call for faster growth in the second half of 2016, starting with a forecast of 3% in the third quarter.
Growing at its second fastest quarterly pace since the recession, personal consumption accounted for over 200% of Q2 growth! Government and investment spending were weak, housing investment declined for the first time since early 2014, and inventories outright contracted for only the second time dating back to 2010.
Long-term economic growth is a function of labor force growth and worker productivity. In addition to unfavorable demographic trends in the U.S., tepid post-crisis growth stems from the stunning decline in productivity shown to the left. Government policies, regulation, and business investment are all highly impactful to productivity.
Relative to previous periods, forecasts of economic results proved fairly accurate in the third quarter. If anything, actual results for both the U.S. and Europe generally exceeded expectations for the first time this year. Favorable investment outcomes and lower market volatility resulted.
The dollar’s strengthening in recent years has given way to stabilization, if not weakness, in 2016. The change in trend has been a welcome respite for manufacturers, multinational companies, U.S. policymakers, and globally diversified investors.
Economic growth in the three largest economies (Euro zone, U.S., and China) has slowed this year, as expected. Forecasts of a net deceleration in advanced economies has generally been offset by emerging nations. Strong and accelerating growth in India, as well as “less bad” results out of Russia and Brazil, have been key drivers.
Aside from an aberrant result in May, the U.S. labor market continues to improve. Net payroll growth, while somewhat slower than last year, continues to exceed the pace of population expansion. Workers are more mobile, willing to leave jobs for better opportunities, while employers are reluctant to let workers go. Labor market slack has diminished and the percentage of individuals participating in the labor force has bounced nicely off of the low set at this time last year. A stable unemployment rate, at the Federal Reserve’s target, has resulted. Importantly, wage gains have accelerated as well. The growth rate of nominal wage gains has accelerated over the past year, and inflation adjusted wage contraction from years ago has reversed to expansion in recent periods. Considering these improvements, and the increasing potential for wage related inflationary pressures, the Federal Reserve is expected to raise interest rates before year end.
Low interest rates, more jobs, higher wages, cheap gasoline, and a new all-time high in household wealth have all contributed to the U.S. consumer remaining resilient and confident. September marked the highest post-recession level of consumer confidence, and second quarter personal consumption expenditures grew at nearly the fastest pace of this recovery. Despite the positives, it is notable that consumer spending and retail sales have been soft in recent months. Likewise, auto sales have posted year-over-year declines in five of the past seven months. It remains to be seen whether these trends are simply election year jitters or something more ominous.
As shown by the ISM graph on the following page, business activity has slowed and become somewhat more erratic. Over the past year, manufacturing has vacillated between expansion and contraction, and the service sector is less vibrant this year than last. Industrial production has been in decline for nearly two years and capacity utilization, while possibly stabilizing, shows no signs yet of improvement.
Along with the consumer, housing has been a pillar of U.S. economic strength in recent years. That said, recent data suggests a somewhat murkier outlook for housing. Investment in residential housing cratered in the second quarter, becoming an actual drag on GDP growth for the first time in over two years. Housing price gains are slowing as well. Half of the nation’s real estate markets have experienced falling prices since May, and year-over-year price gains have been trending lower throughout 2016. Despite the negatives, home builder sentiment â€” a reliable leading indicator â€” hit another new post-crisis high in September. Likewise, mortgage rates have fallen throughout 2016 to the lowest level since May 2013. In short, the jury is still out on housing. Considering the segment’s economic importance, developments bear watching.
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This commentary was written by Robert W. Lamberti, CFA, VP and Co-Chief Investment Officer of 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.â€™s affiliate Summit Financial Resources, Inc. Sources of Performance: MorningstarÂ®. 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.