July 2, 2018
As we cross 2018’s halfway mark, several related themes have emerged that will likely continue to shape the investment landscape for the balance of the year. The strong U.S. economy continues to provide a foundation for the Federal Reserve’s path toward policy normalization. Robust earnings growth continues to buoy U.S. equities against the backdrop of agita-inducing geopolitical developments, although rising short-term interest rates and central bank balance sheet shrinkage will likely have the greatest ongoing influence on markets.
To be sure, the U.S. economy’s strength continues to provide a compelling backdrop for investors. In May, the unemployment rate ticked lower to a better-than-expected 3.8%, and is now approaching lows last seen in the 1960s. The same employment report also revealed a modest, but encouraging, 2.7% bump in wages over the prior year.
The manufacturing sector is benefiting from accelerating demand, as the 58.7% reading in May’s Institute for Supply Management (ISM) Manufacturing Index reflected broad strength in both new orders and backlogs. Anecdotally, survey respondents acknowledged concerns regarding the potential impact of tariffs and noted that higher costs will likely drive price increases in the second half of the year. May’s ISM Non-Manufacturing Index also showed strength, registering growth for the 100th consecutive month with a 58.6% reading. Fourteen of the 15 industries covered in the index also reported growth.
On June 28, the U.S. Bureau of Economic Analysis revised its reading of first-quarter Gross Domestic Product to reflect 2% annualized growth. The solid showing was supported by positive contributions in personal consumption as well as nonresidential fixed investments. The latter suggests that businesses are applying savings generated by the 2017 Tax Cuts and Jobs Act toward increases in capital expenditures. Moreover, the consensus forecast for 2Q annualized GDP growth is 3.4% as of June 30.
As discussed in Fiduciary Trust’s Q2 Market Outlook, there is a growing consensus that the U.S. is currently in the later innings of the economic cycle. This theme will likely serve as a leitmotif that will run through the capital markets until the cycle reaches its natural end.
To this point, the financial “commentariat” has started to focus on certain traits characterizing late-cycle behavior, particularly as lenders increase bank-loan issuance while credit-quality trends lower. As bank loan investor protections and underwriting standards decrease, valuations expand, and interest rates normalize, investors should consider rotating their credit exposure into investment-grade fixed income with shorter durations.
At its June meeting, the Federal Open Market Committee (FOMC) reflected the Fed’s confidence in the economy by raising the Fed Funds target short-term rate by 25 basis points (bps) to a range of 1.75% to 2%. The increase also came on the heels of the Consumer Price Index’s largest year-over-year jump since 2012 and speaks to the Fed’s efforts to temper inflationary pressures.
The FOMC meeting confirmed that the economy remains not only in fine form, but appears to be accelerating. Furthermore, inflation is moving closer to the central bank’s target 2% rate.
The 10-year Treasury yield eclipsed the psychologically important 3% threshold on multiple occasions in the second quarter, finishing the quarter at 2.85%. The flattening yield curve — another characteristic more common in the later innings of an economic cycle — raised some red flags for investors over the past three months. When the Fed began raising rates in December 2015, the spread between two- and 10-year Treasury notes was over 120 bps. During the second quarter, the spread narrowed and ended the quarter at 33 bps.
As the yield curve flattens, this typically reduces the ballast value of intermediate- and longer-dated bonds, a theme we discussed in last quarter’s Market Outlook. This was a contributing factor that influenced our decision to rotate into shorter-duration fixed income.
U.S. Equity Markets
Equity investors are well attuned to the impact of rising interest rates and the potential for the higher cost of capital to affect both consumer spending and corporate profits. In the second quarter, however, the S&P 500 reversed course, posting a solid gain of 3.4%. Volatility was also less pronounced compared to the first quarter, although lingering skittishness was evident in the reactions to rising bond yields.
Second quarter performance was ultimately an earnings story, as strong profits were a catalyst for equities across both large- and small-cap stocks. Among the S&P 500 companies reporting Q1 earnings over the past three months, 77% posted EPS higher than expected. Collectively, their earnings grew by an impressive 25%. Nine of the eleven S&P 500 sectors posted double-digit earnings growth, with the energy, materials, and technology sectors showing the most acceleration during the quarter. Current estimates ahead of the July reporting season are projecting second quarter year-over-year profit growth of 19%.1
Equally notable was the bullishness among small businesses, which account for roughly half of all private-sector jobs. The May Small Business Optimism Index released by the National Federation of Independent Businesses tracked record highs in earnings trends, and 62% of survey respondents signaled that they had made capital outlays on new equipment, vehicles, or facilities improvements. Despite some volatility in April, the Russell 2000 Small Cap Index posted a strong 7.8% gain on the quarter and remained largely shielded from the unsettling verbal volleys attendant in trade disputes. Trade discussions were a fixture of financial headlines during the quarter.
As earnings accelerate, valuations are beginning to appear less expensive. At quarter end, the forward 12-month price-to-earnings ratio of the S&P 500 stood at 16.2x, which is consistent with the 25-year average of 16x. Given the recent economic trends, we will be monitoring valuations closely, as inflationary pressures will generally have a gravitational effect on these ratios. Assuming that we may be entering a higher inflationary regime — which is not unexpected given the stimulus of December’s tax cuts — P/E ratios could contract.
While the Federal Reserve is trying to strike the right policy posture in the face of an accelerating economy, the European Central Bank (ECB) is contending with a decelerating economy, thanks in part to a rising euro which has clipped exports. The ECB signaled its intention to apply the brakes to its bond-buying program, but left interest rates untouched given the emergence of new risks ranging from political upheaval in Italy to June’s inconclusive and rancorous G7 meeting.
The G7 meeting, recently held in Quebec, underscored the growing trade rift after the U.S. imposed tariffs on steel and aluminum imports, which went into effect on June 1. IMF Managing Director Christine Lagarde noted that the escalation of trade tensions represents the global economy’s “biggest and darkest cloud.” Although Canada, Mexico, and the EU have promised retaliatory measures, it remains to be seen the extent to which other countries respond in kind. If what’s past is prologue, trade wars are conflicts without victors, as each side suffers losses as they jockey for advantage. Thankfully, the current state of trade tensions amounts to a skirmish rather than a war. If we are lucky, it will remain so.
Within the Eurozone, Italy’s political turmoil gave the continent one of its episodic existential frights. Following nearly three months in which the country was unable to form a coalition after its March election, the prospect of a snap election to resolve its hung parliament introduced new fears that a referendum vote could determine whether Italy remains in the EU. In June, however, Italian Finance Minister Giovanni Tria eased worries when he re-asserted Italy’s commitment to the euro. These fears were likely overblown, as a majority of Italians favor remaining in the Eurozone.
Even as these developments and rising oil prices chipped away at momentum, the global economy continued to expand, according to the Organization for Economic Cooperation and Development. Among the G7 economies, Germany, France, and Canada registered the fastest rate of real GDP growth in the first quarter. Japan, meanwhile, posted the slowest growth, and even saw its economy contract slightly. Across the broader G20, India again was the Q1 pacesetter among developing nations, followed closely by China.
While geopolitical tensions in the second quarter may have created more questions than answers, the June meeting between U.S. President Donald Trump and North Korean leader Kim Jong Un could set the stage for further negotiation toward denuclearization on the Korean peninsula. While this was welcome news in Asia, U.S. allies South Korea and Japan were taken by surprise by the U.S.’s concession to suspend military exercises with South Korea. It is still very early in the rapprochement of bi-lateral relations between the United States and North Korea, and is therefore too soon to be cheered by recent developments. The history of deals with North Korea is characterized by being rich with promise, but short on delivery.
As we move into the second half of the year, monetary policy will remain the focal point for investors, particularly as the Federal Reserve, ECB, and the Bank of England chart increasingly similar paths forward. It appears that the policy pivot of interest rate normalization is finally at hand. If the Fed becomes more aggressive in trying to counter inflation, a stronger dollar could have an outsized effect on emerging market (EM) economies.
Global Equity Markets
The global equity markets were generally down in the second quarter. The MSCI EAFE Index, which measures the international developed markets excluding the U.S. and Canada, finished the quarter down 1.2% The MSCI European Monetary Union Index, meanwhile, was weighed down by Italy’s uncertainty and lost 2.7% in the second quarter, while the MSCI Pacific Index finished Q2 down 1.4%. The dollar’s strength over the past three months has already impacted EM shares, as measured by the MSCI Emerging Markets Index, which fell 8.0% on the quarter. The MSCI EAFE index closed the quarter with a forward 12-month P/E ratio of 13.6x, while the MSCI Emerging Market Index ended June with a forward P/E ratio of 11.3x.
Europe’s economic slowdown should not be entirely surprising given the euro’s run against the dollar. Assuming trade tensions do not escalate further, the seeds are in place for a pickup in trade flows that will benefit European equities down the road. Indeed, Europe’s economic cycle appears roughly 12 to 18 months behind the U.S., so while near-term roadblocks remain, the European market likely has a longer runway than that of its American cousin.
Among EM stocks, investors are digesting parallel narratives. One is that while China’s GDP growth of 6.8% in the first quarter topped forecasts, observers expect a controlled deceleration as the government moves to manage risk and contain rising debt levels. Given China’s outsized influence on EM indices, this could weigh on EM equities for the balance of the year, particularly if the U.S. and China trade skirmish escalates into a trade war. The other narrative relates back to currency risk: if the U.S. economy continues to grow and the Fed becomes even more aggressive in normalizing monetary policy, EM countries with dollar-denominated financing will effectively face a higher debt burden.
As the market confronts several potential challenges ranging from ongoing trade negotiations to rising populist movements that influence geopolitical developments, the economy’s underlying strength should remain supportive of earnings. The wild card, however, will remain the extent to which central banks are able to normalize monetary policies. Over the medium- to longer-term time horizons, investors will also be tracking certain market characteristics that tend to reflect the later stages of a cycle, from the accelerating debt issuance to labor-market tightness’s impact on growth.
As always, we will continue to assess both the risks and opportunities that present themselves in the second half of the year to help our clients remain well positioned in this dynamic environment.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.