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  • Stocks advanced despite heightened trade tensions.
  • Economic growth accelerated during the quarter.
  • Corporate profits are expected to increase an impressive 20% this year.
  • Facts vs. Fears.
  • Via Nova’s outlook for the stock market remains positive based on facts, but ongoing fears remain a concern.

Stocks advanced despite heightened trade tensions.

U.S. stocks posted solid gains in the second quarter, despite another interest rate hike from the Federal Reserve and heightened trade tensions.  The S&P 500 gained 3.43% paced by a rebound in the energy sector and continued strength in consumer and technology stocks.  On the negative side, industrials bore the brunt of trade fears and a stronger dollar, while financials struggled with narrowing interest rate spreads.  The clear winners in the second quarter were small cap stocks, which benefited from a stronger economy and are typically less impacted by export turbulence and currency movements.  The Russell 2000 small cap index rose an impressive 7.75%. 

While trade headlines dominated the domestic news, the more export-dependent international and emerging markets were hit even harder by the volatility.  In contrast to the gains in U.S. markets, the two major international stock indices fell in the second quarter.  The MSCI Developed Markets Index fell -2.37%, and the MSCI Emerging Markets Index lost -7.86%, underperforming the S&P 500 by significant amounts.  The 5.05% rise in the value of the dollar also lowered international returns, since a higher dollar lowers the price and return of non-dollar securities.

A gradual rise in bond yields lowered bond prices and pushed the broad Bloomberg Barclays Aggregate Index down a modest -0.17% for the quarter.  However, narrower credit spreads helped lift both investment grade and high yield bond performance marginally.  In other markets, oil prices soared over 14% on lower inventories and expectations of lower supply in Iran, Libya and Venezuela.  The higher oil prices were positive for energy companies, but also renewed upward pressure on inflation.  The value of Treasury Inflation Protected Securities (TIPS) rose on the higher inflation pressures.  However, gold prices, a historically effective inflation hedge, fell over 5%.

Economic Growth accelerated during the quarter.

The pace of U.S. economic growth accelerated during the second quarter supported by higher employment, a lower unemployment rate, faster growth in consumer income and spending as well as increased manufacturing output.  Consumer and business confidence also hovered near record levels, despite trade fears.  The Atlanta Fed’s GDPNow measure currently projects healthy second quarter growth of over 3½%.  Inflation pressures, however, appear to be on the rise.  The key measures of inflation tracked by the Federal Reserve rose to their target 2% level following years of underperformance.

The improving economic backdrop and firming inflation pressures were cited by the Federal Reserve in their decision to raise short term interest rates again at their June meeting.  Moreover, the combination of healthy economic growth and a tightening labor market, boosted by federal tax cuts and spending increases, prompted the Fed to raise the total number of projected rate hikes this year from three to four.  The Fed is committed to normalizing monetary policy following years of near zero interest rates and massive bond purchases.

Corporate profits are expected to increase an impressive 20% this year.

S&P 500 earnings rose an remarkable 24.8% in the first quarter on higher revenue and profit margins, according to FactSet Research.  Second quarter earnings are estimated to increase 20.7%, and full year 2018 profits are forecasted to rise 20%.  Full year profit growth in 2018 could be even higher if companies beat analysts’ estimates, which often occurs.

However, the strong earnings growth has not been fully reflected in stock prices.  The S&P 500 Index price to projected earnings ratio (Forward PE) was just 16.1 times at the end of the quarter, which was below the average over the past five years.  Stock valuations are certainly not low by historical standards, but it appears that market concerns about international trade has had a dampening effect on stock prices in the second quarter.

Facts vs. Fears.

An ongoing theme in our commentary has been the battle between facts and fears.  The facts are what we know, and the fears are negative events that could happen in the future.

The facts are a strengthening economy with increased employment, earnings and spending which is helping to fuel impressive sales and earnings growth for companies.  We believe these are powerful and persuasive facts that support higher equity prices.

There are two main fears in the market at present.  The first is that the Federal Reserve may see a need to raise interest rates more aggressively in the coming months and possibly short-circuit the expansion that began in 2009.  The second fear is that the President’s current efforts to renegotiate international trade agreements to more favorable terms for the U.S. may blow up and cause an international trade war which would be a significant negative for global growth.

Via Nova’s outlook for the stock market remains positive based on facts, but ongoing fears remain a concern.

Via Nova remains positive on the economy and the equity markets in the second half of 2018.  The economy is relatively strong and healthy.  The risks of recession are very low at present suggesting a favorable environment for corporate sales and earnings growth in the coming quarters and firm support for stock prices.  However, the fears of excessive monetary tightening and a possible trade war have cast a cloud of doubt over an otherwise positive outlook.

Our most likely scenario is that the Federal Reserve will not raise interest rates too rapidly and short-circuit the current expansion.  Interest rates are still historically low, and borrowers are still able to obtain loans.  While the Fed could make a policy mistake, we do not see it as likely at this point.  Still, we believe interest rates are heading higher, and so we favor stocks over bonds.

We also believe that a global trade war is unlikely.  Markets often extrapolate negative initial events to a dire conclusion.  We believe that is the case here, as it would be negative for all parties.  Still, we are monitoring events closely for signs of notable deterioration.

However, we also believe these fears will not magically disappear overnight, but rather will linger unresolved for a least a few more months if not longer.  The Federal Reserve’s policy decisions will reflect the evolution of economic data, both positive and negative, and they have a history of reaching consensus only after considerable analysis.  On the trade front, international negotiations tend to move forward at a glacial pace often measured in years.  While the Trump administration’s aggressive tactics may add a sense of urgency to the discussions, we believe that significant progress is unlikely for at least several months if not longer.  If these fears linger as we expect, companies with significant international exposure would likely remain vulnerable, while small cap and domestically oriented firms will benefit from a more predictable environment.  Also, international markets could continue to underperform during this time, particularly if the value of the dollar rises as it often does during periods of uncertainty.

We believe the facts of a healthy economy and strong earnings growth justify a bias in favor of equities and away from bonds. However, less accommodative central bank policies and the potential for a trade war are tangible threats to an otherwise positive outlook.  Caution, not fear, is warranted.