Stocks higher as summer begins. Will they hold through the dog days?

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  • Strong earnings, a healthy economy and reduced trade tensions buoyed stock prices in July.
  • Second quarter economic growth rebounded.
  • Second quarter earnings growth is tracking above 20% again.
  • Trade tensions rose, then fell as the U.S. appears to be shifting tactics.
  • Via Nova’s outlook remains positive, but near term, the dog days of summer may weigh on stocks particularly in a mid-term election year.

Strong earnings, a healthy economy and reduced trade tensions buoyed stock prices in July.

The S&P 500 rose an impressive 3.72% in July, supported by strong economic and earnings growth as well as a slight lessening in trade tensions.  Industrial, health care and financial stocks led the move higher, while the technology sector fell following a strong first half advance.  International stocks also rose, helped by the apparent pause in the escalation in international trade tensions, but lagged the S&P 500.  Small cap stocks posted a smaller advance in July but led the S&P 500 by 3% through seven months.

Bond yields edged higher over the month, and the yield on the 10-year Treasury note moved back close to 3%.  This yield increase weighed on Treasury bond returns, but narrower credit spreads, the difference between corporate and Treasury yields, mostly offset the loss in Treasuries, allowing a small gain in the Bloomberg Barclays Aggregate Bond Index.

In other markets, oil and gold prices fell, but real estate and Treasury Inflation Protection Securities (TIPS) gained.  The value of the dollar edged slightly lower but was up 2.67% year to date.  A stronger dollar reduces import costs but makes exports less competitive internationally.

Second quarter economic growth rebounded.

The economic picture remained healthy in the latest month punctuated by the 4.1% increase in second quarter real GDP.  The strong growth rate was nearly twice the 2.3% rate of growth in the current expansion, which began in mid-2009.  A pre-tariff surge in soybean exports increase provided a one-shot boost to the quarter, but that was largely offset by a comparable drop in inventories.  Overall, the second quarter was strong.  We believe the economy is on track to grow at least 3% in 2018 and will have positive momentum as we head into next year.  The Atlanta Fed’s GDPNow growth tracker currently estimates another 4% increase in the third quarter.

Second quarter earnings growth is tracking above 20% again.

The strength in the economy is helping companies generate increased sales and earnings.  Second quarter corporate profits are on track to rise 23.3% compared to a year ago following a 26.6% increase in the first quarter.  Revenues (sales) are estimated to increase 8.7%, and margins are holding at cyclically high levels.  Companies are watching for growing headwinds from escalating trade tensions and the stronger dollar, but most conclude that the impact of current actions will be minor.  Analysts project that corporate earnings will continue to rise 20% or higher in both the third and fourth quarters before slowing in 2019.

Trade tensions rose, then fell as the U.S. appears to be shifting tactics.

A steady escalation in trade tensions has been perhaps the largest shadow over what is an otherwise positive economic and earnings environment.  Tweets, threats and challenges have been the bread and butter of President Trump’s aggressive negotiating style. 

However, we believe there were signs of a shift in the President’s approach to trade talks during July.  A summit with EU President Juncker early in July ended with a firm commitment from both sides to move ahead with discussions.  Perhaps more importantly, the two presidents hinted at a potential collaboration in dealing with China’s unfair trade practices, which have been a major concern for all developed nations.  The summit prompted a rebound in equities, particularly international stocks.  Late in July, trade negotiations with Mexico thawed under the leadership of the incoming Mexican president Obrador, which in turn could lead to progress with Canada negotiations.

In our view, the shift to what appears to be a more collaborative approach to dealing with China has the potential to achieve measurable results.  However, we continue to believe that trade talks move slowly and that the markets will have to navigate more ups and downs before meaningful progress is achieved.

Via Nova’s outlook remains positive, but near term, the dog days of summer may weigh on stocks particularly in a mid-term election year.

Via Nova believes the facts of a healthy economy and increasing profits continue to support equity returns in the current, fear-filled and turbulent political climate.  We are encouraged by the improved tone of trade negotiations in July.  However, bonds are likely to be facing steady headwinds, as the Fed continues raising interest rates.  In this environment, we favor stocks over bonds.

Against this favorable backdrop, there are risks that could hamper stock returns over the near term.  First, the Federal Reserve could decide to increase rates more and faster than they planned, potentially putting the current expansion at risk.  Higher interest rates raise the cost of borrowing and lower the discounted value of future corporate earnings, both of which would be a headwind for stock prices.  We view this risk as relatively low, because Federal Open Market Committee Chair Jerome Powell has said the Fed would be willing to tolerate above target inflation for a time without feeling pressed to raise rates faster than the current plan.

Second is the risk of a trade war and the damage that could exert on foreign sales as well as the cost of domestic goods.  The current level of announced tariffs and countervailing duties would not likely have a significant impact on U.S. growth, but an escalation could pose a challenge.  We do not believe that a trade war is the most likely scenario, particularly in light of developments in July, but it is a fluid and unresolved issue. 

A third near-term risk is market seasonality in a midterm election year.  We pay attention to market seasonality at Via Nova, but we believe that fundamentals are more important drivers of equity returns than the calendar.  While much is made of the market adage to “sell in May and go away,” the actual market weakness does not historically begin until August and September.  It wasn’t always like that.  Harvest historically made August the best month of the year.  But now that agriculture has fallen to about 2% of the economy, August and September have been the two weakest months of the year, based on data which goes back to 1950.  It is important to point out that August has seen more market “ups” than “downs,” (36 to 31), but the average -0.1% decline overall and -0.4% decline in midterm election years is of interest.  That said, the fourth quarter stock market returns on average more than offset the potential weakness that comes with the “dog days” of summer.