- Fundamentals outweighed the calendar in August.
- The U.S. economy is healthy.
- S&P 500 earnings growth remains strong.
- Trade tensions eased a bit.
- Could the Fed slow its pace of rate hikes?
- Via Nova’s outlook remains positive, but risks remain.
Fundamentals outweighed the calendar in August.
In August, the S&P 500 ignored the month’s weak history and completed its recovery from the late-January/early-February market correction hitting a fresh record high. The strong fundamentals of a healthy economy and robust earnings, bolstered by a slight easing in trade tensions, were credited with the improvement. The S&P 500 added 3.26% lifting the year-to-date gain to 9.94%. Technology, consumer discretionary and health care stocks powered the advance, while the commodity-oriented energy and materials stocks declined. Small cap stocks also posted strong gains, but international and emerging market equities fell and are negative through the first eight months of 2018.
Bond yields edged lower, as growing concerns over rising risks in emerging markets, particularly Turkey and Argentina, pushed investors into the perceived safety of U.S. bonds. The yield on the 10-year Treasury note fell to 2.86% from 2.96% at the end of July, and the Bloomberg Barclays Aggregate Bond Index rose 0.68%. However, the index was still off just over -1% so far this year.
In other markets, oil and gold prices remained under downward pressure, but real estate and Treasury Inflation Protection Securities (TIPS) gained. The value of the dollar moved higher and was up 2.65% from a year ago. A stronger dollar reduces import costs but makes exports less competitive internationally. As Paul Simon wrote, “one man’s ceiling is another man’s floor.”
The U.S. economy is healthy.
The economic picture remained healthy in the latest month punctuated by an upward revision to second quarter real GDP. Jobs are plentiful, income growth is accelerating, unemployment is at historic lows, leading indicators are making new cycle highs, inflation is modest and interest rates are relatively low. The Atlanta Fed’s GDPNow growth tracker currently estimates a 4.1% increase in the third quarter.
However, there are two areas Via Nova is monitoring for weakness. The first is the degree to which existing tariffs have dampened domestic growth and momentum. So far, there is little evidence that the economic expansion is in danger, but anecdotal reports suggest the risks are very much on the minds of many companies. The second area is global economic momentum. The synchronized global expansion of 2017 that supported global stock markets has given way to a shift in domestic and international growth in favor of the U.S. The combination of U.S. tax cuts and deregulation as well as the rise in trade tensions is credited with this shift. Both are potential risks.
S&P 500 earnings growth remains strong.
The strength in the economy is helping companies generate increased sales and earnings. Second quarter S&P 500 earnings grew nearly 25% over the previous year, and sales increased nearly 10%. These gains far outpaced those in Europe and partially explain why domestic equities have outperformed international markets. The stellar pace of profit growth is expected to continue through the end of the year. Third quarter earnings are currently projected to increase over 22% and fourth quarter profits more than 20%. Actual reported earnings usually beat estimates, so growth might be even stronger. 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.
At Via Nova, we believe profits have been growing into expectations so far in 2018, and that market valuations remain reasonable. The ratio of the S&P 500 index to expected earnings over the coming year (forward P/E ratio) was 16.8 times at the end of August. This P/E ratio is very close to the 16.3X 5-year average, suggesting further upside potential for equities.
Trade tensions eased a bit.
Trade tensions eased in August helping boost stock prices, but numerous unresolved issues remain a cloud over the global economy and financial markets. The markets cheered an agreement in principle between the U.S. and Mexico, which boosts North American content in auto production, mandates higher car industry wages, and other important changes. However, hopes of a quick agreement with Canada and a successful full renegotiation of NAFTA by the end of August were dashed. Analysts generally agree that a trade deal is in Canada’s best interests, but many of the exchanges between President Trump and Prime Minister Trudeau suggest these trade talks are increasingly personal which complicates the situation.
Via Nova believes trade tensions will gradually dissipate in the coming months providing renewed support to the stock markets, but the negotiation process is far from complete. While strains with the EU cooled after the Trump-Juncker meeting in July, progress on a successful trade resolution has lagged. Also, President Trump indicated renewed trade talks with China may be delayed until after the midterm elections and plans for additional tariffs on Chinese products would move forward. 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. If so, international markets and U.S. exporters could continue to see heightened volatility.
Could the Fed slow its pace of rate hikes?
There is consensus that the FOMC will continue raising interest rates steadily through 2019, but Via Nova believes there is growing evidence that the FOMC may slow or pause the pace of rate increases in the months ahead. “Gradual” has been the Fed’s mantra in raising interest rates over the past couple of years. After holding rates steady at the August meeting, the markets have priced in a near 100% probability that the Federal Open Market Committee (FOMC) will raise the federal funds rate at their next meeting in late September. The market is also pricing a 65% chance of yet another quarter point rate hike at the December meeting.
However, Fed Chairman Jay Powell’s speech at Jackson Hole in August suggests that the FOMC may be more careful, raising interest rates less rapidly than the markets expect. Powell explained the potential perils and pitfalls of blindly following some of the Fed’s theoretical economic constructs in implementing monetary policy. Estimates of “full employment,” “potential GDP,” and the “neutral” interest rate, crucial inputs in setting policy, have changed over time and could still be changing. While Via Nova believes the trend in interest rates will continue higher, low inflation expectations, a relatively flat yield curve, increased emerging market financial strains and persistently low international yields may slow the pace of future rate hikes.
Via Nova’s outlook remains positive, but risks remain.
Via Nova believes the facts of a healthy economy and increasing profits continue to support equity returns despite the fears of trade wars and political uncertainty. We do not believe equity valuations are over-extended and continue to favor stocks over bonds. The S&P 500 broke to new highs after six months of consolidation, and historically this pattern has led to further strength over the next 3, 6 and 12 months according to Chaikin Analytics. We are encouraged by the improved tone of trade negotiations in July and the tentative understanding with Mexico in August. We are also optimistic that the Fed is not on “autopilot” in implementing monetary policy and will not short-circuit the current expansion with excessive rate increases.
The two primary risks to the stock market in this environment are 1) a breakdown in trade negotiations which disrupts global commerce, particularly in the emerging market economies and 2) excessive Fed tightening, which would also be felt most keenly in the emerging markets where much of the foreign debt is priced in dollars. Higher interest rates also raise the cost of borrowing and lower the discounted value of future corporate earnings, both of which would be a headwind for stock prices. The most likely scenario is that policy makers, the economy and the markets will successfully navigate the issues.
A third near-term risk is market seasonality. September is historically the weakest month of the year, but the average loss is a relatively modest -0.5%. We pay attention to market seasonality at Via Nova, but 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 S&P 500 gained 7.76% between Memorial Day and Labor Day, highlighting the risks of blind calendar investing.