Third quarter review and outlook: Stocks rose to record highs despite the summer doldrums.

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  • Stocks shrugged off tariffs, rate hikes and the calendar, rising to fresh record highs.

  • Economic momentum remained strong.

  • FOMC raised rates a third time and plans a fourth this year.

  • Trade tensions eased but also intensified.

  • Via Nova’s outlook for the stock market remains positive, but bonds likely to face further headwinds.

  • Early thoughts on 2019.

Stocks shrugged off tariffs, rate hikes and the calendar, rising to fresh record highs.

The S&P 500 shrugged off additional trade tariffs, a Fed rate hike and the summer doldrums to reach another record high in the third quarter.  Via Nova has often cautioned against relying solely on seasonal factors, or “calendar investing,” without examining the underlying facts and trends, and the third quarter performance provided another useful example.  The index rose 7.71% during the period for the best quarterly performance since the end of 2013.

The broad rise in the S&P 500 was paced by renewed strength in the healthcare and industrial sectors.  The performance of these sectors was followed closely by the newly-created communication services sector, formed from selected technology, consumer discretionary and telecommunication stocks.  The leadership from healthcare and industrials, instead of technology, was a welcome sign of broader market participation and suggested continued durability of the current bull market.

Glimmers of hope on the trade front helped the large-cap S&P 500 outperform the more domestically oriented small cap indexes during the period.  International equities also gained slightly on easing trade tensions, but emerging market stocks fell.  Both developed and emerging market stocks significantly lagged the major U.S. indexes in the third quarter and year to date.

In the fixed income markets, continued economic strength, confirmed in the September Federal Open Market Committee (FOMC) rate hike announcement, helped push the yield on the 10-year Treasury note back up above 3% to close the quarter 3.05%, slightly below the mid-May high.  The higher rates pushed down Treasury bond returns for the quarter.  However, lower credit spreads, helped by the stronger economy, allowed corporate and high yield bonds to post modest gains.  On balance, the benchmark Bloomberg Barclays U.S. Aggregate Bond Index finished the third quarter with a modest 0.02% increase.

In other markets, traditional inflation hedges such as gold, oil and Treasury Inflation Protection Securities (TIPS) declined, though real estate rose slightly.  The value of the dollar also rose slightly during the quarter and was up 1.94% over the past year.

Economic momentum remained strong.

The pace of U.S. economic growth remained strong in the third quarter following the above average 4.2% gain in the second quarter, despite rising risks from trade disruptions.  Employment continued to increase boosting consumer incomes, confidence and spending.  Small business confidence rose to a new record, suggesting employment and capital spending will move higher in the months ahead.  The Atlanta Fed’s GDPNow measure projected healthy third quarter growth of over 4% based on available data at the end of September. 

Inflation pressures, however, appear to be on the rise.  The key measures of inflation tracked by the Federal Reserve, especially wage inflation, have increased and are now at or above the FOMC’s target 2% level.  While the Fed monitors numerous inflation metrics, wage inflation is a key measure for policy makers, as it provides an important perspective on the relative health and tightness of the labor market.  If inflation accelerates, the FOMC will be more likely to raise interest rates faster to cool the economy.  Higher interest rates are negative for fixed income securities like bonds.

FOMC raised rates a third time and plans a fourth this year.

The improving economic backdrop and firming inflation pressures were cited by the Federal Reserve in their decision to raise short term interest rates a third time this year at their September meeting.  Moreover, the FOMC confirmed its plans to raise short term rates again in the fourth quarter as part of its gradual approach to “normalize” monetary policy following the extraordinary easing measures enacted in the wake of the Financial Crisis.  The Fed also raised its economic growth forecast for 2018 and 2019.

Trade tensions eased but also intensified.

Trade disputes and rhetoric have been a persistent cloud hanging over the markets this year.  However, a last-minute agreement in the closing hours of September to modify and continue NAFTA under a new moniker, USMCA, raised expectations that a full-scale trade war could be avoided and that a more positive trading environment might emerge from the current rubble.  The apparent success with our neighbors to the north and south raised hopes that trade deals with other key trading partners may evolve in the coming months.

The details of the proposed trade agreement between the U.S., Mexico and Canada are sketchy at present, but the overall impact appears to improve and enhance trade between the three nations.  However, potential shifts in supply chains could emerge because of the new agreement which could generate disruptions as companies adjust to the new rules and regulations.

While North American trade tensions eased, the trade dispute with China intensified.  In response to a lack of progress in negotiations, the U.S. imposed tariffs on a wide range of Chinese products.  In response, the Chinese raised tariffs on selected U.S. goods.  The evidence suggests the impasse will continue until at least after the mid term elections.  The U.S. promised a further increase in tariffs by the beginning of 2019 if negotiations continue to be unproductive.

Via Nova’s outlook for the stock market remains positive, but bonds likely to face further headwinds.

Via Nova remains positive on the economy and the equity markets for the remainder of 2018 and into 2019.  The facts of a healthy economy and strong earnings growth justify a bias in favor of equities and away from bonds.  The risks of recession are very low at present suggesting a favorable environment for corporate sales and earnings growth and firm support for stock prices.  However, the fears of excessive monetary tightening and escalating trade tensions with China remain a cloud of doubt over an otherwise positive outlook.

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 yet blow up and cause an international trade war which would be a significant negative for global growth.

The upcoming midterm elections are also expected to generate considerable controversy which could affect the financial markets.  Historically, the incumbent party loses seats in the midterms.  The current pundit prognostications call for the Republicans to lose control of the House but retain control of the Senate.  If that happens, and recent experience reminds us that pundits are not always correct, there would be a split Congress and an increased likelihood of policy gridlock.  Businesses and the markets often like Washington gridlock, because there is a lower risk of fiscal and regulatory changes that could adversely affect corporate growth strategies.

Via Nova’s most likely scenario in the months ahead 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, it is not 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.  The recent negotiation breakthroughs related to NAFTA and, to a lesser extent, the EU, suggest a favorable resolution is attainable.  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 with China is unlikely for at least several months if not longer.  If progress continues in trade negotiations, international stocks could rebound following months of lagging performance.

Early thoughts on 2019: The economic expansion is likely to continue.  More of 2018 but less.

The backdrop for the equity markets remains positive in 2019, but the bond market could face continued headwinds.  The economic expansion is likely to continue with a low risk of recession, but the pace of growth could slow a bit as the initial boost from the fiscal tax cuts and spending package fades.  The consumer remains quite healthy with strong job growth, rising incomes, a low unemployment rate and high confidence, all of which should lead to further gains in retail sales.  Corporate sales and profits should also move higher, but the pace of earnings growth will likely slow from roughly 20% in 2018 closer to 10%-12% in 2019, still comfortably above the long run average.

Via Nova believes interest rates will continue moving higher next year and maintain downward pressure on fixed income returns, but monetary policy could be approaching a crossroad of sorts in 2019, and interest rates may rise more slowly.  The Federal Reserve is expected to continue raising short term interest rates as it seeks to “normalize” monetary policy following the Financial Crisis and keep inflation pressures in check.  However, short term interest rates, which are set by the Fed, have risen closer to long term interest rates, which are mostly set by the markets.  Historically, when short term interest rates have risen above long-term rates, the economy subsequently entered a recession.  The Fed will try to avoid moves that could damage the expansion and force a policy reversal.  Moreover, U.S. yields are well above yields in other developed countries, which encourages global money to move domestically.  This “gravitational pull” of lower global interest rates could also limit the rise in domestic yields.

Trade tensions will likely remain a cloud over the markets in 2019, but the focus will center more on China in the wake of the preliminary trade agreements reached with Mexico and Canada.  Via Nova believes that all sides prefer to avoid a trade war and resume unfettered trade, but negotiations usually take considerable time, and China is accustomed to playing the long game.  Any progress in resolving the current dispute will likely be a positive for the equity markets, but most of the boost could benefit U.S. multinationals, foreign and emerging markets.

New investment opportunities may emerge from the changes in trade agreements and tax reform.Via Nova believes the revised tax codes, reduced regulation and improved trade terms represent important changes to the “rules of the game” for many businesses and will likely affect their supply chains and corporate strategies in 2019 and beyond.The good news is that the reduction in corporate tax rates and the repatriation of foreign cash could provide important capital that would enable corporations to adjust operations relatively quickly.