Market Outlook: September 2017

Economic Summary
Our nation continues to grapple with the devastating impact of Hurricanes Harvey and Irma, and we brace ourselves for the potential of more hurricanes. Congress agreed to a three-month extension of the federal debt ceiling in exchange for $8 billion for hurricane relief.  It will take time before we know the full extent of the economic impact of these hurricanes. Some suggest the impact could trim second-half growth a tick or two before turning stimulative as relief appropriations start trickling down into the hands of the people who actually will use them.  Others wonder if because of massive numbers of homeowners without flood insurance, this event will expose the financial weakness of America’s lower and perhaps even middle class. Will paycheck-to-paycheck earners be able to recover financially? The Fed could potentially put on hold future rate increases and balance-sheet reduction until these unknowns can be quantified.

Recent economic data has somehow suggested both improvement and softening. We highlight some recent releases below.

Consumers confident and spending Contrary to expectations for a pullback, the Conference Board gauge jumped in August to its second highest level since December 2000. The Michigan sentiment gauge wasn’t as strong but was still up from July and remains at post-election elevated levels, while the weekly Bloomberg Consumer Comfort Index hit a new 16-year high. These reports, upwardly revised Q2 consumer spending, and a second month of solid same-store retail sales bode well for the back-to-school and holiday sale seasons.

Manufacturing accelerating. Led by production and new orders, ISM’s manufacturing index came in well above forecasts at 58.8, a 6-year high. ISM said both backlog and exports orders were unusually strong, a positive sign for activity this fall. While other regional gauges were not as high, the ISM report was in line with a similarly robust reading from the closely watched Chicago PMI. The reports fit with the September 1 employment report, which showed substantial gains in factory payrolls.

Growth accelerating. The second estimate of Q2 GDP put the pace of real growth at an above-consensus 3%, the most in nine quarters, on upward revisions to personal consumption and capital expenditures. If the trend holds, it would be welcome news for corporate executives, who are confronting an elevated bar for corporate earnings in 2018. Is 3% growth sustainable though with sluggish productivity and lack of population growth?

August jobs tend to be ‘noisy.’ August nonfarm payrolls disappointed, coming in at a below-consensus 156K, and the prior months’ gains were trimmed by 41K. Wage gains also slowed. The unemployment rate rose to 4.4% while the participation rate stayed flat 62.9%, driven by both a fall in employment and a rise in unemployment. However, the August report tends to have seasonal issues. The other major August jobs report was strong as ADP’s separate count of private payrolls jumped the most in five months to 237K, raising its 12-month average to an 18-month high. The labor market data may continue to be volatile through September as disruptions from Harvey are likely to persist, so it may not be until November before we get a clear picture on hiring momentum.

Housing slows further. Pending sales fell in July for the fourth time in five months, suggesting fall could see added weakness in an area of the economy that started the year with a bang before fizzling in the spring and limping through summer. The National Association of Realtors says contract signing activity continues to be depressed by the lack of inventory, which is boosting home values and weighing on affordability. It now expects existing sales to rise 0.7% this year, a notable deceleration from last year’s 3.8% increase. On a positive note, increases in single-family homes helped July residential construction increase 11.6% year-over-year.

Auto sales soften. After bouncing back a bit in July, auto sales in August looked to be on track to slip a bit with about 2/3 of the data in as of this writing. Moderation off last year’s cycle high isn’t just a U.S. phenomenon. Despite a weaker dollar, vehicle exports fell by the most in nearly three years in July, causing overall exports to decline by the most in nine months and the trade gap to widen to $65.1 billion.

Equity Market Summary

• August 2017 saw the S&P 500 index barely in positive territory with a 0.3% gain. This small positive trend continued with the Dow Jones Industrial Average (DJIA) advancing 0.65% and the NASDAQ Composite up by 1.4%. Developed foreign markets as measured by the MSCI EAFE index decreased slightly by .04% for the month while emerging markets stocks added to its yearly returns as the MSCI Emerging Markets index returned 2.2% for the month (the best performing asset class in August). The month started strong with a higher than expected payroll number (the market reaching a new high on August 8^th). Aggressive North Korean rhetoric and the implications of Hurricane Harvey pressured the market somewhat. The second quarter 2017 corporate earnings season showed 73% of companies beating their earnings estimates and 69% beat on revenue estimates, which shows companies have been able to obtain EPS growth from revenue and not just by cutting costs. The sectors showing the strongest growth in earnings, measured by the highest percentage of positive quarterly earnings surprises were technology (86%) and health care (80%). Large cap stocks continued its outperformance versus small cap stocks for the month.

   

  LARGE CAPS OUTPERFORM SMALLER CAPS YTD:

  Dow Jones	13.0%
  S&P 500	11.9%
  Russell 2000	4.4%

  GROWTH OUTPERFORMING VALUE YTD :

  Large Cap	19.2% vs. 5.2%
  Mid Cap	14.4% vs. 5.1%
  Small Cap	11.3% vs. -0.68%

   

• Best performers: Year to date through the end of August, the Technology sector has the best returns at 26.5% followed by Healthcare at 19%. While both sectors have benefited from reasonable valuations, the growth expectations of Technology and Healthcare have increased from an improvement in consumer sentiment over the last several months.
• Worst performers: Energy (-14.3%) and Telecom (-7.9%) have had the worst negative YTD returns with oil prices declining due to inventory supply/demand imbalances. Telecom with its high dividend payout ratios is suffering by being an income proxy with rising rates. Some of the pullback has to do with higher valuations in these two sectors with their strong performance in 2016.
• Emerging markets solidly outperformed developed markets as higher growth and gains from currency movements such as the weakening dollar contributed to the 28.7% YTD gain of the MSCI EM (Emerging Markets) compared to a YTD gain of 17.5% by the MSCI EAFE (the more developed market international index).
• We continue to think a balanced portfolio including alternatives continues to be appropriate for investors. While we do see some continued upside in equities, we believe returns will be muted with slow but positive economic growth, which will limit corporate earnings growth. Valuations on equities have generally moved higher in anticipation of higher growth so prudent to not overreact (and overinvest) in sectors that may have gotten ahead of improving fundamentals. Investors will need to be realistic on returns going forward.

Fixed Income Summary

• A flight to quality has pushed the 10-year S. Treasury yield to 2017 lows, partially driven by foreign demand because outside the U.S. rates are even lower and partially driven by nuclear threats from North Korea threatening to destabilize the region. This has caused the yield curve to fall below levels when the Fed first started tightening in 2015. Whether the Fed will raise rates one more time during 2017 is now questionable, as wage growth and inflation have stalled. Although many recessions have come after a flattening yield curve, only half of flattening yield curves have been followed by recessions. The 10-year ended the month 16 basis points lower at 2.12%, and 32 basis points lower since the start of the year.
• Fixed income performance: The broadest measure of the U.S. bond market, the Barclays U.S. Aggregate, returned 0.91% during August and 3.72% year to date. Global bonds have had the highest returns, +0.99% during August and +7.22% year to date. Municipal bonds returned 0.76% in August and 5.20% year to date. High yield was the only softening sector, returning -0.04% during August but still up 6.05% year to date.

YEAR-TO-DATE INDEX RETURNS (as of 8/31)