The current expansion is a year away from becoming the longest in U.S. history. Goldman Sachs studied other countries where growth cycles have lasted more than 10 years (Australia from 1992 to the present; the U.K., 1992-2008; Canada, 1992-2008; and Japan, 1975-1992). It found similar advantageous factors exist in the U.S.: a relatively flat Phillips curve (the relationship between inflation and unemployment), strengthened financial regulation, and a lack of financial imbalances. In the past three U.S. expansions, the late-cycle phase lasted 2-4 years, indicating the next recession could be as far out as 2021. What could lengthen the cycle? Increasing labor force participation, rising productivity, and a strong dollar. Recent data reflect improvement in the first two, and despite some weakness of late, the dollar has strengthened significantly this year. All of this is important for investors as past performance suggests getting out early can be costly. While timing the move from late to end cycle is impossible, in the last three cycles, the equity market’s median cumulative late-cycle return was 42%!
Employment remains strong but labor force participation is low and wage growth flat In July, the unemployment rate fell from 4.0% to 3.9% as expected. The labor force grew by 105,000, a gain of 1.1% year-over-year (y/y), down from 1.2% in June. It appears that although labor force participation is better than demographics would suggest, it remains a constraint for the economy. In addition, average hourly earnings grew by only 2.7%, less than the y/y June inflation rate despite some improvements in productivity. The report highlighted that the labor market continues to tighten and seems to prove that anyone who wants a job can get one.
Manufacturing accelerates The Markit PMI rose again in July to well above its expansion average, while regional Kansas City and Richmond Fed gauges and the Chicago Fed’s national survey also reflected strength. Unfilled orders—fuel for future activity—continued to rise. The manufacturing sector added much stronger-than-expected jobs in July.
Housing slump worsens Housing remains disappointing this summer, with construction adding fewer than expected jobs. Existing home sales fell a fifth time in six months and June new home sales hit an 8-month low. Culprits include tight supply and affordability, the latter hurt by rising mortgage rates and housing prices that have increased faster than personal income the past 12 months.
Tariffs hit trade The trade gap widened more than expected, as May’s race to ship goods before tariffs kicked in eased in June, causing exports to fall off. Trade for the quarter was still a big positive to Q2 GDP, although future revisions as a result of June’s trade figures could trim the improvement.
GDP jumps The initial Q2 estimate came in at a 4.1% annualized pace, slightly below estimates but the first 4%+ print in almost four years. Strong retail sales and an improving trade position helped to boost growth to above-trend levels, though falling inventories and weak housing were net drags on the economy. Q1 GDP also was revised up two ticks to 2.2%. Moving forward, growth should continue to be strong for the next few quarters before slowing in the second half of 2019, reflecting fading fiscal stimulus and higher interest rates.
Capex climbing Core capital goods orders—a capital expenditures (capex) proxy—rose a healthy 0.6% in June and were revised up for May from an initial estimated decline of 0.2% to a gain of 0.7%. As noted above, increased capex was a key contributor to Q2 GDP growth. This bodes well for future productivity.
Inflation gradually rising June inflation data came in strong, with headline CPI up 2.8% y/y and core up 2.2% y/y. Both figures were higher than May’s numbers, continuing a gradual trend of rising inflation. The Fed’s preferred inflation measure, PCE, rose 2.2% y/y in June, with core PCE cooling slightly to 1.9% y/y. At the Fed meeting last week, changes to the statement were minimal. However, the committee described economic activity as “strong” instead of solid. This further supports the backdrop for two additional hikes this year and three next year.
EQUITY MARKET SUMMARY
July 2018 saw the S&P 500 index end 3.72% higher. Both U.S. and international stocks went higher in July, as large-cap stocks led the way in the U.S. Volatility in July was low, except for Facebook’s drop of nearly 20% in late July. The S&P 500 was not up or down by more than 1% on any day for the month. U.S. stocks finished the month slightly ahead of foreign developed equities as measured by the MSCI EAFE index, which advanced 2.46% for the month. Emerging market equities (MSCI EM) also showed a positive month with a 2.2% increase. All major asset classes rose in July.
Strong corporate earnings for the second quarter of 2018 have helped to increase the expected operating earnings per share in 2018 to a 26% growth rate year over year. All sectors are forecasted to have positive earnings, with strength in energy, technology, healthcare and telecom. With over half of S&P 500 companies reporting, over 79% of companies have beaten their earnings estimates and 61% have beat their revenue estimates. Margins continue to be a major reason for earnings growth this quarter and are expected to increase to over 11%, their highest level on record. This margin growth is coming mostly from tax reform and efficiency efforts at many companies.
Markets have reacted to the strong economic news as well as tariff threats around the world. On the economic front, second-quarter growth was at slightly more than 4.1%, a level not seen in four years. Jobs growth was also strong, with upward revisions to the prior two months. There have been many tariff threats between the U.S. and other countries, mostly with China. Even though the market has reacted almost daily to these threats, the long-term effects of these tariffs are still to be decided. Fortunately, trade tensions seemed to have eased in late July following a positive development between the U.S. and the European Union (EU).
- LARGE CAPS LAGS SMALLER CAPS YTD:
Dow Jones 4.28% S&P 500 6.47% Russell 2000 9.54% NASDAQ 13.81%
GROWTH OUTPERFORMING VALUE YTD :
Large Cap 12.2% vs. 2.44% Mid Cap 8.75% vs. 2.72% Small Cap 11.95% vs. 7.32%
Best performers: Year to date through the end of July, the Consumer Discretionary sector has the best returns at 13.6% while the Technology sector has the next best returns at 13.2%. While both sectors have benefited from reasonable valuations, the growth expectations of both of these sectors have increased from an improvement in consumer sentiment over the last several months.
Worst performers: Telecom (-6.22%) and Consumer Staples (-4.83%) have had the worst YTD returns with large brand-oriented companies under pricing pressure and the Telecom sector under pressure as its high dividend payout ratios are suffering by being an income proxy with rising rates.
FIXED INCOME SUMMARY
Short-term rates. As expected, the Federal Reserve (Fed) raised its target for the federal funds rate to a range of 1.75%-2.00% at the June meeting. Both the language in its statement and economic projections were slightly more hawkish than in previous meetings. The committee raised both economic growth and inflation forecasts and cut the unemployment rate forecast for this year and next. In addition, the slightly more hawkish view was enough to increase the median forecast to four rate hikes in 2018 and three in 2019. With interest rates set to continue rising on the back of firmer inflation and stronger growth, bonds will face continued headwinds, and investors will need to be more selective in fixed income investing.
The 10-year Treasury yield climbed 12 basis points during July ending the month at 2.97%. US Treasury yields rose after the Fed delivered hawkish remarks and trade tensions re-emerged. The US 10-Year Treasury yield hit a 10-week high of 3% mid-week and ended lower at 2.96% as investors sought safety in government debt. Meanwhile, Japanese government bond (JGB) yields fell after the Bank of Japan unexpectedly bought ~400 billion yen of 5-to-10 Year bonds to stem a selloff. The rise in yields was uniform across the curve, with slight flattening between the 10 and 30 year.
U.S. fixed income investment performance is mostly negative year-to-date except for cash (0.85%) and High Yield (1.25%). Within the U.S., corporates have declined the most (Barclays US Corporate index -2.47%) so far with the long end -5.2% while the intermediate portion was only -1.17%. The Barclays Aggregate index is down -1.58% YTD. Municipal bonds outperformed comparable maturity Treasuries since the start of the second quarter—muni yields were steady to lower, while Treasury yields crept up—and it wouldn’t be surprising if this trend were to continue for basic reasons of supply and demand. Meanwhile, with the U.S. economy relatively robust, the muni credit picture looks good in general. Internationally, the Euro Aggregate is flat YTD returning 0.06%, losing ground over the last quarter.
Year-to-Date Index Returns (as of 7/31):
Index YTD Returns Barclays Aggregate -1.58% Barclays Euro Agg 0.06% Barclays U.S. High Yield 1.25% Barclays Municipal -0.01%
In summary, we maintain a positive view of global growth and equities in general but with some downside risks increasing at the margin. We still believe continued international exposure (particularly developed international) is warranted given growth prospects abroad. Diversified portfolios in fixed income are attractive given the continued Fed tightening.