Recent Developments:
Evidence continued to mount that U.S. economic growth was poised to remain solid in the second half of 2018. Real GDP appeared set to average a 3% pace during the third quarter, led by continued growth in consumer spending and strong gains in business fixed investment.
The labor market continued to improve and employers added jobs across a wide array of industries. The unemployment rate remained below 4% while wage growth trended higher. Consumer confidence hit an 18-year high in September, a positive indicator for spending going into the holiday shopping season. Robust job growth and a strong economic outlook bolstered Americans’ expectations for the future.
Not all of the data was positive though, with soft pockets including housing. Pending home sales, a leading indicator of sales activity, fell in August. This marked the fourth decline in five months, suggesting that sales should continue to languish in the near-term.
The estimated impact of tariffs has so far been quite small. However, the tariffs in place have only been the tip of the iceberg relative to those under review or threatened. If implemented, they could place about 1.2% of U.S. and 0.4% of global growth at risk. All told, an escalation in the trade spat with China and waning global demand could yet test the durability of the current expansion.
Outlook:
The U.S. economy continues to maintain strong momentum heading into Q4. From a bottom up perspective, the economy looks incredibly sound. Strong job growth, higher asset prices and a relatively high saving rate should continue to support consumer spending. Business fixed investment also looks set to grow solidly, with an emphasis on productivity enhancing investment. Inventories are relatively low and government spending looks set to improve modestly in coming quarters.
For the rest of the world, a leveling off is expected rather than a continued slide in economic growth. Central bankers in regions such as Europe and Japan have so far maintained very accommodative monetary policy, while policymakers in China have also taken measures to support growth.
Beyond this point, however, there is more uncertainty, as trade disputes pose significant downside risk to the economic outlook. The U.S.-China trade conflict saga continues to play out in the background, given other more salacious domestic political developments. With the two economic heavyweights on a hard-to-avoid collision course, this dispute is a key risk to growth.
Economic Activity
* Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers an August 2018 reading in the 32nd percentile.
Markets
Recent Developments:
U.S. equity indexes produced strong results during the third quarter. The S&P 500 soared 7.7%, its best quarterly gain since the end of 2013. A positive macro environment has led to strong corporate profits, which, in turn, have driven the current S&P 500 bull market rally to all-time highs despite the ongoing risks posed by trade disputes, rising interest rates, higher oil prices, narrow breadth and stretched valuations.
Following a strong 2017 and a good start to 2018, international equities have generally disappointed. Multiples have contracted as investors attempt to account for a multitude of risks. Weaker currencies, relative to the dollar, have also been a driver of poor returns. Concerns about a trade war between the U.S. and its major trading partners have led investors to question their macro assumptions and earnings forecasts. A strengthening U.S. dollar has been especially challenging for emerging markets.
Year-to-date, U.S. fixed income returns have been lackluster, with the Bloomberg Barclays U.S. Aggregate Bond index dropping 1.6%. Amongst major fixed income sectors, U.S. high yield has been the clear winner while emerging market debt has struggled in the face of a strengthening U.S. dollar. Despite the weak results, it is probably fair to note that returns have been better than many market prognosticators had expected, given solid economic growth, rising inflation, and rising interest rates in the U.S.
Outlook:
In the U.S., corporate earnings have been the star of the show, superseding a fairly consistent stream of negative headlines focused on trade policy, Washington dysfunction, North Korea, Iran, and other market risks. In the near term, we expect more positive news on the earnings front. FactSet is projecting a third quarter earnings growth rate of 19.3%. Double-digit earnings growth is also expected for the fourth quarter. Earnings growth should begin to normalize in 2019, however, as the benefits from tax reform begin to fade. Margins, currently at record levels, may begin to come under pressure as wages, interest rates, and raw material costs all continue to increase. Highlighting the macro environment is the end of ultra-loose monetary policy as central banks raise interest rates and trim balance sheets. All things considered, we are cautiously optimistic and do not believe a shift to a defensive posture is currently warranted. Given the late-cycle dynamics, however, investors who are heavily weighted in favor of growth names may want to consider pursuing a total return that is more balanced between capital appreciation and income.
International equities remain attractive. Developed and emerging markets continue to serve as both return generators and diversifiers. Fundamentals are favorable. Recent weakness has been driven more by negative sentiment than macro factors or corporate performance. The good news is that valuations and currencies already reflect much of the risk that had been driving negative investor sentiment. When risks abate, investors may again focus on the positive economic and earnings stories abroad and drive markets higher.
Fixed income investors face a challenging environment. We expect the Fed to continue to normalize policy by both raising short-term interest rates and reducing its balance sheet. Interest rates have risen considerably since the start of the year, and we expect this trend to continue. Adding to the challenge, the extended period of low interest rates has encouraged longer term borrowing, thus pushing the duration of the U.S. bond market to near record highs. Given this environment, flexibility is important. We encourage investors to work with asset managers who have the experience and flexibility to pursue returns wherever they may be available. In the intermediate term, a passive approach to fixed income markets may produce suboptimal results.
Equity Valuation
* Based on the S&P 500 trailing twelve month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading in the 16th percentile.
Investment Strategy:
The current equity market has been dominated by certain themes, sectors, and stocks. In 2018, U.S. stocks have outperformed their international counterparts by 12%. Domestic large cap growth stocks have outperformed large cap value stocks by 13%. Technology and consumer discretionary names are up 20%. More narrowly, an equally weighted investment in Amazon, Netflix, Microsoft, Apple, and Alphabet (Google) would be up more than 50%. So why diversify? Although it is always tempting to chase the hot asset class, sector, or stock, we would like to remind you of the importance of remaining diversified and disciplined. Broad exposure to different themes, asset classes, and individual issues is fundamental to a disciplined approach. Winners this year may be losers next year. For example, in 2017 international stocks outperformed U.S. stocks. Historically, value names have outperformed growth stocks. Currently frustrated emerging market investors shouldn’t forget that these stocks produced a 37% gain last year. Seemingly invincible innovators occasionally crash and burn (remember Blockbuster?) or underperform (Facebook is down ~12%, year-to-date). And an allocation to fixed income serves as an important portfolio stabilizer when the inevitable equity market correction or bear market occurs.
In short, remain focused on your long-term goals, and trust the process. If you have questions, please contact us at any time.
Laurie W. Gerber, Client Development
GW & Wade, LLC
T. 781-239-1188
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