Second Quarter Economic Review for 2019
The stock market is signaling continued bullishness about corporate earnings, the tale told by the bond market is the exact opposite—one of worry about economic prospects both here and abroad.
U.S. Economy
First let’s discuss the U.S. economy, which we leave in a slow forward position. GDP in the first quarter of 2019 was stronger than expected at 3.1%. Second quarter GDP is expected to slow from the first quarter, but ongoing growth is anticipated. The current U.S. economic expansion has been resilient and is now the longest on record, but at the same time has been marked by the slowest pace of growth (at 2.3%), since World War II. Overinvestment, which led to the internet and housing bubbles, ended the prior two expansions. In this expansion, we believe more regulation, low productivity, the lack of investment and demographics have led to this slower and more steady growth environment, and we expect growth to continue in 2019 and into 2020. The economic indicators we follow that reflect the front edge of the economy continue to show more runway for this expansion.
The Conference Board’s Leading Economic Indicators Index has been putting in new all-time highs in recent months. Since 1960, this indicator has rolled over about 11 months prior to a recession (16 months prior to the last three recessions) and we have not seen that lower trend develop at this time. Job market data looks solid as well as the weekly initial jobless claims continue to hover near their lowest or best levels since 1969. Layoffs, which would be reflected in this reading, tend to turn up about 6 to 12 months before a recession and those indications are not present at this time. Furthermore, the unemployment rate sits at 3.6%, also at its lowest level since 1969, and this rate tends to move higher, on average about 0.4 percentage points, prior to a recession. The U.S. economy added 164,000 jobs in July as the unemployment rate held at 3.7%, the Labor Department said Friday. Annual wage growth came in at 3.2%, a bit stronger than expected. But hours worked fell, as the U.S. manufacturing workweek slumped. After the jobs report, the Dow Jones and broader stock market extended overnight declines on China trade war fears.
Wall Street expected 151,000 new jobs, including 160,000 in the private sector. Private payrolls grew by 148,000, while the government added 16,000 jobs, including 2020 Census hiring. Economists forecast a 3.6% unemployment rate and 3.1% annual wage growth.
The Labor Department revised May and June job gains down by a combined 41,000. Hiring has averaged a more moderate 140,000 per month over the past three months.
The real surprise in the jobs report was the shorter average workweek, which slipped to 34.3 hours. Outside of especially stormy months, that hasn’t happened since 2011. Bottom line: Despite net hiring, Labor Department data showed that American workers clocked fewer hours in aggregate in July than in June.
The weakness came in the goods-producing sectors of the U.S. economy. The factory workweek slipped to an average of 40.4 hours, down from 41.0 hours a year ago and the lowest since 2011. Factories added 16,000 jobs last month and 157,000 from a year ago. But U.S. manufacturing workers together worked slightly fewer hours (0.2%) than a year ago, as the shorter workweek more than offset net hiring.
The risk for the U.S economy and for President Trump is that the weakest sector of the economy stands to take another hit from his latest move to hit China with new tariffs
Both the leading economic indicators index and job market data suggest that the U.S. economy has more growth ahead. The yield curve has now turned decidedly inverted, which is cause for concern, as its track record of forecasting recessions has been very good. The prior 7 recessions dating back to 1962 have been preceded by an inverted yield curve. After briefly going inverted in late March, the yield curve, as measured by the 10-year U.S. Treasury yield and the 3-month T-bill yield, turned positive before a more definitive move, which has resulted in an inverted yield curve since May 23rd. The duration of the inversion seems to matter historically as the yield curve was inverted for at least 50 days prior to six of the previous seven recessions.
However, it is worth noting that there have been two false signals from the inverted yield curve when a recession did not follow. At this time, other indicators of stress in the credit market are not yet appearing, and credit conditions remain favorable.
We will continue to monitor the shape of the yield curve, but at this point, other economic measures are not confirming this signal of caution. Overall, we believe the fundamental backdrop for the economy continues to look solid and we expect growth to continue throughout 2019 and into 2020.
Valuations
Next are valuations, which we maintain as modestly attractive. The 25% stock market run since the December 24th low has resulted in valuations moving higher from the depressed levels in late 2018. The forward P/E ratio of the S&P 500 is around 17 times earnings…slightly above the historical mean, but still favorable given the level of interest rates. We believe valuations are still modestly attractive, especially when one considers the large drop in interest rates, which tends to push up P/E ratios as bonds provide less competition to stocks. As an active manager, we believe we can find opportunities in this type of environment.
In a fairly valued market, earnings growth becomes key. As of early June, full year 2019 earnings growth was expected to be 8.9% with low single digit growth through the first three quarters of 2019 and then comparisons becoming easier in the 4th quarter with significant earnings growth expected. It is important to note that earnings expectations tend to drop the closer one gets to the actual earnings period. Furthermore, ongoing trade concerns and increased economic uncertainty could pressure earnings expectations, so earnings reductions would not be unexpected.
Capital Markets
Moving to capital markets, sharp swings dominated market activity in the second quarter. Equities continued on their 1st quarter rally with more gains in April and the S&P 500 closed out the month at a new all-time high. But trade rhetoric picked up in May and the once smooth sailing trade negotiations with China turned negative, resulting in a slump for stocks. However, equities rebounded sharply in June amid growing expectations of a Fed that might cut rates and the S&P 500 achieved a new all-time high once again. When it was all said and done, the 2nd quarter saw both stocks and bonds reach higher. The S&P 500 Index surged over 7% in June, putting the 2nd quarter gain at 4.3%, which resulted in a year-to-date advance of just above 18.5%. International equities enjoyed strong returns as well, but they have not been able to keep up with the pace of U.S. markets. The nature of the equity market rally is worth exploring. In simple terms, this latest move higher in equities, similar to market action for much of 2018, was driven by large-cap growth stocks with significant dispersion among sectors and style. The valuation difference between value stocks and the overall market is as great as we’ve seen it since the late 1990s.
Conclusion
Putting this all together, while the 2nd quarter was rockier than the 1st quarter, it has still been a very strong 1st half of the year and both stocks and bonds have enjoyed gains during this period. We expect volatility to continue in the months ahead and acknowledge that the range of outcomes for the market is rather wide over the next six months. Uncertainty on the trade front, Fed action, and slowing economic activity lead the list of uncertainties with the largest unknown being the outcome of the trade situation with China—just one tweet either way could send stocks soaring or plunging. We entered the year with a singular price target for the S&P 500 at 2900 and have shifted this to a range of between 2800-3100. Ultimately, however, we believe that fundamentals are what matter in the long run and the current fundamentals remain positive for the U.S. During periods of elevated volatility, we believe it is imperative for investors to stay focused on their long-term goals and not let short-term swings in the market derail them from their longer-term objectives.
The market’s first quarter sprint tripped up in May, when the S&P 500 fell 6.4% before finding its feet again in June (it rebounded 7.0%) to finish the quarter with a 4.3% gain. The MSCI U.S. Broad Market index (which includes small- and mid-cap stocks) and the Dow Jones Industrial Average gained 4.0% and 3.2% in Q2, respectively. Year-to-date, the three indexes have returned between 15.4% (the Dow) and 18.7% (MSCI U.S. Broad Market). The S&P 500’s 18.5% gain makes it the best first half of a year for that index since 1997. For the year-to-date, every sector of the U.S. market has produced a positive return, ranging from health care’s 9.8% gain (questions about further reform and drug pricing have given traders some pause) to the technology sector’s 27.2% rise. Developed foreign markets nearly kept pace with their U.S. counterparts—the MSCI EAFE returned 3.7% over the three months through June and is up 14.0% through the first six months of 2019. Its 1.1% return over the last 12 months lags the S&P 500’s 10.4% gain over the same period, however. Emerging market stocks remain the laggards, with a meager 0.6% return in the second quarter and a respectable 10.6% return year-to-date. Slowing growth in China, concerns over its impact on other countries and worries over continuing tariff fights were a greater drag for the emerging markets in Q2 than for other markets. With yield-curve inversions and Fed policy often in the news, the broad U.S. bond market gained 3.1% in the second quarter. The U.S. bond market is up 6.1% this year and has nearly matched the returns of the stock market over the last 12 months with a 7.9% gain. Meanwhile, the 10-year U.S. Treasury’s yield fell to 2.00% at the end of June, down from 2.41% at the end of Q1 and 2.69% at the end of 2018. We view high-quality bonds as a valuable buffer to stock market risks as well as useful portfolio components for income-oriented investors. But at today’s yields, bonds should not be viewed as wealth creators.
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