2018 Third Quarter Market & Strategy Update

Transcription

1 2018 Third Quarter Market & Strategy Update Highlights: October 1, 2018 Stephen M. Mills, CIMA Managing Partner Chief Investment Officer U.S economic growth is accelerating. Rising interest rates and Federal Reserve tightening could threaten the current economic expansion. U.S. corporate profits continue to hit record highs. The recent implementation of trade tariffs on China could lead to a prolonged trade war. The results of the mid-term elections could have a major short-term impact on the financial markets. U.S. Economic Outlook The U.S. economy is enjoying one of the longest expansions in U.S. history. The current nine year old economic expansion is the second longest in U.S. history, however, it has also been one of the slowest until the past several quarters. 1 As of the first quarter of 2018, real U.S. Gross Domestic Product (GDP) had expanded by 21% since the beginning of the current expansion. This is far lower than the 36% compound growth at the same point in the expansion. 2 However, GDP growth appears to be accelerating so far in 2018 with second quarter GDP growth estimate revised upward to 4.2% according to the U.S. Department of Commerce. This is the highest growth rate since the third quarter of We believe three factors are primarily boosting economic growth: 1) consumer spending, 2) capital spending, and 3) productivity growth. First, consumer spending, which accounts for approximately two-thirds of U.S. economic activity, grew at a 3.8% annualized rate in the second quarter of this year. 4 Consumers have become more confident in the economy and their own personal finances over the past 18 months. Consumer confidence, as reported by The Conference Board on September 25, hit an 18-year high in September. 5 This bodes well for the holiday shopping season and future economic growth. Second, we believe that capital investment on the part of businesses, which includes money spent to upgrade physical equipment such as buildings, equipment and machinery, has played a major role in boosting the economy. Capital spending jumped to $341 billion in the first half of the year, an increase of $55 billion, or 19%. 6 In addition, companies spent $147 billion on research and development in the first half, a 14% increase. 6 The surge in spending follows the passage of the Tax Cuts & Jobs Act of 2017 in December 2018 that lowered the highest corporate tax rate from 35% to 21%. This is the fastest rate of capital spending in years and could help extend the current economic expansion for several more quarters as business owners and corporations continue to hire employees and invest their tax savings back in their businesses. 1

2 The third factor we feel is contributing to U.S. economic growth is productivity growth. Productivity measures the efficiency of use of capital and production. Productivity growth is a major contributor to business profits which in turn often leads to higher wages for workers and increased capital spending. Business productivity has been a missing element of the economic expansion since However, recent productivity improvement is helping to support profit margins and keep core inflation low. The U.S. Department of Labor recently reported that nonfarm worker productivity increased at an annual rate of 2.9% in the April-June quarter. This was the strongest pace of growth since the first quarter of We believe these three factors along with moderate inflation and relatively low interest rates will continue to boost economic growth for the next several quarters. We see strong employment trends continuing as well. Approximately 2.4 million jobs have been created in the past 12 months. 7 In addition, the number of Americans filing applications for new unemployment benefits fell to a new 49-year low for the week ended September 15 according to the Department of Labor report. 8 Given the current strength of the U.S. economy, we feel that the chance of a recession in the next twelve months is very low. Popular recessionary indicators like job creation, manufacturing activity, business and consumer confidence, inflation trends, corporate earnings, and housing point to limited downside risk for the economy. Of course a negative geopolitical event or financial crisis somewhere around the world could halt or slow the economic advance. Also, overly aggressive Federal Reserve monetary tightening (which we will address below) could negatively impact economic activity. However, barring something of this nature, we believe economic activity in the U.S. will remain strong for the foreseeable future. Interest rates & The Federal Reserve As mentioned above, rising short-term interest rates caused by U.S. Federal Reserve (the Fed) monetary tightening could threaten economic growth. Since December of 2015, the Fed has implemented eight rate hikes of.25 percent each for its benchmark federal funds rate. 9 The fed funds rate is now set at a level between 2% to 2.25%. 9 We have viewed the Fed s rate hikes since December 2015, as moving the fed funds rate to a more normalized interest rate environment after the rate was dropped to an extraordinarily low level during the U.S. financial crisis. We feel this tightening will be beneficial in keeping inflation low and preventing the economy from overheating. We believe another move in December is highly likely with at least a couple more rate hikes next year. Longer term interest rates have risen as well over the past 12 months. A little over a year ago in early September 2017, the benchmark 10-Year U.S. Treasury note yielded just a bit above 2%. 10 As of the date of this report, the 10- Year note is just above 3%. 10 When yields rise on interest rate instruments like corporate bonds, treasury securities and municipal bonds, prices decline. So the market value of a portfolio that contained such instruments, whether it held individual securities or bond funds, has been hurt by the rising rate environment. However, those who are employing a disciplined bond ladder approach are enjoying higher reinvestment rates than they have seen in years. Trade War President Trump recently implemented tariffs on $200 billion worth of goods imported from China. The 10% tariff was imposed on September 24 and will be raised to 25% the beginning of next year. In addition, the Trump administration has indicated they will consider placing tariffs on an additional $267 billion of Chinese imports. In retaliation, China imposed new tariffs of 5 to 10 percent on U.S. goods worth $60 billion on September 24. The financial markets barely reacted to the announcement and implementation of these tariffs indicating there is not a great deal of concern on the part of investors as to the economic impact of this trade war with China. This muted reaction may be due to favorable developments with other U.S. trading partners. Mexico, Canada and 2

3 South Korea recently agreed to a new trade deal. Although these deals need to be approved by Congress, we believe these are very positive developments on the trade front. In addition, progress is being made with U.S. trading partners in the European Union. We feel that these favorable trade negotiations could increase pressure on China to make trade concessions with the United States to resolve the current dispute. However, we expect China will wait until after the mid-term elections before entering serious negotiations. The elections will determine how much political capital Trump has to pursue his trade policies. In our 2018 Investment Outlook & Strategy dated January 8, 2018, we stated that one of the risk factors for the global economy and financial markets was rising trade tensions. We felt Trump s abandoning of the Trans-Pacific Partnership, his attacks on NAFTA and negative rhetoric toward China could lead to increased global trade barriers and tensions. Although we are now somewhat more optimistic that a full blown global trade war will be avoided, we still have concerns about the impact of a U.S.-China trade war. If tariffs are implemented on most US and China imports, we believe the impact of those tariffs will have a material effect on Chinese economic growth which could have a material impact on growth of other countries in the region. However, we do not feel U.S. economic growth will be materially impacted. Mid-term Elections The dysfunction in Washington has reached new heights over the past couple of months. It didn t seem possible that the divisive atmosphere in Washington could get worse. However, the battle to fill retiring Justice Anthony Kennedy s seat has pushed the discord in Washington to a level not seen since the Civil War. This discord will undoubtedly make the mid-term elections more contentious than previous elections. The outcome could have a significant impact on the Trump agenda and future government policy. Many political strategists believe that the Democrats have the advantage in the House of Representatives and will possibly pick up enough seats to gain control. The Senate is more uncertain but it appears the Republicans have the advantage in keeping control. If it goes as the experts predict with the Democrats gaining control of the House and the Republicans keeping control of the Senate, we see very little negative impact on the economy or the financial markets. That outcome would likely result in a gridlock environment in Washington where very little gets done for the next two years. This gridlock environment existed for the last six years of the Obama administration during which the economy grew, albeit at a slower than normal rate, and the equity markets made good progress. Even if the Democrats gain control of both chambers of Congress, they likely will be unable to reverse the policy initiatives like tax reform and deregulation that have been implemented since Trump s election. Any policy contrary to the Trump agenda would be quickly vetoed with little chance of overriding a Trump veto since it would take two-thirds vote in each Chamber to do so. Equity Markets Stocks prices have continued an upward but choppy path so far this year. As of the date of this report, the S&P 500 index has gained 9% while the Dow Jones Industrial Average has returned 7%. 10 The S&P 500 is up mostly because of the influence of the FANG stocks (Facebook, Amazon, Netflix, and Google) which, because of their very large increase in value this year, account for a majority of the S&P s return so far in The average stock as measured by the broader based New York Stock Exchange Composite Index is up only 2.1%. 10 Stock prices have been propelled forward over the past eighteen months by strong corporate earnings. Second quarter 2018 earnings for the S&P 500 increased by 20.4% compared to the same quarter in This was after a 25% increase in first quarter S&P profits. 11 Although we don t see earnings growing at that pace over the next several quarters will do feel earnings will continue to grow for the balance of 2018 and all of We see this earnings growth as supportive of stock prices. There are certainly risks that could derail stock prices like potentially disruptive midterm elections, 3

4 aggressive Fed tightening and escalating trade tensions. However, despite these headline risks, we believe that solid economic and corporate earnings growth will propel stocks higher for the next twelve months. On August 22, 2018, the stock market, as measured by the S&P 500 Index, hit the milestone of the longest bull market in history. A bull market is defined as a rise in the market of 20% from the low set at the end of a bear market which is measured by a 20% fall from a previous peak. The current bull market, which officially began March 9, 2009, has risen approximately 325% using the S&P 500 Index. 10 There has been a recent argument put forth suggesting the current nine plus year bull market has run its course and will soon enter a new bear market. This argument is not necessarily based on the fundamental outlook for stocks but simply on the law of averages. We disagree with this idea and believe as long as the economic fundamentals remain favorable, stocks can continue to move higher for several more quarters and perhaps even several more years. We operate under the principle adopted by the influential economist John Maynard Keynes who was quoted as saying, When facts change, I change my mind. What do you do sir? The facts are this: Fundamentals are very positive for continued economic growth and rising stock prices. Until that changes, we will stay the course and continue to recommend being fully invested in the growth allocation of our clients portfolios. Fixed Income Markets Over the past couple of years, we have consistently advised clients to shorten overall bond maturities and durations to mitigate the impact of rising interest rates. We still believe interest rates in general will rise over the next twelve months and continue recommending a conservative fixed income strategy. Despite the rise in bond yields over the past twelve months, interest rates on high quality bonds remain near historically low levels. As we have mentioned in our previous reports this year, the challenge for bond investors is lessening losses in their bond portfolio in a period of rising interest rates. As mentioned earlier, we believe the potential for rising inflation and a less accommodating Federal Reserve Bank (Fed), could continue to push interest rates marginally higher. Thus, in light of the potential for rising interest rates, we continue to recommend that investors keep the average maturity of their bond portfolios and bond funds to 10 years or less to avoid potential large losses if longer term interest rates continue to rise. For investors that utilize bond ladders, we believe adding bonds to the end of a ladder is still a good strategy. We would avoid so called high yield or junk bonds and recommend investing in high quality bonds, like high grade corporate, mortgage securities, and municipal bonds. These types of bonds tend to hold their value better in periods of heightened market volatility. They can help stabilize a portfolio and insulate against many investment risks. The Bottom Line We remain bullish of stocks based on a strong fundamental picture for the U.S. economy and reasonable equity valuations. We understand and highlight that corrections like the 12% drop in stock prices in late January and early February, will occur from time-to-time during bull markets. For now, we remain fully invested in our equity allocations and see corrections as opportunities to put cash to work. The Trinity Capital Management Team Footnotes 1 CNN Money, Where The Current Economic Boom Ranks in American History, January 30, Factset, U.S. Expansion is Now the Second Longest in the Post-War ERA, May 9, Trading Economics, US GDP Growth Revised Higher to 4.2% in Q2, August 29, CNBC.com, Consumer Spending Increases Strongly; Inflation Rising, August 30, Wall Street Journal, U.S. Consumer Confidence Hist 18-Year High, September 25,

5 6 CNBC.com, Capital expenditures surge to 25-year high, R&D jumps 14% as companies spend tax cut riches freely, September 17, Credit Suisse Equity Strategy Navigator, Sept 4, WSJ, U.S. Jobless Claims Fall to a 49-Year Low for the Third Straight Week, September 26, Federalreserve.gov, Open Market Operations 10 Thompson Charts 11 Factset, Earnings Insight, September 21, 2018 Trinity Capital Management, 821 ESE Loop 323, Suite 100, Tyler, Texas Investment products and services are offered through Wells Fargo Advisors Financial Network, LLC (WFAFN), Member SIPC, a registered broker-dealer and separate non-bank affiliate of Wells Fargo and Company. Trinity Capital Management, LLC is separate entity from WFAFN. The indices presented in this material are to provide you with an understanding of their historic performance and are not presented to illustrate the performance of any security. Investors cannot directly purchase any index. Wells Fargo Advisors Financial Network did not assist in the preparation of this report, and its accuracy and completeness are not guaranteed. The opinions expressed in this report are those of Trinity Capital Management, LLC and are not necessarily those of Wells Fargo Advisors Financial Network or its affiliates. The material has been prepared or is distributed solely for information purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Additional information is available upon request. Stocks offer long-term growth potential, but may fluctuate more and provide less current income than other investments. An investment in the stock market should be made with an understanding of the risks associated with common stocks, including market fluctuations. Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. Wells Fargo Advisors Financial Network is not a legal or tax advisor. Consult your tax advisor or accountant for more details regarding your specific circumstance. Investing in fixed income securities involves certain risks such as market risk if sold prior to maturity and credit risk especially if investing in high yield bonds, which have lower ratings and are subject to greater volatility. All fixed income securities may be worth less than the original cost upon redemption or maturity. Yields and market value will fluctuate so that your investment, if sold prior to maturity, may be worth more or less than its original cost. Bond prices fluctuate inversely to changes in interest rates. Therefore, a general rise in interest rates can result in the decline of the value of your investment. Bond laddering does not assure a profit or protect against loss in a declining market. Asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns nor can diversification guarantee profits in a declining market. Diversification does not guarantee profit or protect against loss in declining markets. Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo & Company and provides investment advice to Wells Fargo Bank, N.A., Wells Fargo Advisors and other Wells Fargo affiliates. Wells Fargo Bank, N.A. is a bank affiliate of Wells Fargo & Company. P/E Ratio is a valuation of a company or an index s current value compared to it s earnings per share. It is calculated by dividing the market value per share by earnings per share. S&P 500 Index: The S&P 500 Index consists of 500 stocks chosen for market size, liquidity, and industry group representation. It is a market value weighted index with each stock's weight in the Index proportionate to its market value. Dow Jones Industrial Average: The Dow Jones Industrial Average is an unweighted index of 30 "blue-chip" industrial U.S. stocks. Past performance is no guarantee of future results and there is no guarantee that any forward looking statements made in this communication will be attained. CAR