Investment Outlook – July 2018

  • July 3, 2018

Halfway Through 2018 and Not Much to Show for It


At this time last year, the S&P 500 had gained about 8% on the back of Donald Trump’s promises of tax cuts and relaxed financial regulations. And this was only the first half of the year: 2017 finished with a twelve-month gain of 19.4%. So far in 2018, the S&P 500 is up about 1.4%. And technically, the stock market is still in a correction mode, having declined from its high by over 10% and having so far failed to surpass its previous high.

The euphoria of a year ago has given way to caution and market participants are beginning to wonder how far away a bear market may be. Although we’re not ready to describe the current mood as pessimistic, we do notice a decline from last year’s euphoria.

A possible reason for this absence in enthusiasm could be age. The market itself may be a little long in the tooth: since its beginning in March of 2009, the current bull market has run for the second longest period in the S&P 500’s history, has endured five corrections, counting the present one, and has grown 300% over its 2009 low.

Age is not necessarily an indicator of imminent demise, but it does give one pause: both individuals and markets eventually realize their own mortality. Some approach this subject with anxiety: a market collapse is just around the corner. For the market, every minor setback or negative report hastens the arrival of the inevitable event and builds what market participants call “a wall of worry.”

Others approach the subject of mortality with complacency: the good times will never end and, if they do, the end is too far away in time to worry about it. Complacency encourages risk taking and a culture of excess while anxiety urges caution. Of the two, anxiety is the more productive emotion for markets. A market that fears the worst is already trading at modest levels; good news, or news less calamitous than feared, can drive it higher, while truly bad news, because it is expected, has a diminished impact.

Complacency expects no negatives and is eventually and inevitably disappointed. Mature bull markets often follow progressions from anxiety to complacency as waves of positive economic news and results drive the previously anxious into the camp of the happily complacent. Corrections occur when negative events or convincing rumors of negative events drive the complacent into anxiety. Bear markets occur when the process skips anxiety entirely and drops directly into fear and panic.

Today’s market shows signs of both anxiety and complacency: there are signs of excess — valuations are moderately elevated, acquisitions and initial public offerings are at levels not seen since the dot-com bubble of the early 2000s — and caution — hand-wringing among market participants continues apace — but neither emotion, at this time, appears dominant. The five corrections over the last nine years may have much to do with this; one might even consider them “speed bumps” for delaying the arrival of irrational exuberance. More importantly, despite the age of the current bull market and some indications of its maturity, there doesn’t appear to be enough evidence of excess to raise anything other than a caution flag.

Markets are imperfect oracles of future economic activity. Imminent recessions and expansions are always predicted by bear and bull markets, though not always accurately. False positives are common: the economist Paul Samuelson once famously quipped that “the stock market has predicted nine of the last five recessions.”

Like the stock market, the economy also has an age issue: the last recession ended nine years ago, making the current expansion the second longest since the end of WWII. During most of its early years, however, the expansion was characterized by slow growth, elevated unemployment and ultra-low interest rates. It can even be argued that without near zero interest rates, the first few years of the expansion would have been a continuation of the previous recession. Some would even argue that it’s only been in the last two or three years that the U.S. economy has begun to behave like an expansion. Expansions usually end when there’s too much capacity and/or too little demand to sustain growth. A primary medium for this balancing act is the level of civilian employment.

A low unemployment rate is a good indicator of a healthy economy. More employment means more income for consumers, which in turn means more demand for goods and services, more profits for the providers of those goods and services and more investment in employees and capital equipment to meet the increased demand for goods and services. It’s a virtuous circle, particularly for an economy that derives sixty to seventy percent of its growth from consumer expenditures.

The circle ceases to be virtuous when an economy runs out of productive employees to hire and/or fails to make the right investments in productivity enhancing capital equipment. The latest reading (May) on the U.S unemployment rate was 3.8%, the lowest level since April of 2001. We’re not yet running out of people to hire — the labor participation rate for May was 62.7%, well below the 83% numbers struck before the last recession — but baby boomers are retiring at a rapid clip and immigration controversies in Washington are limiting possible solutions to an aging U.S. workforce. There are signs that the longawaited capital investment wave will finally appear this year and increase employee productivity: last quarter, S&P 500 companies increased capital expenditures by 24%.

This is key: without higher productivity, the more unemployment drops, the more difficult it will be to find productive workers and the more likely it will be that cost-push inflation removes the virtue from full employment.

Acting as the primary monetary policeman against imbalances in the U.S. economy, the Federal Reserve has continued to push short term interest rates higher. After keeping the Fed Funds rate at an effective 0% rate (0% to .25%) for seven years following the “Great Recession”, the Fed raised the rate by .25% seven times, beginning in December of 2015, to a current level of 2.0%. It has also indicated that it plans to raise the rate to 2.5% by the end of 2018, 3.0% by the end of 2019 and 3.5% by the end of 2020.

Two and a half years to raise the Fed Funds rate by 1.5% hardly seems like a case of aggressive monetary policing but, given that the current ten year and thirty-year U.S. Treasury bonds are yielding 2.88% and 3.03%, it suggests that between now and the end of 2020, either that these bonds will be presenting yields in the 4% to 5% range or that the Fed will reconsider its path.

It seems unlikely to us that, absent evidence of a virulent streak of inflation, the Fed would intentionally invert the yield curve and risk plunging the economy into another recession. It also seems unlikely that, given the apparent health of the U.S. economy, the Fed would feel the need to pare back on its steps to return short term interest rates to more normal levels. That essentially means that the bond market is likely to push up yields over the near term.

GDP growth since the last recession has averaged about 2.2%. It’s been a relatively steady, but somewhat lackluster post-recession rate: the average recovery following a recession has clocked in at 2.7%, a not insignificant difference when compounded over the last nine years. There are rumors and forecasts that the quarter just ending (Q2, 2018) will show a growth rate of 4% or more; if that number is reported — the first estimate will be released at the end of July — it will represent the fastest GDP growth rate since the first quarter of 2004 and could indicate a general quickening of the economic expansion that, despite likely higher interest rates on bonds, should support equity returns.

Arguing against this optimism is the specter of a trade war between the U.S. and its trading partners. Like so much about President Trump’s actions and statements, it’s difficult to predict where this trade initiative will lead. He may be bluffing for negotiating leverage, but he gives every indication that he’s prepared to carry through on his threats.

A trade war is an unambiguously bad thing for everyone and, once begun, difficult to undo without serious damage to all parties. Of course, the U.S. would suffer much less direct harm than its trading partners from such a war: net exports are a minor negative contributor to U.S. GDP (-3.2% for this year’s first quarter) but represent major positive sources of growth for most of our partners. And, unlike the U.S., a good bit of the rest of the world is still searching for a sustainable recovery from the last recession.

The president is probably correct that the U.S. bargaining position in this game of chicken is strong; however, agreements once shattered may prove to be very difficult to put together again. And a collapse of the current rules and institutions of world trade, with no immediate replacement, would have long term negative effects upon the global economy, including the U.S. We believe that despite the brinksmanship, a detente among the partners is likely and an all-out trade war will be averted.

Despite its age, we believe the domestic economy still has room to grow. There are challenges ahead — corporations must increase investments in productivity enhancing capital goods, the yield curve needs to remain in a positive slope, a crippling trade war must be avoided — but the prospects for success are good. As long as the economy is expanding and corporate earnings follow suit — S&P 500 operating earnings grew 10.8% in 2017 and are expected to grow 15.9% in the 2018 calendar year — the equity market should benefit, even if rising interest rates impede or diminish market P/E multiples.

For more information about the commentary found in this newsletter, please contact a member of Argent’s investment team:

Not Investment Advice or an Offer

This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate, or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.