What is U.S. Blues?
The U.S. economy continues to show exceptional strength and resilience in the face of myriad negative headlines, as well as slowdowns in several parts of Europe and Asia. As the chart below shows, U.S. GDP growth bottomed in Q2 2016 and has risen sequentially in every quarter since. This trend is expected to continue for Q2 and Q3 of this year. Confidence also remains strong, with consumer confidence near its highest levels since 2000 and small business confidence at multi-decade highs.
The current economic expansion is one of the longest in history, but some of this is due to the fact that the first several years of the rebound were among the weakest in U.S. history. As such, many of the excesses that normally surface in the economy remain absent from the current backdrop. This has helped prolong the duration of the current expansion, which appears to have further room to run. We continue to monitor the environment for the emergence of dark clouds on the horizon, but as we sit here today it remains premature to act on those concerns.
For its part, the Federal Reserve continues to hike short-term interest rates. The most recent 25 basis point hike brought the fed funds rate (overnight rate) to 1.87% – still a low level by historical standards. The market is currently pricing in another rate hike this September, followed by an additional 2-3 hikes in 2019. If those forecasts prove accurate, that would bring the fed funds rate to 2.62% next year. While the Fed will never state this as part of their objective, it is likely that the Fed wants to continue to raise rates ahead of the next economic downturn so that they can create room to cut interest rates again if needed. In effect, they need ammo.
With short-term rates on the rise, the chatter surrounding the potential for the yield curve to “invert” (meaning short-term rates higher than long-term ones) continues to escalate. An inversion of the yield curve has preceded every U.S. recession since 1950, but the lag time before the onset of recession can vary widely. The average lag from the date of the yield curve inversion to the onset of recession can be anywhere from 6-18 months. Selling out of current investments because the yield curve is getting close to inverting also seems premature to us.
The current yield on the 10-yr T-note is 2.86%, about 26 basis points higher than the 2-yr T-note. And although there is upward pressure on short-term rates due to the Fed, there are also upward pressures on long-term rates. For one, inflation gauges in the economy are finally starting to firm. Additionally, the Fed is reducing its balance sheet and no longer buying Treasuries. There are also rumors that China is buying less Treasuries than normal. Last, the ECB has announced that it too will start to reduce its bond purchases starting in October. All else being equal, the above should exert slight upward pressures to longer-term yields, thus extending the time before the yield curve inverts.
Moving on to the stock market, while many market observers have pointed out the lackluster returns so far this year, we would point to the surprising resiliency and outperformance of the U.S. markets as a big positive. To wit, we have all seen the barrage of negative headlines surrounding trade tariffs assessed against China, Europe, and even Canada and Mexico. But despite these seemingly negative developments, the U.S. stock market continues to experience shallow pullbacks each time reports surface, and stairstep higher once the dust settles.
An old investing adage says that it’s not the news per se, but rather the stock market’s reaction to the news that is important. On that front, the stock market has done surprisingly well by holding up in the face of the negative headlines. Maybe the market is forecasting that the tariff skirmish will not escalate into a full-blown trade war, and that in the end maybe all of this back and forth will lead to more fairness among global trade policy? That would certainly be a net positive longer-term.
Remember that the ultimate driver of stock prices remains the underlying corporate earnings growth. The combination of the recent tax cuts combined with the strengthening economy is setting the stage for another very strong quarter of profit growth. This continues to be a tailwind for the stock market.
Current forecasts for the upcoming Q2 earnings season show corporate profit growth is expected to exceed +25% year/year, a hefty growth rate. And estimates for fiscal 2019 earnings for the S&P 500 have been steady near $175. That puts the current market valuation at a P/E ratio (price / earnings) of just under 16x forward earnings. That is a reasonable valuation level given the strength of this economy, the low level of interest rates, and the overall inflation picture.
As of the end of Q2, the S&P 500 was up +1.7% for the year and remained -5% off of its January peak. But underneath the surface there is a more bullish picture. The other major indexes such as the Nasdaq, the S&P Midcap Index, and the Russell 2000 small-cap index all touched new highs in June. And as the chart below shows, the cumulative advance-decline line for the overall NYSE index also made new all-time highs in June. This measure is often considered a good barometer of the overall health of the broader stock market. Taken together, and one gets the sense that the stock market is on solid footing and likely to continue to make solid gains this year.
In summary, while the current economic expansion does look long in the tooth by historical standards, it is likely to continue in the near-term. And despite the flattening of the yield curve, it remains premature to start forecasting the onset of recession and thus the impetus to lighten up on stocks. The backdrop of a strengthening economy combined with the recent tax cuts provide a tailwind for stocks that will likely result in new highs for the market in the back half of the year.
We continue to place an emphasis on managing risk in client portfolios, but remain cognizant of the need and desire to participate in the potential gains from the market as well. While we have begun work on defensive strategies we feel its too soon at this juncture to implement them. Stay tuned.
Jordan L. Kahn, CFA
Chief Investment Officer
Sources: Stockcharts.com; BTIG research; Raymond James; Briefing.com; IBD; Standard & Poors; Barron’s; Charles Schwab
