Both the positives and negatives of earnings, tax cuts, and trade are affecting the market, but is the glass half full or half empty? After the volatility of the first quarter, the second quarter of 2018 saw the fluctuation subside, but interest rate choppiness continued, along with a flattening yield curve on bonds — all indicating a transition in the economy. Up or down, investors should, as always, should remain diversified and disciplined.
As of the end of July, all of the major market indicators were up for the year. The Dow and S&P 500 were still below the all-time highs reached in January. The NASDAQ and the Russell 1000 reached new highs in July and then backed off by the end of the month.
The most notable risk to growth is trade uncertainty, which remains high and continues to have implications for both the economy overall and corporate earnings. This uncertainty is starting to have an impact on forward-looking economic indicators, including new orders in manufacturing and services. This warrants close scrutiny over the coming months.
Economists are watching manufacturing closely for signs of a drag, which could result from the Trump administration’s escalation of trade tensions with China and erstwhile allies including Turkey and Canada. In addition, November brings a mid-term election, which has historically been a rough time for stocks (and, sometimes, presidents). Meanwhile, in the best U.S. labor market in decades, the unemployment rate fell sharply by some measures.
The median existing-home price is at an all-time high, while total housing inventory saw its first year-over-year increase since June 2015.
Economic forecasters largely agreed that the recent tax legislation would boost growth in the near term, but were split over whether it would increase the economy’s rate of growth over the long term. Second-quarter earnings received a boost from the Trump tax cuts, and second-quarter earnings also continued trends from the first quarter. Earnings are expected to be up more than 24% in the second quarter, following a nearly 27% gain in the first quarter. However, consumer spending could slow in the third quarter as the boost from the tax cut fades.
At the margin, there are signs that the Trump tariffs are beginning to hurt. Some examples: Caterpillar, a leading manufacturer of construction and mining equipment, diesel engines, industrial gas turbines, and diesel-electric locomotives, says tariffs on steel and aluminum are expected to add between $100 to $200 million in extra material costs. The firm will raise prices to offset these costs. Jim McGreevy, president and chief executive officer of the Beer Institute—the national trade association representing U.S. brewers, beer importers, and suppliers—says that aluminum tariffs will cost American brewers an additional $347 million and may see more than 20,000 jobs eliminated in the supply chain. Coca-Cola has hiked prices on its carbonated drinks since the recently enacted 10% tariff on imported aluminum has made Coke cans more expensive to produce. Last month, Alcoa said the aluminum tariffs were likely to add $100 million in costs this year. The National Association of Home Builders says that tariffs on softwood lumber from Canada have increased the cost of building a house by $7,000 per home.
The second-quarter gross domestic product (GDP) release showed that the U.S. trade deficit narrowed, adding a bit more than a full percentage point to GDP growth. A big reason is that exporters were racing to get goods off the dock before retaliatory tariffs on a number of U.S. products were imposed. Exports of foods, feeds, and beverages—a category including the soybeans that China placed a 25% tariff on this month—rose at a 110% annual rate. That export surge won’t be there in the third quarter, and the likely result is that trade will be a negative for GDP as a result.
Despite the growth, businesses cut their inventories, which served as a brake on the GDP rise. This may have happened because goods that otherwise would have been stockpiled were put on boats to Europe and China, but it also might reflect a pickup in demand that businesses didn’t anticipate. That could set the stage for inventory restocking in the third quarter, which could result in a GDP boost.
American agriculture is among the hardest-hit sectors as other countries retaliate with tariffs of their own. Soybeans, which recently surpassed corn to become the largest U.S. crops in terms of acres planted, saw prices fall in early July to the lowest levels in a decade.
Stripping out trade and inventory effects, final sales to domestic purchasers grew at a 3.9% annual rate, driven by a 4% increase in consumer spending. But these measures of underlying demand might be slightly misleading, as they reflect a catch-up from the first quarter. Final demand grew by 1.9% and consumer spending grew at an annual rate of just 0.5% in the first quarter, in part due to issues such as a harsh winter.
For now, the best thing to do is to look at the underlying trend in final demand. Since the recession ended in 2009, it has averaged 2.3%. As of the second quarter 2018, final demand is up 2.9% from a year earlier, when it was up 2.4%.
The Economy
In the second quarter of 2018, the U.S. economy grew at its fastest pace in nearly four years. Robust consumer spending, solid business investment, surging exports, and increased government outlays were among the factors that gave it a boost. Real GDP increased at an annual rate of 4.1% in the second quarter of 2018, according to the advance estimate, up from 2.2% growth in the first quarter of 2018.
Growth in consumer spending, which accounts for more than two-thirds of U.S. economic activity, accelerated sharply in the second quarter, rising at a 4.0% rate compared to a 0.5% growth rate in the first quarter. The acceleration was broad-based across the major segments of consumer spending, with durable goods spending rising 9.3%, nondurable goods spending up 4.2%, and services gaining 3.1%. Consumer spending contributed 2.7 percentage points of the 4.1% real GDP growth rate, versus just 0.4 percentage points in the first quarter.
Business investment rose at a 7.3 % annualized rate in the second quarter of 2018, slower than the 11.5% pace of the first quarter. At annualized rates, the gain was led by a 13.3% surge in spending on structures, while spending on equipment rose 3.9%, and intellectual property investment rose 8.2%. Real business investment contributed 1.0 percentage points to overall real GDP growth, versus a 1.5 percentage point contribution in the first quarter.
Residential investment (housing) fell at a 1.1% pace in the second quarter compared to a 3.4% decline in the prior quarter. Altogether, business and residential investment grew at a 5.4% pace in the first quarter, contributing 0.9 percentage points to total GDP growth, compared to a 1.3 percentage point contribution in the first quarter. Inventory liquidation by businesses subtracted 1.0 percentage points from second-quarter growth, after adding 0.3 percentage points in the prior quarter.
Trade contributed strongly to the economy’s performance. Net exports added 1.06 percentage points to the second quarter’s 4.1% GDP growth rate, which likely reflected the surge in soybean exports as buyers abroad rushed to get their supplies before China’s retaliatory tariffs on the U.S. crop hit in July.
Personal Consumption Expenditures (PCE) increased to 2.2% annually in June, unchanged from May and up slightly from 2.0% in April. At the same time, core PCE—which strips out volatile food and energy prices and is the Federal Reserve’s preferred inflation measure—showed an annual increase of 1.9% for the third straight month. The data was in line with economists’ expectations. Gold prices, usually a good indicator of inflation, are ignoring the inflation data, reacting to a stronger U.S. dollar and easing geopolitical tensions.
Along with inflation data, reports say personal spending rose 0.4% in June, down slightly from a 0.5% rise in May. It was the smallest increase in personal spending in four months. However, consumers continue to spend just as much or more than they make as income only rose 0.4% last month, unchanged from 0.4% in May. The slightly softer income numbers may dampen expectations for third-quarter consumer spending.
The unemployment rate fell in July to 3.9% from 4.0% the prior month. The number of jobs increased by 157,000 in July, which was less than expected. However, revised figures for the past two quarters added 59,000 jobs more than originally reported, pushing the three-month average for job gains to 224,000. Through the first seven months of the year, employers added an average of 215,000 jobs a month, acceleration from last year’s average through July of 184,000 a month. The manufacturing sector added 37,000 jobs in July, the most since December. The retail sector also added 7,000 jobs, despite 32,000 jobs lost in sporting goods, hobby, book, music, and toy stores–Toys-“R”-Us finally closed in late June, resulting in layoffs of the final set of workers.
A broader measure of joblessness — one that includes the unemployed as well as discouraged jobseekers now sidelined and part-time workers looking for full-time jobs — fell sharply, from 7.8% to 7.5%, its lowest since May 2001. That’s a good sign because it means workers on the margins are getting full-time jobs in the best labor market in decades. The unemployment rate fell from 4.2% to 4% for high school graduates and from 5.5% to 5.1% for people with less than a high school diploma. By contrast, for college graduates, the rate edged down more modestly, from 2.3% to 2.2%.
Economic theory suggests that when workers become scarce, employers raise wages quickly to recruit and retain employees. But wage growth has persistently undershot economist expectations. Wages were up 2.7 percent from a year earlier, an annual increase that’s unchanged from June. Pay increases haven’t accelerated as much as anticipated in light of the historically low jobless rate. Since the Consumer Price Index, year-over-year, was up by about +2.9% in June, real hourly wages in July were essentially flat for another month. The dip in the unemployment rate without any corresponding upward pressure on wages suggests more slack in the labor market than the unemployment rate might otherwise suggest.
According to the National Association of Realtors (NAR), existing home sales decreased 0.6% to a seasonally adjusted annual rate of 5.38 million in June. This was the third straight monthly decrease. Existing sales are now 2.2% below a year ago. Lawrence Yun, the association’s chief economist, says closings inched backwards in June and fell on an annual basis for the fourth straight month. “There continues to be a mismatch since the spring,” he said, “between the growing level of homebuyer demand in most of the country in relation to the actual pace of home sales—which are declining.” Yun says the root cause is “the severe housing shortage that is not releasing its grip on the nation’s housing market. What is for sale in most areas is going under contract very fast and in many cases, has multiple offers. This dynamic is keeping home price growth elevated, pricing out would-be buyers and ultimately slowing sales.”
In addition, the NAR reported that the Pending Home Sales Index, a forward-looking indicator based on contract signings, increased in all four major markets in June, but overall activity lagged year-ago levels for the sixth straight month. Pending sales rose 0.9% to 106.9 in June from, 105.9 in May. Despite the increase, contract signings are still down 2.5% on an annual basis. The latest results show that interested buyers continue to face a persistent shortage of affordable inventory that is driving up property prices faster than wage growth. Also, as mortgage rates climb to an almost five-year high, affordability declines.
The median existing-home price for all housing types in June 2018 was $276,900, up 5.2% from June 2017. June’s price increase marks the 76th straight month of year-over-year gains and a new all-time high. In addition, total housing inventory at the end of June rose 4.3% to 1.95 million existing homes available for sale, which is 0.5% above June 2017. This is the first year-over-year increase since June 2015.
Unsold inventory is at a 4.3-month supply at the current sales pace; it was 4.2 months a year ago. Properties typically stayed on the market for 26 days in June, which is unchanged from the last three months and down from 28 days a year ago. Fifty-eight percent of all homes sold in March were on the market for less than a month.
We note that affordability of housing is negatively affected not only by home price but also by debt/income levels, required down payments, rising interest rates, rising property taxes, and increasing insurance costs. According to Freddie Mac, the average 30-year fixed-rate mortgage decreased to 4.57% in June from 4.59% in May. The 30-year mortgage rate ended 2017 with a December rate of 3.95%.
According to The Conference Board, a nonprofit business research group, their Consumer Confidence Index® increased to 127.4 in July from 127.1 in June. More broadly, the index has eased a bit since February, when it hit its highest level since November 2000. (The Consumer Confidence Survey® reflects prevailing business conditions and likely developments for the months ahead. This monthly report details consumer attitudes and buying intentions, with data available by age, income, and region. The 1985 index equals 100.) “Consumers’ assessment of present-day conditions improved, suggesting that economic growth is still strong,” the board stated. “However, while expectations continue to reflect optimism in the short-term economic outlook, back-to-back declines suggest consumers do not foresee growth accelerating.”
In early August, as anticipated, the Federal Reserve chose to maintain the target range for the federal funds rate at 1.75-to-2 percent. This decision was widely expected. It is anticipated that the Fed will raise interest rates two more times this year, including next month and possibly three times next year. “Information received since the Federal Open Market Committee met in June indicates that the labor market has continued to strengthen and that economic activity has been rising at a strong rate,” the Fed noted. “Job gains have been strong, on average, in recent months, and the unemployment rate has stayed low. Household spending and business fixed investment have grown strongly. On a 12-month basis, both overall inflation and inflation for items other than food and energy remain near 2 percent. Indicators of longer-term inflation expectations are little changed, on balance. The Committee expects that further gradual increases in the target range for the federal funds rate will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term.”
The Stock Market
Through the end of July, all the major averages were up for the year, with the Dow rising the least at 2.82%. The S&P 500 was up 5.34% and the NASDAQ was up 11.13%. Both the NASDAQ and the Russell 2000 hit new highs in July. Of the 10 sectors represented in the S&P, seven sectors saw positive performance for the quarter, as measured by the SPDR sector ETFs. The best performing sector was Energy (13.47%), followed by Consumer Discretionary (8.18%). Only three sectors saw negative performance, with the worst performers being Financials (-3.24%), followed by Industrials (-3.18%).
In Fixed Income, yields for the 10-year note rose quickly in the early part of the quarter to a high of 3.1% in mid-May before concerns about mounting trade tensions and slower global growth had yields retreating from their highs. The 10-year note finished off the quarter at 2.861% above its starting point of 2.5% for the year. While the long end of the yield curve continued to flatten, the 30-year bond also increased 13 basis points—but at a slower pace than the 10-year note—and ended the quarter at 2.97%. In 2018, 10-year Treasury bond yields have continued to rise primarily due to strong economic data, signs of higher inflation, continued job gains for U.S. workers, higher funding needs by the federal government as a result of higher budgets and the tax reform package, and concerns about Fed tightening policies. Stubbornly low yields on longer-term maturity bonds have fueled concerns that the yield curve could eventually invert, with short-dated yields moving above long-dated yields. This is keeping investors on edge. An inverted yield curve has often preceded a recession.
We expect the Fed will continue to raise short-term interest rates as inflation pressures are building. The Fed is also tightening policy by shrinking its balance sheet, which means the market will need to absorb about $400 billion more in Treasury bond supply this year than in 2017. Thus, yields will likely need to rise to attract buyers to the market. That said, when stocks selloff sharply, Treasury bonds tend to rally because they serve as safe haven investments in times of heightened volatility.
The Barclays U.S. Aggregate Bond Index, after rallying in 2016 and 2017, ended the second quarter down 0.16% and the first half down 1.62% as the Fed raised interest rates and foreign buyers of corporate bonds retreated during the first half of 2018. These are the first back-to-back losses since the financial crisis.
As measured by the SPDR sector ETFs, the energy sector had the best performing gains in both the second quarter and the first half of 2018. The Brent Crude oil prices average $74 per barrel in July, largely unchanged from June. The energy market has also been reacting to threats from the Trump administration, which indicated that the White House would look to sanction countries that don’t reduce their imports of Iranian crude to “zero” by November 4. The U.S. dollar, which is widely viewed as a safe-haven currency, often benefits from rising trade friction. The Wall Street Journal Dollar Index increased in the second quarter of 2018 by 5.5% to end the quarter at 88.38. This is after peaking in early 2017 and then declining for most of the rest of the year and into the first quarter of 2018.
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