Through mid-July, the S&P 500 is up nearly 5%, a respectable start following 2017’s strong performance. The move higher has come despite what appears to be slowing, but still solid, global growth and concerns surrounding trade. President Trump recently proposed tariffs on $200 billion in Chinese goods after Beijing responded in kind to earlier tariffs on $34 billion of Chinese imports. The proposal is in addition to ongoing trade disputes with Europe, Canada, and Mexico. Trade wars result in uncertainty that could slow business investment and potentially offset the tailwinds businesses are enjoying in the form of tax reform and regulatory relief. For now, the market seems to be shrugging off, though not completely disregarding, concerns related to trade, but it is a topic worth closely monitoring.
The Federal Reserve pointed to “solid” U.S. economic growth during the first half of the year in its semi-annual report to Congress. This is supported by the Federal Reserve Bank of Atlanta’s forecast of 4.5% GDP growth in Q2, up from 2.0% growth in Q1. The report to Congress also reiterated that the Fed expected to continue to raise interest rates gradually given a strengthening economy. In the current rate cycle going back to December 2015, the Fed has raised interest rates seven times and it is projecting another two rate hikes by year-end. The market doesn’t fully concur with this view. For the remainder of this year, the Fed is expected to raise rates again in September, but the market is only placing approximately 50-50 odds of another rate hike in December. Developments surrounding trade have the potential to disrupt current plans, though communications from Chairman Powell have been consistent that a solid job market, inflation near the Fed’s objective, and balanced risks to the outlook mean gradual increases to the Fed Funds rate is appropriate.
An economic indicator that has been getting increasing attention is the difference between the 2-year and 10-year Treasury bond yields. An inverted yield curve, where 2-year Treasury yields are higher than 10-year yields, has historically been a reliable indicator of recession. The 2-10 “spread” has declined steadily since 2014 and is currently only around 0.25%, in line with lows last seen in 2007. Quantitative easing has suppressed longer-term treasury yields, meaning the 2-10 spread may no longer be as reliable an indicator of recession as it historically has been. The 2-year Treasury yield is more sensitive to Fed rate increases than 10-year yields and the Fed is keenly aware of the relationship between an inverted yield curve and recession. This could also potentially cause the Fed to hike more slowly than currently anticipated. Recently, the President of the Federal Reserve Bank of Minneapolis noted that the flat yield curve is an indication it may be time to stop raising interest rates.
The June jobs report delivered good news. The data showed the addition of 213,000 jobs in the month, better than the 195,000 expected. For the first half of the year, monthly job growth averaged a solid 215,000. Though the June jobs number was strong, the unemployment rate actually ticked higher, to 4.0% from an 18-year low of 3.8%. This was for positive reasons, however, as discouraged workers reentered the labor market. It appears Americans on the margin are returning to a job market that’s providing more opportunities for workers, which was reflected in the increase in the labor force participation rate.
June data also showed average hourly earnings increased 2.7% versus a year ago. The bad news for workers is the Consumer Price Index in June showed prices rose 2.9%, outstripping gains in wages. This was the fastest increase in consumer prices since February 2012, though the increase was goosed by higher gas prices. Removing the impact of volatile gas and food prices, core inflation increased a more modest 2.3%.
Higher inflation and faster wage growth means companies are facing cost pressures. One example is increased freight costs. Trucking companies are having a difficult time finding drivers, and the increase in fuel prices has also contributed to the higher cost of moving goods. The June Producer Price Index data showed the cost for truck transportation had increased 7.7% compared to last year. Some of these pressures can be offset with greater efficiency or higher prices, though not all companies are able to successfully do so.
It will be difficult for Q2 corporate earnings to match the growth we experienced in Q1, when companies grew earnings at the fastest pace since 2010. Expectations are for earnings growth of just over 20%, below the 23% increase recorded last quarter. It is worth noting earnings have historically outpaced expectations by about 3%-4%, so Q2 growth may yet exceed what companies reported for the first three months of the year. Many of the same tailwinds from Q1 remain intact, most notably the benefit from tax reform and global growth. One tailwind companies enjoyed in Q1, a depreciating dollar, has reversed and will instead serve as a modest drag on earnings in Q2.
A good sign for the upcoming earnings season is the consensus forecast for S&P 500 earnings has increased since early June, marking the second quarter in a row where forecasts increased heading into earnings season. The usual Wall Street dance is to instead reduce estimates into the announced results, lowering the bar for companies and allowing for an earnings “beat” once quarterly results are released. To be certain, there remain risks, but if earnings come in as expected, 2018 will have produced strong corporate results through its midpoint.
James M. Skubik, CFA