July Investment Comments

The S&P 500 mostly sputtered through the first five months of 2018, but a strong start to June has pushed its year-to-date performance up to +5.5%.  Renewed volatility has made this year’s gains feel hard-earned, even grueling.  It is somewhat difficult to believe that we are currently on pace for another year of double-digit returns, although we are, at least for the moment. 2018 is unlikely to approach 2017’s spectacular 22% return, but how could it?  2017 enjoyed a huge boost from investors suddenly imputing the future benefits of the surprising late-year corporate tax cuts.  That trick won’t repeat, although 2018 and beyond should enjoy follow-on benefits as lower taxes promote more business investment and faster overall growth.

Corporate earnings now demonstrate the benefits of those tax cuts.  According to John Butters in FactSet’s Earnings Insights from June 7, the S&P 500’s estimated Q2 earnings growth rate is a robust 19%.  This is driven largely by tax cuts, but also by a strong recovery in energy prices providing a welcome boost to the beaten-down energy sector.  Higher energy prices are a double-edged sword for the economy overall because of increased input costs for producers and tighter budgets for consumers.  However, the immediate effect on S&P 500 earnings is a net positive.

The Consumer Price Index has risen 2.8% over the past twelve months.  The Producer Price Index has increased 3.1%.  Both seem to be accelerating, and the Federal Reserve has little choice but to hold to its expected course and continue to reduce its balance sheet while raising short-term interest rates.  The Fed has adhered to its expected course so far in 2018 and raised its target rate again on June 13 to a range of 1.75%-2.0%.  It also implied a slightly more aggressive stance may be necessary to stay ahead of inflation.

Long-term interest rates have not risen as fast as short-term rates, producing a flatter yield curve.  Low long-term interest rates support higher values for assets, but the flat yield curve is especially bad for many financial stocks.  Banks are seeing a rising cost of capital without an offsetting rise in lending opportunities.

Long-term rates are a global phenomenon, but the global economy does not look as sanguine as these low yields and high asset values would imply.  The European Union experienced some palpitations recently, as Italy briefly seemed poised to follow Great Britain out of the Union.  Italy represents the EU’s 4th largest economy (including Great Britain) and was the 3rd largest economy to adopt the euro as its currency, which Great Britain never did.  The consequences of an Italian exit could be vast, but a new Italian government elected not to pursue that course.  Any related anxieties seemed to quickly get pushed back down into the global economy’s collective subconscious.  Fears around various Mediterranean countries exiting the EU seem to resurface every year, but the world is breathing a sigh of relief for the moment.

Meanwhile, President Trump’s efforts to wrestle China into a more equitable stance on bilateral trade were overshadowed by his disagreements with our closer, older allies.  At the G7 summit in Canada, the President made headlines by refusing to endorse the Group’s official economic statement in support of free trade.  His complaint seems to be that America’s trading partners are being hypocritical by publicly supporting free trade when it suits them while also imposing high tariffs on many U.S. goods.  He has a point, although that doesn’t necessarily make his strategy a good one.

The U.S. stock market does not normally respond well to geopolitical instability, but growth cures a lot of ills.  The U.S. unemployment rate has declined to 3.8%.  The Wall Street Journal recently noted that falling unemployment and rising business confidence have produced a rare situation where the current number of estimated job openings is higher than the estimated number of people looking for work.  In turn, wages are rising faster than inflation.  Workers are also keeping a bit more of that higher income thanks to tax cuts, although rising energy costs are likely to offset those incremental benefits.  The overall landscape supports faster growth.

We note that the 2018 stock market earns extra style points for producing its gains in the presence of a U.S. dollar rally.  After falling about 8% in 2017, the dollar is up about 3% this year measured against a GDP-weighted basket of foreign currencies.

For better or worse, investors should brace for a wave of mergers.  On June 12, U.S. District Judge Richard Leon ruled that AT&T’s acquisition of Time Warner could proceed, against the Department of Justice’s contention that the combination would be anticompetitive.  The ruling will almost certainly lead to more mergers within and between telecommunications and media industries.  Prior to the ruling, Comcast had already stated its intention to outbid Disney for Twenty-Frist Century Fox, should AT&T’s Time Warner acquisition be allowed.  We may well see the same thing across other industries.

Mergers excite investors because most acquisitions come with a generous premium paid to the lucky holders of the target company.  That said, mergers rarely achieve their stated synergy goals, and acquirers’ shares tend to underperform the overall market in the wake of a big deal.  An acquisition binge typically produces a hangover.  There is a reason Wall Street calls them “merger manias.”

The overall investor landscape seems reasonably balanced.  Stocks aren’t cheap, but neither are valuations outlandish—some exceptions aside. Low long-term interest rates can support high stock values.  There is no shortage of optimism in the market, and growth-oriented investors have to work hard to find good companies at fair prices.  That is almost always the case, though.  We wouldn’t have it any other way.

Miles Putnam, CFA