Investors in 2018 haven’t had much to cheer about. The stock market is about flat. The resumption of normal volatility seems abnormal because prior years were so placid in comparison. Normally investors can seek relief in the bond market, but with both the Federal Reserve and a stronger economy pushing interest rates higher, many are surprised to see the value of their bond portfolios declining. This is the reverse of 30 years of experience, as ever lower rates caused bond portfolios to appreciate.
While interest rates are clearly behind the bond market’s problems, the stock market can’t blame corporate earnings or the economy. According to FactSet Research, as of early May 81% of companies in the S&P 500 have reported first quarter results. These companies reported a composite earnings growth rate of 24.2%. If this growth rate holds up it will mark the highest earnings growth since 34% for the third quarter of 2010 when the economy was recovering from deep recession. This is impressive growth, but we should keep in mind that roughly half of it is due to corporate tax reform that cut U.S. tax rates from 35% to 21%.
Even so, double-digit organic earnings growth this far along in what became the second-longest economic expansion in May is impressive. This earnings growth doesn’t happen without sales advancing, and the 81% of companies reporting grew sales 8.5%. This is the highest growth rate since the third quarter of 2011. Analysts have updated their 2018 projections and now expect earnings growth of 19.5% and sales growth of 7.2%.
The global economy looks strong. In the U.S., first quarter GDP advanced 2.3%, down a bit from the 3%+ levels of the prior three quarters, but the best showing for a first quarter since 2015. Since the recovery got going there has been a repeating trend of relatively weaker first quarters, as some analysts have questioned the seasonal factors used to adjust the raw data. In any event, consumers held back growth with a modest 1.1% spending increase, likely taking a breather after a 4% advance in the fourth quarter and in the presence of harsher winter weather in Q1. Most encouraging for future growth is the 6.1% advance in nonresidential fixed investment, reflecting business investment in buildings, equipment, software, etc. This investment sows the seeds for faster growth as it gives businesses and their employees the tools they need. Trade also got into the act as exports advanced 4.8% and imports slowed to a 2.6% growth rate.
The international backdrop is solid. The International Monetary Fund (IMF) estimates that global growth for 2018 will come in at 3.9%. After 2.4% growth in 2017, the Eurozone expects about the same performance, 2.3%, in 2018. China continues to report its steady growth of 6% or more, and even if the statistics are a bit too consistent to believe there is no question that Chinese consumers and businesses are doing well.
So why is the stock market struggling to advance? The key lies with the Federal Reserve as investors try to gauge the pace of future interest rate increases. In April, the Fed got to check off both boxes against its dual mandate: low but positive inflation and (perhaps) full employment. In that month the index measuring personal consumption expenditures, the Fed’s preferred inflation gauge, hit 2.0%, a long-sought goal over this expansion. Further, unemployment broke below the 4.0% level, to 3.9%, a 17-year low, as the economy added 164,000 jobs. This is quite an accomplishment as the pace of monthly job growth has accelerated over the past year. However, the true unemployment rate may not be as low as it looks due to the significant number of workers that are working part-time jobs and want full time employment, as well as workers too discouraged to seek work. This measure fell to 7.8% in April, but remains above the low of 6.9% in December 2000.
Rising inflation and low unemployment are usually a recipe for rapid interest rate increases as the Fed tries to cool things down. However, the Fed is in uncharted territory as its current monetary position is still somewhat expansionary. The Fed Funds rate has reached a range of 1.5%-1.75%, below the level of inflation. Most economists believe a premium of 1% over inflation is a neutral position, implying the Fed can raise rates another 1.25%-1.5% without hurting the economy. However, there is no way to know what the Fed’s gradual bond-reduction program to shrink its balance sheet will do to rates as, at the margin, it is contractionary.
The Fed signaled at its May meeting it expects to raise interest rates twice more, 0.5% in total, in 2018. However, the futures market has placed better than 50% odds on three 0.25% increases. If the market is right this would leave the Fed Funds rate between 2.00%-2.25%, implying no worse than a neutral rate position. If inflation begins to advance faster the Fed would likely raise rates more rapidly, a negative for stocks.
Expansions usually end due to either an over-aggressive Fed or an external shock. We believe the Fed is acting prudently and will be careful not to raise rates too quickly. Data from the housing and automotive markets has been somewhat sluggish lately, not surprising as these interest sensitive sectors are responding to increasing long-term rates. This should tamp down growth a bit as 2018 progresses. Further, the Fed isn’t too concerned about temporarily exceeding its 2.0% interest rate target. Gradual rate increases are likely the norm.
However, trade is becoming a bigger risk as rhetoric from Washington is met with cold shoulders from countries overseas. We believe China holds the key to successfully diffusing tensions if it moves in the direction of reforming some of its practices, particularly around intellectual property. We also don’t yet have a new NAFTA agreement and the possibility of operating without NAFTA would hurt all three countries.
As always there are uncertainties in the investing environment. However, current risks don’t strike us as excessive, particularly with strong corporate earnings growth and a growing global economy. Investors have been complaining about elevated valuations for quite some time, but the forward twelve-month P/E ratio for S&P 500 companies is now 16.0, below the 16.1 average of the past five years and only 12% above the 14.3 mark of the prior ten. This doesn’t strike us as a bad time to be in stocks, particularly in the face of increasing bond yields.