September Investment Comments


U.S. economic indicators appear quite strong and supported an impressive 4.1% annualized growth rate in second quarter Gross Domestic Product.  Underlying growth would have been 5.1% excluding inventory de-stocking; ups and downs in inventories typically correct themselves the following quarter.

Retail sales growth also remains solid, up 6.4% from last year.  After inflation, real retail sales growth is 3.5% and may be a reasonable measure of trendline economic growth.  Consumer optimism, an excellent employment environment, and the impact of lower withholding from last year’s tax cuts suggest spending growth will continue.

Job growth is outstripping growth in population and the labor force, pushing the unemployment rate below 4%.  Help-wanted signs abound and businesses complain of worker shortages.  This should lead to faster wage growth due to competition for workers.  According to the Labor Department, the “employment-cost index” grew at the fastest rate of the past ten years in June.  However, the increase was just 2.8% so there is a ways to go before wage growth becomes embedded in consumer prices.

Consumer prices continue to edge up, rising 2.9% for the year ended July 31st.  Excluding volatile food and energy costs, the CPI would have risen 2.4%.  By the method preferred by the Federal Reserve Board, inflation is running at 2%, which is precisely the Fed’s inflation target.  Growing labor shortages, rising costs for materials, and the impact of tariffs suggest that inflation will be headed higher in coming months.  This underscores the Fed’s program of gradually hiking short-term interest rates to moderate the rate of economic growth and slow the rise of inflation before it gets out of hand.

Overseas growth is less robust, adding to investor anxiety caused by tariff battles.  Eurozone economies grew at an annualized rate of 1.5% in the second quarter.  While Germany continues to lead the way, orders for manufactured products in Germany have turned negative.  Japan rebounded from a 0.9% GDP decline change in the first quarter to 1.9% growth in the second.

Emerging markets are sporting higher growth rates, but bigger question marks as well.  While China’s official economic growth rates are stellar, most other indicators suggest deeper problems.  The Chinese stock market is down more than 20% this year, a reflection of investor concerns.  Capital spending is still growing, but slower than all but one year in the past two decades.  Retail sales growth slowed too, but remains enviable compared to growth rates in the West.

Chinese leaders sense the slowdown and have been encouraging banks to open the money spigot.  New loans increased 75% in July compared to the previous year.  However, the country also has a problem with rising levels of bad debt from previous lending sprees.  A government-directed spike in lending will likely exacerbate its bad-debt problems.  Total debt in China is 270% of its GDP, most of which consists of corporate borrowing.

Increasing U.S. tariffs are creating anxiety throughout the world, particularly in China.  In contrast with the perception of China as an export powerhouse, China runs a trade deficit with the rest of the world except the U.S., against which China has a massive trade surplus.  This imbalance has obviously caught the attention of the Trump administration, which has instituted a series of tariffs in order to foster significant changes in the U.S.-China trade picture.

Despite strong economic growth in India, its currency has been remarkably weak.  A standoff between the U.S. and Turkey over its jailing of an American pastor has spilled out of the world of diplomacy and into the economic world with U.S. pressure and threats of tariffs.  The value of the Turkish lira has plummeted.

Despite these global worries, second quarter growth of U.S. companies is shaping up to be the best in recent memory.  Thanks to sharp declines in U.S. corporate tax rates, stocks are trading at about 17.5 estimated earnings for 2018.  This is a reasonable multiple, suggesting that stocks are fairly valued.  However, anecdotally, it seems that the best companies are not particularly cheap and investors need to be careful to keep quality high.

Scott D. Horsburgh, CFA