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News & Insights

 

October Investment Comments

 

From listening to the media, it is hard to believe the market is again flirting with all-time highs.  An “inverted” yield curve, trade policy uncertainties, overseas economic weakness, and always-present political instabilities, such as the recent attack on Saudi Arabian oilfields, should surely be enough to make anyone run for cover.

 But these concerns don’t seem to be holding back equity investors.  The forward 12-month P/E ratio for the S&P 500 is 16.8, just slightly ahead of the 5-year average of 16.5 and about 14% above the 10-year average of 14.8, a period that includes very weak earnings from 2009 and 2010.  Further, unlike a year ago, analysts aren’t expecting double-digit earnings growth.  For calendar years 2019 and 2020, earnings are expected to grow 4.3% and 5.6%, respectively.

 Given the media’s “wall of worry,” can these modest earnings projections hold up?  The answer likely lies with the U.S. consumer, who for now is doing quite well.  Jobs and income growth continue to move in the right direction.  August job growth was 130,000, a bit inflated by the hiring of temporary workers to support the U.S. Census.  The unemployment rate stayed at 3.7%.  Average hourly earnings were up 3.2% over the past year and 4.0% when including the boost from additional hours worked.  With inflation running around 1.5%-2.0%, consumers are enjoying solid real income gains they can spend to support the economy.  This strength is showing up in retail sales, which grew 0.6% month-over-month in July on top of a 0.7% increase in June.

 Lower interest rates will also help consumers.  The average 30-year fixed rate mortgage has dropped by roughly a full percentage point since last December, to 3.62% in August.  Housing is already reacting as existing-home sales rose 2.5% in July from June and 0.6% year-over-year, the first increase since February 2018.  The rate drop is leading to mortgage refinancing activity and should help spur other interest sensitive sectors, including autos.

 But strength from consumers shouldn’t be taken for granted.  In August, U.S. manufacturing shrank for the first time in three years according to the widely followed Institute for Supply Management (ISM) Index.  Trade was cited as the most significant issue facing U.S. manufacturers due to global supply chain adjustments in response to increasing tariffs on Chinese goods.  Manufacturing can be a leading indicator for the labor market as weakness leads to cutbacks in hours worked and employment.  However, August’s poor showing isn’t coming from lack of demand, the typical reason for contraction.  Trade policy is the culprit.

 After several months of increasing tariffs from the U.S. and Chinese rhetoric about being treated unfairly, relations between the two countries seem to be improving.  In September, both the U.S. and China took steps to remove or delay tariffs on each other’s goods and are making positive gestures to resume trade negotiations.  The likely reason is economics.  U.S. GDP growth has slipped to 2%, a level that the Trump Administration finds unacceptably low, and China’s growth has clearly slowed.  While officially China expects 6% GDP growth in 2019, there is evidence from unofficial sources that growth is running about half that level.  It is in both countries’ interest to put together a deal, even a small one, that leads to planning certainty for businesses.

 The greater problem for the U.S. long-term is overseas moribund economies, particularly Europe and Japan.  The Eurozone is right on the brink of recession and, in response, the European Central Bank recently reduced its borrowing rate by another 0.1%, to negative 0.5%, and resumed a $22 billion per month bond buying program that it had ended in March 2016.  The Japanese Central Bank’s borrowing rate is negative 0.1%.  It is questionable how much more monetary policy can do for these economies given the heavy dose of monetary stimulus both have received over the years.

 Negative overseas rates hurt the U.S. in two ways.  First, our low, but positive, interest rates look attractive to foreign investors.  In June, the last month of available data, foreign investors purchased about $64 billion of U.S. stocks and bonds, the largest sum since August 2018.  Undoubtedly this trend has continued, pushing down U.S. long-term rates and complicating the typical recession signal sent by an “inverted” yield curve.

The demand for U.S. investment also helps push the dollar higher.  A stronger dollar makes U.S. exports more expensive and imports cheaper, leading to lower GDP growth and weaker inflation, neither of which is welcome.

As is always the case, stock selection is very important but particularly so in this economic environment.  According to FactSet, companies in the S&P 500 that rely more heavily on foreign sales are expected to see earnings lag.  For firms with less than 50% of sales from overseas, third quarter earnings are expected to grow 0.4%.  This isn’t anything to write home about, but it is far better than the 10.7% decline expected for firms with more than half of sales generated overseas.  The combination of weak overseas economies and the strong dollar are hurting these companies far more than their more U.S. dependent brethren.

In summary, while the market looks modestly expensive, expectations are reasonable and there is the possibility that if trade tensions ease economic performance can improve, providing the setting for further market gains.

Daniel J. Boyle, CFA