QUARTERLY ECONOMIC UPDATE, Q3 2018
Tompkins Financial Advisors Investment Committee
The Quarter in Brief
The third quarter of 2018 shall be remembered as a great one for stocks. The Dow Industrials, Nasdaq Composite, and S&P 500 all rose more than 7% in three months as bullish investors maintained their confidence in the face of some momentous news developments. Consistently strong economic indicators and impressive corporate profits helped motivate the summer rally. While the prospect of a global trade war did not ruffle Wall Street, investors in other regions shouldered more worry about the imposition of tariffs. Meanwhile, the Federal Reserve continued raising interest rates, the housing market cooled, and wage growth improved.1
Domestic Economic Health
The trade war with China that began in the second quarter intensified in the third, even while both nations attempted to resume negotiations. On July 6, China and the U.S. each imposed import taxes on $34 billion worth of each other’s products. August 23 saw both parties expand the tariffs to cover $50 billion in goods. On September 24, the U.S. placed a 10% tariff on $200 billion more of Chinese imports, slated to rise to 25% in 2019. China retaliated with further tariffs on its end, assessing levies on $60 billion more of American-made products reaching its borders.2
Apart from a trade war, there was also a crucial trade deal at the end of the quarter. On September 30, the U.S., Canada, and Mexico agreed to a trilateral update for the North American Free Trade Agreement (NAFTA). The tentative accord must now be approved by the respective governments of all three nations. It stipulates that cars in the NAFTA region must be built with 75% or more of their parts manufactured in the three nations, or face tariffs; additionally, 40-45% of cars being built in the region will have to be made by workers paid at least $16 an hour. The agreement would also institute new trade secret and intellectual property standards and environmental regulations intended to thwart unlawful animal, fish, and timber importation and permit easier access to Canada’s dairy market.3
Federal Reserve officials decided on another quarter-point interest rate hike. The September 26 decision took the federal funds rate to a target range of 2.00-2.25%. Notably, the latest Federal Open Market Committee statement removed the word “accommodative,” symbolically shutting the door on the easy money era. In the press conference after that news release, though, Fed chairman Jerome Powell referred to the new funds rate level as “accommodative.” This was the central bank’s third rate move of 2018, and one more is widely expected in December. The FOMC now projects 3.1% growth for the economy in 2019, as opposed to the prior forecast of 2.8%.4
Consumers were keenly optimistic this summer. The Conference Board’s monthly consumer confidence index shows excellent readings of 127.9, 134.7, and 138.4 for July, August, and September, respectively. Those numbers include revisions to the July and August readings. In September, the University of Michigan’s consumer sentiment index settled at 100.1, only the third time in the last 14 years it has topped 100.5,6
The Institute for Supply Management’s factory sector and service sector purchasing manager indices signaled that businesses were in good shape as well. ISM’s service sector index went from 55.7 in July to 58.5 for August, and its manufacturing PMI went from 58.1 in July to 61.3 a month later.7
The July and August employment reports from the Department of Labor were fair to good. July saw employers add a mediocre 147,000 net new jobs, but that improved to 201,000 the next month. More importantly, the annual rise in worker wages improved to 2.9% in August from 2.7% in July, approaching the level economists have long wanted to see in this recovery. In both months, the headline unemployment rate was just 3.9%; the underemployment (U-6) rate ticked down to 7.4% in August from 7.5%.8
Annualized inflation lessened in Q3. The Consumer Price Index displayed a yearly increase of 2.9% in July, then 2.7% in August; yearly core consumer inflation went from 2.4% to 2.2%. The Producer Price Index actually retreated 0.1% in August after a flat July; that retreat took its yearly advance down to 2.8% from the previous 3.3%.9
Other key indicators largely offered good news. By the end of the third quarter, the Bureau of Economic Analysis had delivered its third estimate of Q2 Gross Domestic Product (GDP): 4.2%. Hard goods orders were up 4.5% in August, following a 1.2% dip in July. Retail sales jumped 0.7% in July, but just 0.1% in August. Industrial output was up 0.4% in both those months; manufacturing output rose 0.3% in July and 0.2% a month later. Last but certainly not least, personal income rose 0.3% in both July and August.9
Global Economic Health
Apart from the NAFTA update and the U.S.-China tariff battle, there was plenty of other news drawing the attention of investors here and abroad.
As the quarter ended, just six months remained until the Brexit, and the question was whether the United Kingdom’s separation from the European Union would be hard or soft. A hard Brexit would leave a free trade agreement in place, much like Canada has with the E.U., whereby the U.K. could recast its trade and immigration policies and create its own commerce regulations. Prime Minister Teresa May is against this Brexit route; some estimates forecast it could deliver a long-term economic blow of 5% of GDP. May has pushed for her “Chequers” proposal, which would allow seamless trade between the U.K. and E.U. while allowing freedom of movement to and from the E.U. for the U.K. population and autonomy over its services. E.U. leaders and the U.K.’s Labour party, however, oppose this “soft” Brexit concept. Italy put a scare into E.U. leadership when its populist coalition government moved to run a 2.4% annual deficit through 2021, a risky move given that its debt equals 130% of its GDP. Italian leaders aimed to lower taxes, provide a basic income, and lower the qualification age for retirement pensions.10,11
Were tariffs already impacting China’s economy? Perhaps. The nation’s official factory PMI slipped to 50.8 in September, a 7-month low; the private Caixin/Markit manufacturing PMI hit 50.0, showing a sector on the verge of contraction. Export orders contracted for the fourth month in a row. While India’s economy was growing 8.2% through the first half of 2018, its rupee had lost about 13% against the dollar by the time Q3 ended, a painful consequence given the upturn in crude oil prices; similar currency slides affected Argentina and Turkey.12,13
The Nikkei 225 was the one major foreign index that performed as well as its American counterparts during the quarter. It rose 8.14%. The MSCI World Index also had a fine Q3, improving 4.53%. France’s CAC 40 also went into the plus column with a gain of 3.31%; India’s Sensex advanced 2.27%, and the Australian All Ordinaries added 0.57%.14,15
On the other hand, Hong Kong’s Hang Seng slumped 4.03% for the quarter. MSCI’s Emerging Markets index fell 2.02%, and the United Kingdom’s FTSE 100 lost 1.66%. Canada’s premier benchmark, the TSX Composite, settled 1.26% lower for the quarter, and the Shanghai Composite declined 0.92%. The German DAX index retreated just 0.48%.14,15
Palladium and oats finished first and second in commodity performance across the past three months, logging respective gains of 15.73% and 11.47%. RBOB gasoline advanced 6.97%; WTI crude, 5.38%; wheat, 1.90%; natural gas, 1.38%; the U.S. Dollar Index 0.09%. WTI crude settled at $73.56 on the NYMEX at the end of the quarter.16,17
There is also a long list of losers from Q3. Corn retreated 2.66%; platinum, 4.27%; soybeans, 4.30%; gold, 5.19%; copper, 6.30%; cotton, 8.59%; silver, 8.95%; sugar, 13.31%; coffee, 14.05%; cocoa, 16.89%. Lumber was the worst performer during the three months ending in September, dropping 31.91%. Gold closed the quarter at $1,196.20 on the COMEX, silver at $14.69.16,17
Existing home sales make up the vast majority of residential real estate transactions, and according to the National Association of Realtors, they declined 0.7% in July and went flat in August. NAR’s pending home sales index did bode well for the near future, as it showed housing contract activity down 0.8% for July, then 1.8% for August. One signal that seller expectations seemed to be moderating: the sudden difference in annual price appreciation for the 20-city S&P CoreLogic Case-Shiller home price index. The July edition (the latest available) showed prices rising 5.9% year-over-year, down from 6.4% in June.9
The Census Bureau did find the pace of new home sales 3.5% improved in August after a 1.6% decline for July. It also measured a 9.2% jump for housing starts in August, in contrast to a 0.3% dip a month earlier. (Building permits increased by 1.5% in July, but then slipped 5.7% in August.)9
On June 28, Freddie Mac’s Primary Mortgage Market Survey calculated a 4.55% average interest rate on a 30-year home loan. The mean rate on the 30-year FRM in the September 27 edition of the PMMS: 4.72%. Average interest rates for 15-year FRMs and 5/1-year ARMs were respectively 4.04% and 3.87% back on June 28; they stood at 4.16% and 3.97% on September 27.18
Looking Back, Looking Forward
The third quarter definitely flipped the usual Wall Street yearly script, in which bulls take the summer off between spring and fall rallies. No such behavior in 2018: the three major indices rose as much in the third quarter as some analysts felt they would all year. As the table below shows, the Dow Jones Industrial Average led the way in Q3 rather than the Nasdaq Composite. The small-cap Russell 2000 advanced 3.26% in Q3, and the accepted volatility index for Wall Street, the CBOE VIX, slipped 24.67%. The Dow ended the quarter at 26,458.31; the S&P 500, at 2,913.98; the Nasdaq, at 8,046.35.1,19
In Q3, the current bull market became the longest in the annals of Wall Street, driving stocks to new record heights. The Nasdaq topped both 7,000 and 8,000, marking the first time it had crossed a pair of 1,000-point thresholds since 1999.20
REAL YIELD (%)
1 YR AGO
5 YRS AGO
10 YRS AGO
10 YR TIPS
Sources: wsj.com, bigcharts.com, treasury.gov - 9/28/181,19,21,22,23
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends. 10-year TIPS real yield = projected return at maturity given expected inflation.
The third quarter was not only remarkably rewarding for investors, but also remarkably tranquil: during the quarter’s last 70 trading sessions, the S&P 500 did not make a single 1% move. That kind of calm may be rare in Q4, which quickly presents investors with both the fall earnings season and a midterm election. CNBC just polled a sample of Wall Street strategists, and their consensus forecast calls for the S&P 500 to advance 1.7% further during the remainder of 2018. Whether the index lives up to that projection or not, this does seem to be a worthwhile time to stay invested in equities. Economic indicators are still solid, for the most part; the latest GDP reading is impressive, and wages are keeping pace with inflation. Investors who want some reassurance might find it in the fact that since 1946, the S&P has never retreated in the 12 months after a midterm election. Wall Street is nothing if not unpredictable, of course, and some legendary market falls have happened early in fourth quarters – but currently, there is much to be optimistic about, and that optimism may persist through the end of the year.24
The Fed Continues on its Path of Interest Rate Hikes
As widely expected the Federal Reserve raised interest rates for the third time this year. The Fed acted in response to a strong U.S. economy and signaled it will likely maintain a pace of gradual rate hikes.
The Fed’s so-called dot plot, which the U.S. central bank uses to signal its outlook for the path of interest rates, shows that policy makers expect one more rate increase this year and three in 2019, based on median estimates.
It is worthwhile to note that the Fed has dropped phrasing it had used for years, phrasing that characterized its rate policy as "accommodative," by favoring low rates. By changing its language, the Fed may be signaling its resolve to keep raising rates.
Can Financial Markets Handle the Rate Hike?
The Fed’s interest rate forecasts will likely draw scrutiny. However, the market environment appears to be receptive of the current interest rate trajectory established by the FOMC.
In our view, markets are in good shape for the Federal Reserve’s eighth rate increase since 2015, with financial conditions near their highest level as of 9/30/2018 (within the context of the current hiking cycle). The Bloomberg U.S. Financial Conditions Index (below chart), a gauge of financial-market health based on stock, bond and money markets, is approaching its highest levels since 2007.
With U.S. stocks at historical highs, one of the most frequently asked questions is “when will it end,” or “when will the next economic recession strike?”
Forecasting the future state of the business cycle or, more simply, predicting a recession is a never-ending effort for any money manager, including us. We are always evaluating fundamental and technical data, in an effort to try to determine when the next U.S. recession is likely to occur. One indicator we follow more closely and that has a virtually flawless track record: the year-on-year change in the Conference Board Leading Index.
Every recession, since 1970, has come after a pronounced decline in the Conference Board Leading Index. This index is a composite reading of ten key economic and market measures*, compiled and released monthly by the Conference Board. There’s been only one instance (one month) when the index gave a false signal of an impending economic contraction.
* Below is the list of ten components making up the index
1. Average workweek
2. Jobless claims
3. Consumer goods orders
4. ISM New Orders
5. Orders Non-def Cap Goods ex air
6. Building permits
7. Stock prices
8. Leading Credit index
9. Interest rate spread
10. Avg. consumer expectations
These leading indicators include economic variables that tend to move before changes in the overall economy give way. Collectively, these indicators can be helpful in giving a full sense of the future state of the US economy. The chart included below might provide some comfort to those clients that are nervous about the markets. According to the chart, we are still distance away from the recession.
EQUITIES: Little Room for Profit Disappointment for High-Valuation Stocks
A screen of forward multiples above median benchmark levels shows that online retail, software and biotechnology stocks remain some of the most expensive securities within the U.S. equity index. The one-sidedness of the high-valuation equity rally will likely continue to be tested, as evidenced by the recent challenge to semiconductor stocks.
Year-to-date, Momentum and Growth (high-valuation) factors remain unwavering leaders relative to the performance of other major groups. While these groups have handily outpaced the index's year-to-date advance, warranting closer observation. There's very little room for these companies to disappoint, in our view. We continue to participate in equity rallies with conservative positioning.
FIXED INCOME: Opportunity Cost of Fixed Income Investing
Bond investing has come with quite an “opportunity cost” as inflation has accelerated. For the past two years, Bloomberg Barclays U.S. bond index moved less than 1 percent. As for stocks, the S&P 500 Index had a total return of 41% and the MSCI ACWI returned 32%. The fixed income space has been challenging, but we have been outperforming the index by significant margin through tactical asset class diversification and prudent duration management.
Emerging Markets: Continued Selloff
Besides a strengthening U.S. dollar and the prospect of more U.S. interest rate hikes, global trade tensions are one of the main factors driving the steep sell-off in EM assets. The U.S. continues its escalating trade war with China, which is weighing heavily on the minds of investors. Furthermore, the fear of EM contagion risk (as steep currency selloffs have recently hit Turkey’s lira, Argentina’s peso, India’s rupee, and Indonesia’s rupiah) has also been a pressing concern as of late. The overwhelmingly negative technicals in EM equities is sapping investor sentiment and has resulted in forced liquidations, as key levels of support have been broken.
Good News: S&P 500 Shrugging Off Emerging-Market Pains Thus Far
Surging U.S. stocks have managed to diverge from their slumping emerging-market counterparts for months, despite a stronger-than-usual one-year correlation of 0.71 between the two asset classes. Current one-year correlations are well above historical levels: 0.40 at the peak of EM stocks in 1997, and 0.63 in 2015.
Concerns: How Much Longer the U.S. Market Can Ignore the EM Weakness
Emerging markets make up about a quarter of global GDP growth, up from about 20% in 1997. EM stocks are already down as much as they were the last time their weakness weighed on U.S. equities.
It took a 37% correction in 1997-98 before EM stock declines bled into the U.S. equity landscape. Furthermore, just a 20% correction was needed before the U.S. market turned over in 2015. The MSCI EM equity index has dropped 19% thus far, from its peak in January.
Emerging Markets and S&P 500
We are paying closer attention to the correlations between EM, China and U.S. markets.
Our current view is that unless oil and the dollar confirm the story already told by stocks, emerging-market woes shouldn't weaken U.S. stocks' outlook.
- Oil pricesmay need to drop precipitously to signal whether emerging-market weakness will disrupt U.S. stocks. By the time U.S. equity markets peaked in 1998, EM equities were down 37% and oil traded 47% below its January 1997 apex. Similarly, when stocks peaked in 2015, EM stocks were down 20% and oil prices were 61% below their 2014 high. Unlike 1998 and 2015, oil isn't yet signaling a coming disruption S&P 500 earnings stream. West Texas Intermediate is down just 6% from its year-to-date peak.
- The U.S. dollar's recent gain of less than 10% isn't enough to sway U.S. economic activity or earnings growth much, nor does it signal extreme global capital flight to America. Before the last two corrections in U.S. equities in 1998 and 2015, the greenback surged much more, indicating contagion from other asset classes was likely to spread to stocks. The dollar index (DXY) jumped 19% from late 1996 to the middle of 1998, and almost 27% from its 2014 low to its 2015 peak. So far, the dollar is up about 7% from its trough earlier this year.
Investments are not insured by the FDIC, not deposits of, obligations of, or guaranteed by the bank or its affiliates, and are subject to investment risk including possible loss of principal. I recommend consistency in this disclosure across all print marketing pieces.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. The information herein has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results.
Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. These risks are often heightened for investments in emerging marketsThis material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. MarketingPro, Inc. is not affiliated with any person or firm that may be providing this information to you. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional.
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