QUARTERLY MARKET UPDATE as of October 2018
Stocks had their best quarter since 2013, moving up 7.7% as measured by the S & P 500. Giant cap technology companies Amazon, Apple, and Microsoft weighed heavily on returns increasing on average 17%. Most sectors were in positive territory led by healthcare, industrials, and technology. International markets were marginally higher gaining 1.5% in the developed markets, while small cap stocks increased 3.5%. The Federal Reserve increased the target range for the Federal Funds rate by ¼ of a percent to 2% to 2.25%. The longer end of the yield curve also increased, but by a lesser amount. The ten-year Treasury yield was up 20 basis points and finished the quarter at 3.05%. The dollar index oscillated, starting out strong then weakening to finish nearly unchanged.
Economic growth remains steady. While the second quarter GDP increase of 4.2% is expected to moderate, the Fed’s projection actually increased over the quarter to an annual rate of 3.1% in 2018. Personal income and spending had solid and stable increases of 0.3%, while earnings from the S & P 500 are estimated to increase 19% in the upcoming third quarter reporting season per FactSet. Industrial production and durable goods had strong recent reports, but the manufacturing component was more subdued.
As we expected, wage increases are starting to accelerate. The latest year over year gain was 2.9%, last matched in 2009, and the monthly increase in wages was 0.5%, the largest increase in seven months. Unemployment remains near historical lows at 3.9%, and is projected to decline to 3.5% next year. Jobless claims are at a 50-year low, and there are more job openings than those seeking work.
No surprise then that consumer confidence is the highest in 18 years and close to the all-time record reached at the height of the emerging dot com era in 2000. This may raise a red flag as a very high confidence figure is one of several harbingers for reaching the top of a market cycle. At market bottoms fear and pessimism are pervasive, while market peaks typically exhibit widespread investor euphoria. But other sentiment indicators are not as robust. The Ned Davis Crowd Sentiment Poll is only modestly elevated in the optimistic zone, and fund flow information from ISI Evercore Research shows funds coming out of equities into bonds, not supporting the sentiment we would expect at the top of the stock market.
If steady growth remains in place we expect the Fed will continue its path of regular interest rate increases. Another ¼ point increase is highly likely at the December meeting as the movement towards “normalization” continues. In 2019 three additional increases are expected. Driven by their dual mandate of stable prices and maximum employment, the Fed could adjust their expected increases if growth or inflation accelerate. Unemployment is expected to continue falling over the next year which should keep wages rising. But overall inflation remains surprisingly subdued. The latest monthly core personal consumption expenditures index (PCE) was unchanged. The year over year change is at 2%, right at the Federal Reserve’s policy target.
Offsetting the positives are the looming impact of the tariff battles, especially between the U.S. and China. Over the last six months we have seen some companies showing an adverse effect on their bottom line with costs increasing. The step up in tariffs by both countries will accentuate the influence going forward and widen the number of companies and industries impacted. Per FactSet, for the upcoming third quarter earnings reporting season there has already been a net increase in negative warnings over positive warnings issued by companies.
Housing is still not contributing much to the economy. Growth has slowed in new and existing home sales, as have price increases. Our Pacific Northwest region has been more of the exception, leading the country over the last few years. But the latest overall S&P Case Schiller Home Price Index only nudged up 0.1%, with price declines in New York and Chicago. We don’t expect this to change much over the next year as higher interest rates will continue to impact mortgage rates. Already up 1% year over year, 30-year fixed rate mortgages are now averaging 4.72%, the highest level since 2011.
In light of the reasonably balanced data outlined above, we are cautiously optimistic and will maintain our equity weightings. Strong corporate earnings growth has kept valuations at reasonable levels. The forward price earnings ratio has declined from 19 at the start of the year to 17.5 now. We would become more concerned when levels are above 20. Investors will be contending with the uncertainty in the tariff spats, an upcoming contentious election, and another rate increase. All of which may boost volatility and lead to short term corrections. But the steady strength of the U.S. economy is expected to keep the rally going. As interest rates are expected to move gradually higher we will maintain a shorter duration for our fixed income weighting.