QUARTERLY MARKET UPDATE as of July 2019
Stocks continued to gain ground in the second quarter. The S & P 500 was up 4.3% with all sectors finishing higher except for Energy. Small Cap stocks were up by about half that amount at 2.1%. Mega cap growth stocks Microsoft, Amazon, and Facebook contributed an oversized percentage of the gains while “value” style stocks continued to lag. Intermediate and longer-term interest rates declined with the 10-year treasury yield hitting a two-year low in the quarter at 1.98%, and below the short-term Fed Funds rate currently at 2.5%. This quarter we expect U.S. economic growth to remain slow but steady; the variance of which will be dependent on progress made in global trade talks and the willingness of the Fed to switch to a more accommodative monetary policy.
The U.S. economy grew at a 3.1% annualized rate in the first quarter, but is expected to decline to 1.5% in the second quarter per the latest Atlanta Fed GDPNow forecast. This is still faster than most would have expected possible at this point in the business cycle. Ten years into an economic expansion along with increasing trade issues would normally lead into a recession. But the rate of growth for this cycle has been slower than the average of past expansions, at a 2.3% annual rate versus 2.7% over the last 50 years. Past expansions have typically fizzled out after an overheated economy was cooled off by the Fed raising interest rates higher than necessary in order to keep inflation under control. That has not happened in the current economy. Homebuilding, business investment, vehicle sales, and inventory levels have all been relatively stagnant, inflation is low, and the Fed has been relatively dovish versus past cycles.
The tariff spats have had a negative impact on the global economy, but especially in countries that are reliant on exports like Germany, Japan, and South Korea. The U.S. imports more than it exports and has not been impacted as much as its trading partners. In decades past it would have been a fair conclusion that inflation would have surged with the increase in tariffs. However, the effect of more online purchases, an Amazon effect, has allowed for more competitive pricing and has helped keep inflation in check. There is also the impact from companies like Walmart that source their products globally and will switch to a low-cost supplier whenever possible to keep prices down. The latest inflationary data showed an increase in the core Personal Consumption Expenditures Index (PCE) of only 1.6%, still below the Fed target of 2%.
The unemployment rate remains at a 50-year low of 3.6%. There is a growing shortage of skilled labor in the tightest labor market in decades. More jobs are posted than there are available applicants, with many companies unable to fill their open jobs. That is not what we would expect at the end of an expansion. Combined with our historically low interest rate environment, we continue to expect the economy to grow at a slow and steady pace and not fall into a recession. We are not experiencing the typical end of an expansion when high interest rates and rising prices put the brakes on the economy.
The Fed’s rate hikes over the last three years went from 0.25% to 2.5%, a much more cautious level of increases compared to past cycles. Interest rates are still historically low, and borrowing costs are cheap. With global growth slowing, the Fed’s next move will likely be to lower rates this summer. Additional rate cuts in the fall may follow if global growth remains anemic. Our strong dollar has also contributed to the global slowdown and that may be alleviated with interest rate cuts in the U.S. Interest rates of several of our trading partners remain negative.
At the recently concluded G20 meeting in Japan, concerns were lifted that the U.S. and China would escalate their trade wars. The markets will be on a wait and see approach to determine the level of progress on a long-term deal. Positive developments will boost stocks and make a Fed rate cut less likely.
Overall corporate profits have had a large negative change compared to the past year. Last year earnings grew at over 20%, the fastest pace since 2010. Now the second quarter growth rate is expected to be negative, with similar forecasts for the third quarter per FactSet. But only two of the sectors have negative earnings forecasts, Technology and Energy. Both sectors have a high amount of international revenue exposure, with Technology having the highest of any sector.
Most valuation metrics for stocks are near historical averages. The current forward P/E is at 17.5 versus the 25-year average of 16.2; the dividend yield is 2.5% vs. the 2.1% average; price to book is 2.90 vs. 2.94, and price to cash flow is 11.6 vs. 10.6. Taking into account our low interest rate environment, our current metrics are at reasonable levels. We will continue to trim our exposure to stocks with lofty valuations, and see better long-term value in stocks paying dividends with steady and positive earnings growth.