Market Update

QUARTERLY MARKET UPDATE as of July 2018

Stocks in the U.S. gained ground from the low point at the start of the quarter. The S & P 500 was up 3.4%, led by a 14% increase in the Energy sector while Financials and Industrials fell over 2%.  International stock markets declined. The broad EAFE index was off 2%, with the biggest decline coming from the Euro area which was off 4%.

Interest rates continued moving higher. The short term Federal Funds rate was increased at the Fed’s June meeting by ¼ of a point to a range of 1.75% to 2.0%.  Longer term rates increased by a smaller amount, reducing the slope of the yield curve. If the slope of the curve is down, meaning short term rates are higher than long term rates, then the risk of a recession increases.  But we are not forecasting an “Inverted Curve” anytime soon.

At its meeting last month, the Fed indicated it may increase interest rates two more times this year. This potential total of four increases for the year is more than what was forecasted back in January when most Economists expected two to three increases.  Inflation has been edging up, and the economy appears strong. Corporate tax cuts boosted profits and increased economic momentum, driving the new hawkish tone set by the Fed.  Earnings are now expected to increase 22% this year per Thompson Reuters. After a slow start to the year consumer spending also bounced back fueled by the tax cuts and a strong labor market.  The unemployment rate continues to decline and is now at 3.8%.  The Federal Open Market Committee forecast is for that figure to continue to drop, moving to 3.5% by next year, and a sharp contrast to the 8.5% unemployment rate in the Euro area.

Growth in Europe is also slower than the U.S., with average GDP forecasts showing a 2.3% increase this year compared to 2.8% for the U.S.  Globally we are seeing downward revisions in many countries’ growth forecasts. That is a factor in the dollar’s continued strength this quarter, extending its reversal from last year. In addition, the reduction in the Fed’s balance sheet is also shrinking the supply of dollars. The Fed’s accumulation of bonds over the past nine years is now being partially reversed which is reducing the amount of dollars worldwide. Both factors point to further dollar strength this year.

A stronger currency and slower global demand will likely put a damper on the sales of U.S. products overseas.  The multiple trade spats the U.S. is currently involved in will also not help global growth prospects. Although it may place greater pressure on our trading partners to come to the negotiating table, as most countries are more dependent than the U.S. on exports to boost their economic growth. U.S. GDP is forecasted to increase a very strong 4.5% in the second quarter by the Federal Reserve Bank of Atlanta. Seasonal adjustments to GDP have historically caused the 1st quarter GDP numbers to be understated while overstating the 2nd quarter.  The 2nd half of the year is expected to grow by almost half that amount, or 2.3%.

The somewhat complacent attitude by investors towards a possible trade war stems in part from the optimistic view that the Trump administrations tough rhetoric is a negotiating strategy.  Flexibility and a give and take among all parties in this process will be required, and that is what the market is assuming will occur in the months ahead. If meaningful concessions from our trading partners are reached this will be a tailwind for another rally in equities. But recent comments from several world leaders would indicate that counter tariffs will be implemented this month without any interest in providing concessions.  Without signs of progress, investor sentiment may quickly switch to pessimism which is not being priced into the market right now.

The vibrant housing market in recent years helped fuel the growth in our economy. Recent reports, however, are now showing a declining rate of growth.  Home price increases slowed per the latest Case Schiller home price index, while existing homes and new home sales reports were also on the low end of expectations. Rising mortgage rates and high selling prices may have put a brake on demand.

Stellar corporate earnings have kept valuations down and have reduced the risk of the market becoming too pricey.  The current forward p/e ratio is down to 17.5 from 18.5 last year.  While the possibility of a trade war may be the single biggest risk going forward, the reasonable valuations temper our views of a significant decline. At the same time, we move cautiously into the second half of the year seeking securities that we expect will outpace the market, while selling or trimming positions that become overpriced.