Jeff Krumpelman from Mariner Wealth Advisors discusses the economies strong start to the third quarter.
Aug. 6, 2018 Commentary

Nice Start to the Second Half of 2018

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“It’s the Economy, Stupid!” - Bill Clinton, 1994 Presidential Campaign

July certainly was a nice way to start the second half of the year. Specifically, with the Standard & Poor’s 500 index advancing to 3.7 percent for the month. We also saw nice rotation back into the more economically-sensitive sectors of the stock market, such as financials and industrials, which led returns in July versus lagging in prior months. Importantly, this nice result was driven by good, tangible factors—solid fundamentals. 

Both the economic and earnings news was simply outstanding, as you will see below. Given what can be a seasonally weak summer season and the “wall of worry rhetoric” that continues on the trade front, some may contend the healthy stock market returns in July were unexpected. And, there’s this ongoing myth that the positive 2018 market returns are only the result of a “FANG” stock price surge while all else is failing us to this point. As for the trade and tariff threats, we finally saw some needed progress in July’s final days. Regarding the latter contention—it’s all and only about “FANG” this year—it just ain’t so. 

From our perspective, the ultimate driver of stock prices boils down to fundamentals—the economy and earnings. We have much to celebrate in that regard. As Bill Clinton suggested to George Bush, Sr. in the 1994 presidential campaign and his successful bid for office, the eventual outcome depended on just one thing. “It’s the Economy, Stupid.” We believe the same can be said for stock market returns. It comes down to the economy and associated impact on revenue and earnings.

The Stuff That Really Matters—Earnings and the Economy

The Economy

The economy is in a good place right now. Data released in July supports this view. First, the June employment report, published in early July, was stellar. Payrolls grew by 213,000 jobs in June, prior months’ job growth was revised upward, and wages grew at a 2.7 percent annualized pace, but not so fast to threaten profit margins. Very encouraging, the labor force participation rate rose for the first time in a bit, meaning conditions are good enough that people who had dropped out of the workforce for a while were incented to look for a job again. New job creation has averaged more than 200,000 new jobs per month this year, which is very robust considering we are nine years into an economic recovery.

The fact more people are looking for work is a good sign. It suggests we aren’t as close to inflationary full employment as many fear. Other positive signs on the employment front, include:

  • Lowest unemployment claims since 1969
  • More workers exhibiting confidence and quitting their job for a better one
  • A historically low number of layoff announcements

Plus, there is a plethora of other positive economic data. To wit, consumer and business confidence remain close to record highs, industrial production remains in a continued uptrend and retail sales rose sharply in June, marking the fourth consecutive monthly advance and putting them on pace for robust  8 percent annualized growth this year. The icing on the cake was the Q2 gross domestic product (GDP) report released July 27, 2018. It revealed the U.S. economy advanced by 4.1 percent for the three months ending June 30, 2018.

The details of the report, shown in the adjacent chart, confirm all sectors of the economy contributed to this impressive growth rate: consumer, business investment (capital spending), net exports and government spending. The drawdown in inventories bodes well for GDP next quarter as it suggests strong sales and final demand which depleted goods in stock. The pick-up in capital spending was particularly nice to see and illustrates the economy is more balanced now. In prior years, it was more or less a one trick pony carried solely on the back of the U.S. consumer. 

The only disappointing July economic data is related to housing sales. Housing news has typically been two steps forward, one step back throughout this recovery. Even stabilization in the dollar, and U.S. interest rates via the 10-year Treasury resuming a measured rising trend back toward the 3 percent level, were positive signs this month. Now, we can’t get complacent. We have to continue to monitor this as we get significant new economic news this month. The central banks (Bank of Japan, ECB and the U.S. Federal Reserve) all meet this month and will send signals to the market on interest rate policies that could be market moving. We’ll be watching job reports in future months very closely.  We know from the January 2018 report, when wage growth ran too hot at 2.9 percent for investors liking, that the market can temporarily react negatively to just one number.  At this point, however, we feel the comprehensive body of data skews decidedly to the positive and we would not be bothered by any such temporary volatility.

Percentage Point Contribution To Annual GDP Growth

Source: Commerce Department

Earnings

I’m going to keep this short because earnings news really couldn’t be better and we’ve talked about positive earnings trends quite a bit. But, it is important for you to know that Q2 earnings season is going very well. With roughly 53 percent of S&P 500 companies reporting Q2 earnings through July 27, 83 percent have reported upside surprises, a figure well-above average. The blended earnings growth rate in the second quarter is 21.3 percent, one of the highest earnings growth rates for a quarter since the recovery began, bowing only to Q1 2018 and Q3 2010 growth rates of 25 percent and 34 percent respectively.  

Earnings growth expectations have continued to rise for the quarter and calendar years 2018 and 2019. All this said, while earnings have been strong, the little advertised acceleration in revenue growth has even been more impressive, coming in at a level of more than 9 percent. Such robust top-line growth illustrates that earnings are not growing just because of tax cuts—demand is solid! And, when you have 9 percent revenue growth, companies can absorb a rising, but still moderate, 3 percent wage growth without worrying about declining profit margins.

Further, we should make the point that with rising earnings growth, valuation has become much more attractive. P/E’s have declined from close to 19 times at the peak of the market in January down to the 16.5 times level today. If some of the wall of worry items would be solved (e.g. trade) and multiples would expand back to the 18 times level on expected 2019 S&P 500 earnings, the market would approach 3100….hmm.

Key Wall of Worry Item - An Update on Trade

Regarding our thoughts on the ongoing trade and tariff rhetoric, our conclusion remains the same…these are still negotiations, not trade wars. We believe they will eventually be settled with productive results. There were several key events in late July that we think represent progress:

  • First, it’s worth noting that many folks seem to be confused about the magnitude of these tariffs. For example, in the Trump administration’s latest announcement about potentially applying a 10 percent tariff on an additional $200 billion of Chinese imports, many interpreted this as a $200 billion tariff versus the potential $20 billion tariff that it truly would be. The former is 1 percent of U.S. GDP; the latter is .1 percent of GDP. There’s a big difference and it is not as intrusive as many think.
  • The President of the European Commission, Jean-Claude Juncker visited the White House in late July, and the U.S. and the European Union announced an agreement in principal to move toward zero tariffs on industrial goods and to defer implementation of any additional auto tariffs for now…nice progress. Containing the auto tariff risk is critical. Further, as a sign of opening up their markets, the EU committed to increase purchases of U.S. soybeans, which implies a more united front to address concerns about unfair trade practices of the Chinese.
  • Negotiations for a new NAFTA agreement have begun with the new Mexican administration.
  • Of the S&P 500 companies reporting so far, over 80 percent say they see virtually no negative impact from tariffs. It doesn’t appear to be delaying business investment decisions. 

In summary, we’ve finally seen some good news on the trade front, at least with regard to the Europeans and Mexico. While it sounded like crickets lately on the Chinese front, they have huge incentive to come to the table and negotiate in good faith. The stock price chart below shows that the market assumes the Chinese are the losers in this tariff battle given their much more export centric economy. Since the rhetoric started, the Chinese stock market has fallen roughly 20 percent while the S&P 500 is flat.

S&P 500 & Shanghai Composite

Source: Strategas, July 2018

The positive news flow with regard to the Europeans and the Mexican government also highlights the potential irony in this…by threatening higher tariffs, the world may actually end up with lower global tariffs.  Because of these tariff threats, several major economies, including the Chinese, are implementing fiscal stimulus as an insurance policy against slowdown. The stimulus can re-ignite the pace of global growth. It would be so interesting if this saga resulted in the Fed staying on hold a bit longer. No doubt stocks would like that.

Wrap-up

In conclusion, the backdrop in the United States remains strong. The economy is more balanced and if capital spending continues to accelerate, this could enhance labor productivity and extend the expansion phase for longer than many expect. As for the Wall of Worry, we embrace it. First, it keeps investors cautious and prevents the euphoria that tends to signal market tops. Similarly, it can keep the Fed measured in hiking rates and from being premature in choking out growth by becoming austere too quickly. We are focused on analyzing the trends in the data and to listening to what they tell us rather than making pre-ordained judgements. We shy away from trying to predict the predictors. Why predict when the yield curve will invert? The stock market historically loves a flattening yield curve. We’ll take appropriate action, if such indicators turn negative. At present, the fundamental, valuation and technical price trend indicators are trending in a positive direction. Stay tuned!

 

The views expressed are for commentary purposes only and do not take into account any individual personal, financial, or tax considerations. It is not intended to be personal legal or investment advice or a solicitation to buy or sell any security or engage in a particular investment strategy. The S&P 500 Index is a market-value weighted index provided by Standard & Poor’s comprised of 500 stocks chosen for market size and industry group representation. You cannot invest directly in an index.

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