While international economic growth appeared to slow relative to the U.S. in the third quarter, most signs point to a continued global expansion through the end of the year and well into 2019. As we enter October, our current economic expansion has marked its 111th consecutive month and is now the second longest in U.S. history. Moreover, if current economic estimates hold, this expansion will result in the longest ever recorded.
Domestically, very strong second-quarter economic output was confirmed by the third (and final) revision of real GDP growth that came in at 4.2%. The 4.2% reading generally exceeded economists’ estimates and marks the best pace of growth since the third quarter of 2014.
Manufacturing activity remains robust. The Institute for Supply Management’s Purchasing Managers Index registered an impressive 59.8 in September. This comes on the back of 61.3 for August, the highest level since May of 2004. A reading above 50 indicates that the manufacturing economy is expanding; below 50 indicates contraction.
Growth in the third quarter is likely to be a bit more tepid than the second, but still well above the sluggish gains posted throughout most of this expansion. Consumers will likely continue their unwavering support given that consumer confidence hit a new 18-year high in September, as robust jobs growth bolstered expectations.
The housing market appears to be one of the few areas of the economy that is showing some weakness. Although home-price increases have slowed over the last four months, tight housing supply continues to put upward pressure on prices. Home affordability is becoming a major concern as the cost of constructing or owning a home has significantly outpaced income over the last several years, deterring many would-be buyers.
Inflation remains contained, but tight labor conditions are suggesting this could change. Average hourly earnings of nonsupervisory, private-sector workers rose 2.8% in August from a year earlier, the largest annual increase since 2009. With the national unemployment rate at 3.9%, just above an 18-year low, and skilled workers in short supply, the economy may be shifting bargaining power towards labor and away from ownership. Labor strikes have caused workers (excluding teachers) to miss 633,000 days on the job so far this year, which is on pace to almost double the 440,000 days missed in 2017.
Escalating trade tensions, most notably between the U.S. and China, are on investor’s minds as we enter the fourth quarter. U.S.-China ties remain tense after the Trump administration imposed new 10% tariffs on $200 billion in Chinese exports in the last week of September. Also complicating global trade is the renegotiation of the North American Free Trade Agreement. Fears escalated as the quarter ended that Canada would be left out of the agreement with the U.S. and Mexico. However, it appears all parties reached an agreement just hours before the deadline set by the Trump administration.
Global oil prices surged to their highest close in nearly four years in late September based on improving sentiment regarding the global economy and supply concerns out of Iran and Venezuela. OPEC’s recent decision to hold self-imposed output caps steady added additional price support.
Markets remained pessimistic regarding international growth prospects for much of third quarter. However, investors have begun to reverse such sentiment in the waning days of September. An upbeat assessment of the eurozone economy by European Central Bank President Mario Draghi, strong Japanese equity markets, and brighter prospects for emerging economies were all factors in an improving outlook.
The 10-year Treasury yield approached a seven-year high in late September, a potential sign that global growth will persist despite trade conflicts. Economic data showing solid U.S. growth, persistently low unemployment, good corporate profitability, and encouraging developments in international markets likely led investors to sell bonds in favor of stocks throughout the month. The 10-year finished the month yielding 3.07%, up from 2.86% at the start of the quarter.
The slope of the yield curve flattened during the quarter, although most of the flattening occurred in July with a more stable slope in August through September. The current spread between the 10-year and the 2-year sits at 25 basis points, down from 30 at the start of the quarter. Investors will continue to closely monitor the 10- to 2-relationship as an inverted curve (when short-term interest rates exceed those on longer-term securities) has been a consistent indicator of a looming economic recession.
As expected, the Fed raised rates by 25 basis points to a range of 2.00%-2.25% at its late-September Federal Open Market Committee meeting. This most recent rate increase marks the third rate increase this year and the eighth since the Fed began to lift rates in late 2015. Fed Chairman Jerome Powell expressed continued optimism stating that “this gradual return to normal is helping to sustain this strong economy for the longer-run benefit of all Americans.”
Going forward, investors will be focused on the Fed’s policy path in 2019 and any signs of changes in inflation expectations. Projections released after the meeting show that most Fed officials expect to increase the Fed Funds Rate an additional one percentage over the next twelve months. Interestingly, the Fed dropped the word “accommodative” from its post meeting comments, a word it has used for years to describe its rate stance.
Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).
|Treasury Bill||Treasury Notes & Bonds|
|3 mo.||2 yr.||5 yr.||10 yr.||30 yr.|
The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).
|12 Month Returns (as of 9/28/18)|
|Barclays Capital US Aggregate||-1.22%||Merrill Lunch US High-Yield||2.90%|
|Barclays Intermediate Government||-1.18%||Merrill Lynch US Municipal Index||0.21%|
|Dow Jones Corporate||-1.33%||JP Morgan EMBI Global||-2.94%|
Second-quarter earnings reports were positive, with most companies either meeting or exceeding expectations. The notable exception involved companies exposed to rising input costs largely associated with the advent of steel and aluminum tariffs. On the back of a strong earnings season, domestic indices moved markedly higher in July and August, while providing more modest returns in September. For the quarter, the Dow Jones Industrial Average led the way with a return of 9.63%, but all major U.S. indices posted impressive returns.
Investors continued to prefer growth stocks over their value counterparts in the third quarter, with the exception of a few trading days in late July and scattered days throughout September. While valuations appear stretched for some companies, especially for select stocks in the Information Technology and Consumer Discretionary sectors, the stock market looks less pricey than it did at the beginning of the year given the realization of strong earnings growth.
Markets appear to be largely ignoring deepening trade conflicts likely due to hopes for another strong earnings season. Earnings tailwinds should persist as late-2017 corporate tax cuts continue to manifest and businesses maintain their sizeable share-repurchase programs. According to FactSet projections, companies in the S&P 500 Index are expected to report a 19% increase in earnings for the third quarter, a slight slowdown from the 25% growth posted in the first and second quarters, but still impressive nonetheless.
After positive returns in July, international stocks were rattled in August as Turkey’s currency collapse fueled fears of a spillover effect. European officials voiced growing concern that Turkey’s problems could particularly affect Spanish and Italian banks that may have outsized exposure to Turkish debt. Dollar strength, which has had a negative influence on international-stock returns year-to-date, may be starting to wane. The dollar is off over 3% versus the euro since its August 15th high. Positively, Japanese stocks are up approximately 17% over the last six months on relatively good economic growth, the continuation of accommodative monetary policy, and the reappointment of Shinzo Abe for another term as leader of Japan’s ruling party. Developed international and emerging markets indices finished the quarter up 1.42% and down 1.00%, respectively.
Below is a table which displays various equity index returns for the past quarter.
|Equity Indices||3rd Quarter 2018|
|Dow Jones Industrial||9.63%|
|S&P 500 Growth||9.28%|
|S&P 500 Value||5.86%|
|Russell 2000 (small-cap)||3.57%|
|MSCI/EAFE (developed international)||1.42%|
|MSCI/EM (emerging markets)||-1.00%|
At the sector level within the S&P 500, Health Care emerged as the market leader this quarter, benefiting from the September selloff in technology companies, as investors sought a safer play. The Health Care sector now only trails the Information Technology and Consumer Discretionary sectors on a year-to-date basis. Industrial stocks rebounded during the quarter after posting a poor second quarter as investors bet on a strong economy offsetting uncertainty over global trade. Technology-driven companies remain the biggest drivers of the stock market rally this year, despite a September stumble, as investors appear committed to the “growth” theme.
The following table details S&P 500 sector total returns for the quarter.
|Return by Stock Sector||3rd Quarter 2018|
|1. Health Care||14.53%|
|4. Information Technology||8.80%|
|5. Consumer Discretionary||8.18%|
|6. Consumer Staples||5.69%|
|9. Real Estate||0.86%|