Another solid quarter is in the books, as the S&P 500 rose in price 3.79% for the quarter. May’s 6.4% drop marked the only decline in value for any month so far this year. With June’s recovery, the S&P 500 Index appreciated 17.35% during the first half of the year.
We certainly don’t want to look a gift horse in the mouth. I am pleased that the market has rebounded and has shaken off the negative sentiment of last year. But as wonderful as this year’s performance has been, the S&P 500 is back to where it was at the end of the third quarter in 2018. As you can see from the chart below (and as we’ve discussed at great length), Q4 was a rough quarter for the S&P 500, with a waterfall drop from December 1st until Christmas. We experienced a decline of almost 20% from high to low. Q1 and Q2 of 2019 have shown extreme resilience, as it battled its way back to all-time highs.
What We Like Going Into 2H 2019
The U.S. Economy Looks Good
The most recent economic data looks good. The United States just released its Gross Domestic Product numbers. The United States economy is growing 3.1% on an annualized basis. This is significantly better than the 2.7% 50-year average or the 2.3% we’ve averaged in recovery since the end of the Great Recession.
While the economy has slowed down from its torrent pace during the first half of last year, the Chicago Fed National Activity Index (indicated by the second chart shown below) isn’t giving us any recession signals. As we’ve discussed many times in the past, the two charts below show accumulated economic activity (top chart in blue), and the three-month smoothed average of economic growth (second chart below). In the second chart, the two green dashed green lines indicate the historic levels of the economy, inflation (above the top green line), moderate growth (between the two green lines), and recessions (below the bottom green line). As you can see, we are experiencing moderate economic expansion.
The Index of Leading Economic Indicators, which have accurately flashed recession signals prior to the past seven recessions (since 1969), show no signs that the United States is entering a recession.
Markets Are Properly Valued
Investors can gauge the value of the market in many ways. Below are six of the ways that we look at markets to see if they are over-valued, under-valued, or properly valued. The markets look appropriately valued.
Corporate earnings for S&P 500 companies are expected to rebound and then produce record earnings by the end of the year.
While corporate profits aren’t at record highs, they are very close. S&P 500 companies provided 11.2% quarterly operating earnings to sales, just below records hit last year.
Unemployment has hit levels that we haven’t seen since the late ’60s, with May’s unemployment coming in at 3.6%. According to the Bureau of Labor Statistics, workers with a bachelor’s degree or higher have only a 2.5% unemployment rate. Even with these historically low figures, wages are only growing at 3.4%, below the 50-year average of 4.1%.
The below-average wage increase, even with historically low unemployment, is occurring, in part due to our historically low inflation rate. The Consumer Price Index (CPI) ticked up to a 1.8% annualized increase in the cost of living. This is well below the 4% 50-year average.
Even with the below-average increase in pay, the average American’s lifestyle is improving. Over the past 50 years, wages have gone up 4.1%, while inflation has gone up 4.0%. This means that the average American got a 0.1% increase in pay (wage – inflation = better lifestyle). A 3.4% increase in pay, with a 1.8% inflation rate means the average American has seen a pay raise of 1.6%, well above historical averages.
The Federal Reserve Is About to Cut Rates
Part of the reason that the stock market dropped as much as it did during Q4 2018 was due to investor sentiment. Investors feared that the Fed would raise rates too high, too quickly, and send the U.S. economy into a recession. What a difference a few months make.
The next Fed meeting is scheduled for July 31st. The Fed’s target rate is currently 225-250 (or 2.25% and 2.50%). As you can see to the right, Fed Futures show a 0% chance that the Fed will leave rates where they are currently, a 70% chance of cutting 0.25% and a 30% chance of cutting 0.50%.
If you look out to the end of this year, again there is a 0% probability that the Fed will leave rates where they are currently. As you can see from the chart to the right, there is a 9% chance of the rate being 0.25% lower, a 32% chance of 0.50% lower, a 37% chance of rates being 0.75% lower, and a 20% chance of lower rates by 1% or more.
Cheap money is a stimulus to our economy. As I write this update, the Fed Futures point to an absolute certainty that borrowing money will get less expensive by the end of the year.
What Has Us Concerned Going Into 2H 2019
Our biggest concern going into the second half of 2019 is the trade war with China. China’s most recent GDP numbers show that its economy has slowed to 6.2% growth. While this might sound high, this is the slowest growth China has experienced in 27 years. As we’ve mentioned before, the United States is faring much better. Our economy has been performing above average, even with the trade war.
The issue of any trade war is that it can spill over and impact the world economy. While some countries and areas are benefiting from the trade war, as some firms move out of China and need to find other low-cost manufacturing, most countries are not faring well. For example, first-quarter 2019 Euro Zone GDP has dropped to 1.2% growth, down from 2.8% growth a year and a half ago. Germany, the backbone of the Euro Zone’s economy, is particularly dependent on exports. Germany’s third-largest trade partner (behind the United States and France) is China. China’s slowdown has Germany’s economy growing at 0.7% annually.
China’s economic slowdown is also directly impacting worldwide manufacturing. The most recent Global Manufacturing PMI figures indicate that we are experiencing the first contraction in global manufacturing since 2012.
We are watching to see how all of this unwinds. A meaningful trade settlement with China would be very beneficial to the U.S. economy. An escalation of our trade war would be detrimental. The most challenging possibility is that the trade war drags on without any resolution. As a tactical investment management firm, we will navigate our way through these uncharted waters and do everything in our power to mitigate the risks as they arise and take advantage of opportunities when they present themselves.
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