Oct 3rd, 2018 - Third Quarter Market Review
The U.S. stock market made strong gains in the third quarter of 2018, as the S&P 500 rose by 7.2% while the Nasdaq rose by 7.1%. For the month of September, markets were roughly flat, with a gain of 0.4% for the S&P 500 and a decline of -0.8% for the Nasdaq. Year-to-date, the S&P 500 has a price gain of 9.0%, and a total return (including dividends) of 10.6%.
Bond prices fell in the third quarter, with most of the decline occurring in September. Indices of long-term bond prices dropped by 3% - 4% in the third quarter, as the yield on ten-year Treasury bonds rose from 2.85% at the end of June to 3.06% at the end of September. The dollar rose slightly during the quarter, while the price of oil stayed roughly flat in the range of $70 per barrel.
S&P 500 – daily chart for the first nine months of 2018
Source: Lang Financial Group using TC2000 software.
As seen in the chart above, after a sharp correction in the first quarter of 2018, the stock market has gradually climbed back over the past six months. The market’s gains have been driven by the growth of the U.S. economy and strong corporate earnings, despite a variety of geopolitical issues such as a potential trade war with China. Before discussing these issues in more detail, we will briefly review the events of the third quarter.
Review of Third Quarter
The S&P 500 gained 3.6% in the month of July, driven by good economic news and strong corporate earnings reports. Most companies reported earnings that were better than consensus estimates. In late July the government reported a robust second quarter growth rate of over 4% for the gross domestic product (GDP).
In August the S&P 500 gained another 3.0%, and broke out to a record high. The market was supported by positive comments from Federal Reserve Chairman Jerome Powell, who said that inflation remains under control near the Fed’s target range of 2% per year, implying that the number of future interest rate hikes might be limited. In late August, investors were also encouraged by news of a new trade deal between the U.S. and Mexico, which was viewed as a win – win agreement by both sides.
In September, the market was roughly flat, although the Dow Jones Industrial Average briefly hit a new all-time high of roughly 26,700. Investors were concerned about the growing risk of a trade war with China, as President Trump imposed additional tariffs on imports from China, and tensions between the two countries remained fairly high. In addition, long-term interest rates climbed higher during the month, with the yield on the 10-year Treasury bond breaking through the 3.0% level and closing September at 3.06%.
Economy and Earnings
As mentioned above, one of the main driving factors behind the market’s gains this year has been the strength of the U.S. economy and corporate earnings. Second quarter GDP growth was 4.2%, and most estimates for the third quarter are in the range of 3.0% - 3.5%. The labor market is very strong, as the unemployment rate has fallen to 3.9%, with recent employment reports showing consistent gains in the range of 200,000 jobs per month. Weekly unemployment claims recently hit a 50-year low and blue collar jobs are plentiful, and in fact there are labor shortages in some industries. Data released in late September showed that consumer confidence just hit an 18-year high.
Inflation remains low by historic standards, although it has picked up a bit recently, with most measures now showing an inflation rate of roughly 2.0%, in line with the Federal Reserve’s objectives. One factor that may contribute to inflationary pressures is the tight labor market, as wage growth has accelerated to an annual rate of 2.9%, the highest in 9 years.
Earnings growth has been very strong. Preliminary data for the S&P 500 index shows that second quarter 2018 earnings grew by 27% year-over-year. Earnings for the third quarter, which will be reported in the weeks ahead, are expected to show a similar large percentage gain.
Fed Policy and Interest Rates
At its recent policy meeting on September 26th, the Federal Reserve raised short-term interest rates by a quarter point, to a new target range of 2.0% - 2.25%. As this move was widely expected, it did not have a big impact on the markets. However the Fed did make a noteworthy change in its policy statement, removing the phrase “the stance of monetary policy remains accommodative.” This confirms that Fed policy is now in a tightening phase, a change from the decidedly easy stance of monetary policy that has been one of the main drivers of this historic long-term bull market that began almost ten years ago.
The consensus view is that the Fed is likely to make an additional quarter-point rate hike at its December 19th meeting, bringing the target range up to 2.25% - 2.50%. Then in 2019 the Fed is expected to increase interest rates several more times, to the 3.0% range, although the timing of such rate increases depends on incoming economic data as the year progresses.
As mentioned above, long-term interest rates have also started to rise, reflecting the strong economy, rising inflationary pressures and the budget deficit. However, U.S. Treasury bonds are viewed as a high quality “safe haven” by investors all over the world, so there has been a very strong global demand for Treasury bonds, which has kept interest rates relatively low by historic standards, despite the strong economy.
Tariffs and Trade Negotiations
Over the past year, the markets have been worried about the issue of tariffs and trade wars, especially with China. President Trump has taken a hard line against China on the issue of trade deficits and stealing U.S. technology. At a speech at the United Nations in late September, the President made comments directed toward China that the U.S. will not tolerate unfair trade practices, such as dumping products at artificially low prices.
In late September the U.S. imposed new tariffs of 10% on $200 billion of Chinese imports. If China does not change its behavior, this tariff rate could rise to 25% at the beginning of 2019, and the President’s economic team is considering tariffs on an additional $267 billion of Chinese goods. The impact of a trade war with China, depending on how long it lasts, would be to cause slower economic growth and higher inflation, as well as a disruption in global supply chains.
On October 1, 2018, the stock market rose on news that Canada has agreed to join the recent trade deal between the U.S. and Mexico, creating the USMCA, or U.S. Mexico Canada Agreement, which will replace the old NAFTA (North American Free Trade Agreement) trade deal. This appears to be a good trade deal for all involved, but it still needs to be approved by Congress.
In addition to this successful trade deal, there have been positive developments in other trade negotiations with countries such as South Korea. Despite initial worries that tariffs were a risky and dangerous policy, investors have now become hopeful that trade negotiations will lead to positive outcomes. If negotiations with China eventually result in another successful trade deal, which would stop the theft of technology and result in a more level playing field, the outcome could be very beneficial for the U.S. economy in the long run.
Although the U.S. economy is very strong now, with GDP growth expected to exceed 3% this year, there is some debate about the economic outlook for the next year or two. Some economists argue that the economy will slow sharply in the next year or so, and that a recession is possible in the next few years, based on factors such as a reduction in fiscal stimulus, the Fed’s tightening policy, and higher interest rates.
However, others argue that the economy can remain strong for years to come. This is because the policies of lower regulations and tax cuts have led to a large increase in business confidence and small business optimism, resulting in a boom in capital spending. In addition consumer spending is supported by a high level of consumer confidence. Thus it appears that the economy should remain healthy for the foreseeable future, with a very low risk of a recession any time soon.
Because the economy and earnings remain strong, the bull market in stocks is likely to continue. However, the gains may be more difficult in an environment of rising interest rates and a tighter Federal Reserve policy. Fortunately, even after their dramatic gains of the past few years, stocks are not overvalued now, because earnings have been so strong. The S&P 500 is now expected to have operating earnings of $178 in 2019, and with a current valuation of roughly 2900, this means the forward P/E ratio is only 16.3, not overly expensive by historic standards.
As always there are some risk factors in the environment, including the possibility of rising inflation and higher interest rates, along with geopolitical risks involving countries such as China, North Korea, and Iran, and the possibility of a financial crisis in emerging markets. In addition, over the next month or so, the markets may be affected by political news more than usual, as investors turn their attention to the midterm Congressional elections.
After their strong gains over the past six months, stocks have become somewhat overbought, so any negative news could trigger a short-term pullback. But in general, the investment outlook remains positive, and the long-term bull market remains intact.
The S&P 500 Index is a capitalization weighted index made up of 500 widely held large-cap U.S. stocks in the Industrials, Transportation, Utilities, and Financials sectors.
The NASDAQ Composite Index is a market-value-weighted index of all common stocks listed on the National Association of Securities Dealers Automated Quotations (NASDAQ) system.
Treasuries are U.S. government debt obligations that are backed by the full faith and credit of the government. Often, they are used as a proxy for a risk-free asset when comparing other risky assets. The principal value will fluctuate with changes in market conditions. If they are not held to maturity, they may be worth more or less than their original value.
The views stated in this letter are not necessarily the opinion of Cetera Advisor Networks, LLC and should not be construed directly or indirectly as an offer to buy or sell any securities mentioned herein. Due to volatility within the markets mentioned, opinions are subject to change with or without notice. Information is based on sources believed to be reliable; however their accuracy or completeness cannot be guaranteed. Past performance does not guarantee future results. Investors cannot invest directly in indexes. The performance of any index is not indicative of the performance of any investment and does not take into account the effects of inflation and the fees and expenses associated with investing.
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