The third quarter of 2017 continued an incredibly robust period for equities that many are currently ascribing to a Goldilocks type environment; not too hot, not too cold - just right. Economic growth is solid and may be gaining momentum, interest rates are still close to historical lows and inflation is AWOL (absent without leave). Although a temporary sell-off could happen at any time, Goldilocks may possess the recipe needed to keep the market moving forward. With the S&P 500 now trading above 2,500, very few market prognosticators can take credit for having predicted that milestone at the beginning of the year, once again, demonstrating the futility of market-timing.
There have been numerous opportunities for stocks to reverse course this year, including a ratcheting up of tension with North Korea, wide-scale destruction from three major hurricanes, Congressional inaction on pro-growth initiatives and a data breach at Equifax potentially impacting millions of Americans. Yet, the markets remain resilient, shrugging off each potential crisis with renewed support and a focus on earnings.
Economy
The U.S. economy, as measured by GDP (gross domestic product), grew at an inflation-adjusted annual rate of 3.1% during 2Q17, as compared to 1.2% in 1Q17. The increase in growth was broad-based, reflecting gains in consumer spending, business investment, exports and government spending. The U.S. consumer comprises over 2/3 of the economy so consumer income, spending and sentiment always warrant attention. Initial estimates for 3Q17 have not yet been released, but growth will likely take a hit from the disruptions caused by the recent hurricanes. U.S. corporate profits rose by 6.7% year-over-year in 2Q17 and by 0.7% from 1Q17. Additionally, the unemployment rate has been bouncing around 4% for months now so we may have seen most of the significant progress on that front.
Inflation is running well below the FOMC’s (Federal Open Market Committee) target range of 2%, with core inflation most recently coming in at 1.3% for August. Core inflation excludes volatile food and energy. There are many theories why inflation has been so low for so long (six consecutive years below 2%) but no one really knows. The Federal Reserve has a vast array of economists and data at their disposal, yet they consistently over-estimate the inflation rate. At the end of the day, prices for goods and services are determined by some type of supply-demand relationship. With the U.S. as a participant in the global economy, there are literally 360 degrees of influence on the cost of our domestic goods and services.
Interest rates are higher than a year ago but below levels reached this past spring. Janet Yellen and her data- dependent FOMC colleagues are in a quandary. They would like to continue with their program to “normalize” rates but the absence of any meaningful inflation pressures is giving them reason to pause as they fear tightening credit too much could slow the economy prematurely. The one thing they don’t want is deflation which can cause consumers to cut back on spending hoping they will be able to buy at lower prices later. As such, the Fed is proceeding very deliberately in its double-barreled tightening strategy, which includes modest increases in the federal funds rate and allowing the trillions of dollars invested in bonds and mortgage securities (as a part of the quantitative easing strategy) to slowly roll off its balance sheet as those securities mature.
Markets
Most major equity indexes reached new, all-time highs during the quarter with international emerging markets (MSCI Emerging Markets) continuing to lead the pack posting gains of 7.89% for 3Q17. Domestically, small companies (S&P 600) finally outpaced their larger brethren with gains of 5.96% for the quarter, and overall, it was a very good period for most broad-based markets. For the year’s first nine months international markets continued to distance the field with gains of 27.78% and 19.96% from emerging markets and developed markets (MSCI EAFE) respectively. Back home, large companies (S&P 500) posted the best gains domestically through the first nine months, up 14.24%.
Bonds continue to generate mediocre returns and this will not change until interest rates are higher than current levels. Our benchmark for high quality, short-term bonds is the Bloomberg Barclays 1-5 Year Government/Credit Index which delivered returns of 0.43% and 1.58% for the third quarter and year-to-date periods. Again, most investors own bonds, not for their returns, but to temper the volatility of an otherwise all-stock portfolio. Our experience with many investors over numerous market cycles is that very few possess the risk tolerance to withstand a significant bear market without a reactionary, flight to safety response that can destroy years of prudent planning and execution.
What’s Next?
The market continues to discount hurricanes and other events as temporary setbacks and focuses on corporate earnings with third-quarter results set to be released beginning in mid-October. Current estimates are for earnings growth of 4.2% and revenue growth of 5% with eight of the eleven S&P sectors expecting year-over-year gains. Of course, the third quarter is now in the history books and the market is always forward-looking. As of this writing, the estimate for 4th quarter earnings growth is 11.2%, followed by growth of 10.4% and 10.3% respectively for the first two quarters of 2018.
Tax reform appears to be the last remaining Trump initiative still on the table for 2017. No one knows if, and when Congress will be able to agree on any meaningful reform, but if it happens and if the markets believe it will be accretive to growth, look for a positive response.
As demonstrated by the recent hurricanes and mass shooting in Las Vegas, our lives can change in a heartbeat and the time spent with loved ones can never be reclaimed. As much as we value our role in helping you prudently steward your assets, some things are more important than money. Our thoughts and prayers go out to all those impacted by these recent events.
Best wishes for a safe and pleasant fall.
Sam Taylor, Wealthview Capital LLC