Q3 Review | 2018

The CPI core rate was 2.17% for the quarter, in line with the consensus estimate of 2.20% for the full year – 2018. Higher real wages and tax cuts have led to a wide range of additional consumer spending. Third quarter consumer spending was stronger than expected, however business spending was weaker than expected. Businesses are hesitant to increase spending in the face of ongoing trade tensions. There is still considerable focus on trade and tariffs with China; however, conditions should improve following trade agreements with Mexico, Canada and South Korea. Government spending also rose in the third quarter due in part to an increase in defense spending. Recent Goldman Sachs research points out that the global operating environment is solid. They find that 93% of countries have growing economies and 49% of countries are experiencing accelerating growth. Domestically, the ISM Purchasing Managers Index has exceeded 55 for twenty-one consecutive months. Any reading above 50 indicates growth so at 55+ the country is experiencing considerable growth in manufacturing. The Global Purchasing Managers’ Index for manufacturing shows impressive global expansion particularly in the U.S. and Europe.

Sustainability of improved economic growth is in question due to the lack of support from worker productivity. Growth in the workforce and growth in worker output determine productivity. Growth in the workforce is relatively slow and growth in output per hour for workers in nonfarm business remains below historical norms. However, there is some thought that output is not being captured accurately in a more digitized economy. The Federal Reserve (Fed) as well as most economists do not believe that the current rate of growth will continue through 2019. The Fed forecasts a growth rate of 2.5% and economists expect a growth rate of 2.4% (consensus estimate) for the upcoming year

        It is generally expected that the Fed will increase the rate by an additional 0.25% in December. Economists and Strategists generally expect that the Fed will continue to follow the pattern of periodic 0.25% rate increases in 2019. Federal Reserve chairman Jerome Powell stated on October 2nd that “Removing accommodation too quickly could needlessly foreshorten the expansion.” The consensus estimate places the Fed Funds rate at just over 3.0% at the end of 2019 indicating three more rate increases for next year. 

        The ultimate target for the Fed Funds rate is called the neutral rate. The Federal Reserve Bank of San Francisco states that “the neutral rate is the point where the federal funds rate goes from being low enough to be accommodative to being high enough to dampen economic activity. The neutral rate is also often defined as the rate or range of rates consistent with full employment, trend growth and stable prices.” Federal Reserve Chairman Jerome Powell has stated that there is a ways to go before reaching the neutral rate. The previous Chairman, Dr. Janet Yellen stated: “Research suggests that the neutral real rate is probably somewhere in a 1.5% to 3.5% range. To get to a neutral nominal rate, we have to add in expected inflation. That probably takes us to a neutral nominal range of around 3.5% to 5.5% at this point.” The consensus estimate indicates that the Fed is likely to push the funds rate to 3.4% by 2020 before the upward trend levels out.

        Both developed and emerging international markets have suffered greatly through both the ups and downs of the domestic market. International equities have performed poorly as investors have focused more on the impressive growth rates of the U.S. economy and corporate earnings. Another headwind, or perhaps gale force wind, has been the impact of the higher dollar resulting from the Fed raising rates in a backdrop of low and even negative international interest rates. Slower growth in China and the addition of tariffs and trade conflicts have also negatively impacted international and particularly emerging markets. The MSCI EAFE Index, representing international developed countries, declined -9.4% year-to-date through the end of October. The MSCI Emerging Market Index was down -16.3% for the same time period.

        Valuations for international markets look more attractive than domestic markets but this can remain the case for extended periods of time. The S&P 500 is trading at a 15.7x P/E based on the next twelve months of expected earnings compared with 12.7x for the MSCI EAFE Index and just 10.6x for the MSCI Emerging Market Index. Arguments for the difference in valuation multiples include political stability, legal system stability, stock market liquidity and variation in currency risk. On a relative basis, the S&P 500 is trading at over 95% of its five-year average P/E compared with 89% for international developed markets and 92% for emerging markets utilizing next-twelve-months earnings estimates.

The 2018 S&P 500 estimate of 22% earnings growth compares with estimates of 6.9% for international developed markets (as represented by MSCI EAFE) and 14.2% for emerging markets (as represented by MSCI EM). Investors are beginning to turn their focus towards 2019 and beyond. Earnings growth for the S&P 500 is expected to decline to 9.2% in 2019 compared with 7.7% for international developed markets and 11.2% for emerging markets. Forbes estimates that “on a long-term basis, earnings growth for emerging markets should be around 10+% and long-term earnings growth for the S&P 500 should be around 6%”.

There are 2,876 companies listed in the MSCI Emerging Market Index, with 38% of the market cap in China, followed by 10.9% in India and 8.7% in South Korea. The challenge with emerging markets earnings is that they can be quite volatile. Forbes reports that “the long-term standard deviation of the MSCI Emerging Markets Index is 22%, while the S&P 500 Index has a long-term standard deviation of 15%”. Investors should be prepared for more ups and downs with emerging markets equity investments, however a modest allocation to diversified portfolio with a longer-term horizon may improve returns.

Our twelve-month forecast for the S&P 500 Index is 3,000 indicating an upside of just over 7% from current levels. The forecast is based on slightly lower than consensus earnings growth and a 17.25 P/E multiple

Bond investors enjoyed price appreciation and the total return benefit produced by twenty-five years of declining rates through mid-2016 but did not enjoy the reduced income production. The current trend is causing just the opposite to occur – prices are declining but income is increasing. The problem is that the increase in income lags the decrease in price and may not be sufficient to offset the price decrease over a given period of time. Investors should try to remember that the primary purposes for holding fixed income securities are produce income and to provide a tool to help manage portfolio volatility.

There is some question as to whether interest rates will continue to increase. Arguments for minimal-tono interest rate increases over the next several years include the lack of inflationary pressures, the gap in international and domestic interest rates and the potential for a recession in 2+ years. Arguments for higher interest rates include ongoing Fed Funds “normalization”, the potential for economic overheating and wage growth and the resulting expectations for increased inflationary pressure. We lean towards the latter argument and recommend reducing a portfolio’s sensitivity to interest rates through a reduction in duration and/or the use of individual bonds with final maturities.