U.S. financial markets have soared year to date through September 30, 2019. Not only has the Standard & Poor's 500 Index (S&P 500 Index) surged 20%, but bond prices have also climbed with the Bloomberg Barclays Aggregate Bond Index advancing 8.5%1. Investors are struggling to ascertain the message of the markets. Does strength in stocks presage robust growth, or do plummeting interest rates, which caused bonds to rally, signal a sharp slowdown?
Economic growth has moderated in the United States. However, the outlook is still reasonably solid. The robust first-quarter GDP of 3.1%2 slowed to a more sustainable 2% in Q22. Based on available data the economy probably also grew near 2% in the most recent quarter, and we expect growth to hold close to this pace as 2019 concludes3.
We sense that recession risk is not especially elevated at this time, and while economic expansion should continue well into next year, recent data are mixed. The consumer appears to be in excellent shape with a robust labor market providing a solid foundation as unemployment in the U.S. sits at 3.5%, a 50-year low4. One of the better forward-looking indicators, initial unemployment claims, is near a historic low as well. Consumer spending is strong, but the consumer does not seem overextended, with the savings rate hovering around 8% and debt service quite manageable2.
While personal consumption has been healthy, the same cannot be said for the industrial sector. Capital spending surged after the passage of tax reform but quickly fizzled. Manufacturing appears to have been a casualty of friendly fire from the trade war. Tariffs have increased costs, particularly on intermediate goods thus far, and supply chains have been disrupted. Furthermore, the on-again/off-again nature of the negotiations and tariffs has created uncertainty. Consumer confidence may be holding near cycle highs, but CEO confidence has plummeted to the lowest level since the depth of the recession in early 2009. Problems at Boeing and the General Motors strike create further short-term pressures.
Weakness abroad is a significant factor in the industrial sector’s malaise. We are hard-pressed to find a major economy growing faster in 2019 than in 2018. Global growth will likely slow to 3.2% this year from 3.6% in 20186. With Germany on the cusp of a recession, Europe is a major cause for concern. We have not been particularly troubled by the potential impact of Brexit, but it does represent another incremental negative for a region struggling to grow 1%. China has long been regarded as the engine of global growth, but growth in that geography, while still impressive at around 6%, is slowing steadily with ripple effects felt globally.
Given the global slowdown, central banks have begun to respond. In the United States, the Federal Reserve has already implemented two quarter percent rate cuts, lowering federal funds to a range of 1.75% - 2.00%. Another quarter percent rate cut is likely before year-end, and further cuts are possible in 2020. Bond yields have fallen sharply as well, with the yield of the 10-year Treasury Note declining a full percentage point since year-end to 1.68%. The resulting drop in mortgage rates has resuscitated a moribund housing market. Residential construction should provide a substantial contribution to GDP growth in the coming quarters. U.S. new-vehicle sales have also perked up.
With the overnight Federal Funds rate higher than the 10-year Treasury yield, the yield curve has inverted; and this may be an indication that monetary policy remains too tight. The Federal Reserve is likely to continue reducing short term rates to ensure there is a positive slope across the maturity spectrum. Foreign central banks are also taking steps to provide economic stimulus. China has cut reserve requirements. The European Central Bank recently resumed asset purchases and will likely cut rates further. Likewise, for Japan. However, for central banks that have already implemented negative rates, policy options are relatively limited.
Aggressive policy measures are required to construct a more optimistic economic scenario. China is willing and able to apply a fiscal stimulus, and a large-scale program could have a global impact. There has also been a discussion of fiscal stimulus in Germany, which would be extremely welcome after years of fixation on balanced budgets. In the U.S., greater certainty on trade policy could unleash suppressed capital spending.
We remain relatively constructive on financial markets despite valuation concerns and worries over trade, the Mideast, and even impeachment. Investors are understandably jumpy, especially after the experience of 2018, when stocks were up 10% during the first nine months of the year, only to crater in Q4. Shares have rallied sharply this year to be sure, but the S&P 500 Index is up only 4% from a year ago while mid-cap and small-cap stocks are down. With earnings likely to grow in the mid-single digits, perhaps valuation is fair rather than extreme.
Furthermore, unlike a year ago, when the Federal Reserve was tightening every quarter like clockwork, the Fed is now easing to provide support to the economy. With the precipitous drop in interest rates, equities should be able to support higher valuations, and we now believe that the S&P 500 Index should potentially trade in a range of 15x-19x forward earnings. A year ago, with bond yields 1.5% higher, our valuation range was 14x-18x.
Bond investors, unfortunately, will need to get used to current levels. We believe that the yield of the 10-year Treasury will remain in a range of 1.25% - 1.75%. With bond yields paltry, investors will have to view bonds as a necessary diversifier in a balanced portfolio rather than a return generator. The dividend yield of the S&P 500 Index at 2.0% is once again higher than the yield of the 10-year Treasury note. Investors may wish to consider a higher allocation to dividend growth stocks to enhance income over time.
Sources: (1) Bloomberg; (2) U.S. Bureau of Economic Analysis (BEA); (3) Washington Trust Wealth Management (4) U.S. Bureau of Labor Statistics; (5) The Conference Board; and (6) International Monetary Fund (IMF)
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