Stocks enjoyed a solid third quarter, with the S&P 500 advancing almost 4% for the period. Healthy corporate earnings and strong international economic activity helped boost market sentiment, and the extension of a deadline to address the US government’s debt ceiling at least temporarily removed a key near-term risk for equities. Despite geopolitical tensions and some sluggish US consumption data, we continue to believe that stocks can move higher, driven by a healthy corporate sector and still easy financial conditions.
Political and financial news out of the US was largely positive during the third quarter. While investors had been increasingly concerned about the dual threat of a government shutdown and debt default, particularly given the turbulent political environment, these concerns were temporarily alleviated after government officials were able to reach a deal to extend the debt ceiling and fund the government for three months, allowing investors to refocus on improving economic fundamentals.
The economy accelerated meaningfully during the second quarter, in which GDP advanced at a 3.1% clip, and more recent data has shown continued strength, particularly in the manufacturing sector. The Institute for Supply Management’s widely followed survey of the manufacturing space came in at a robust 60.8 for September, well ahead of economists’ expectations. Other indicators which appear to be offering confirmation of this strength include orders for durable and capital goods, both of which surprised to the upside for August.
That said, consumption data in the US softened during the third quarter, with weak retail sales in August coming in at a 0.2% month over month decline. Initial estimates for June and July were revised downwards as well. Moreover, real personal consumption expenditures declined 0.1% for August, the first negative print since January. We will closely monitor this data given the importance of consumption to the overall economy. Nevertheless, we have not changed our base case expectation that the US will continue to grow GDP at the 2% trend which has persisted for the last several years. We expect that a healthy labor market and strong consumer sentiment will prevent consumption from weakening materially from current levels.
Corporate profits have been strong, and we expect this to continue moving forward. Earnings have grown at a double digit clip for each of the last two quarters, marking the first such run since 2011. Looking ahead, the earnings estimate revision ratio, (which measures the number of companies increasing their guidance compared with those taking it down) hit a 6-year high at the end of August. In our view, this should bode well for the upcoming third quarter corporate earnings season.
The international economic landscape appears healthy. This is particularly true in Europe where consumer confidence recently hit a 16-year high. Readings of both the European manufacturing and service sectors have strengthened as well, with data points for each coming in nicely ahead of expectations for September. We expect that solid international activity will continue to act as a tailwind for US based multinational companies.
In terms of monetary policy, in recent meetings the Federal Reserve Open Market Committee (FOMC) has provided further details on its plans for balance sheet normalization. Beginning this month, the central bank will no longer fully reinvest its maturing bonds andexpects to allow up to $50 billion per month of its bond holdings to roll off. The FOMC also anticipate hiking the federal funds rate once more this year. Despite this incremental tightening and the beginning of the balance sheet normalization process, interest rates remain low by historical standards. Beyond monetary policy, financial conditions generally are still quite accommodative, given the weak dollar, low bond yields, continuing quantitative easing in Japan and the EU, tight credit spreads, and appreciating stock prices.
There are two key questions that US equity investors appear to be struggling with at present. The first is the overall direction of the market, which is supported by a synchronized global economic expansion, easing financial conditions, and healthy earnings growth, but weighed down by domestic political challenges and rising geopolitical tensions. On this question, we expect markets to trend higher, as corporate earnings are typically the key driver of equity values, and last month’s bipartisan deal to temporarily fund the government and raise the debt ceiling likely took the worst of the near-term domestic political concerns off the table.
The second question pertains to which areas of the market are likely to perform best. We believe the answer depends primarily on whether US economic growth remains at its 2% trend or has meaningfully accelerated closer to 3% in a sustainable way. Overall, it seems most likely that the 2% trend remains intact, which is supported by the continued slow pace of wage and price inflation, and softness across housing starts, auto sales, and mall-based retail. However, there is accumulating evidence that supports growth acceleration. In addition to strong consumer confidence and low unemployment domestically, we are also seeing greater than expected growth combined with easing financial conditions across the major global economies. Furthermore, the impacts of Hurricanes Harvey and Irma, while devastating on a personal level to those in its path, should also stimulate home building and auto sales as well as inflationary pressure more broadly, thereby addressing some of the forces that have been holding the economy back.
We have taken small steps to reflect the greater likelihood of stronger economic growth by adding to the portfolio’s weighting in global value cyclical stocks and funding this by reducing our weighting in stocks that may be perceived as safe havens. We believe this slightly more aggressive stance is justified by the rationale that argues for a higher probability of stronger growth ahead. As always, we are prepared to de-risk our portfolios and take a more defensive posture should conditions warrant.
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Past performance is not a guarantee of future results. Indices are unmanaged and cannot accommodate direct investment. Themes assigned as per Roosevelt Investments’ evaluation. Risk tools may include cash or other securities that we believe possess a low or inverse correlation to the overall market.
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