Healthy economic data and a good start to the second quarter earnings season lifted stocks during July, as the S&P 500 achieved a total return of 3.7% for the month. While trade concerns continue to be a focal point for investors, there may have been some progress made, at least with our European partners. We maintain our favorable longer-term outlook for the market, though we remain concerned that ongoing trade disputes may cloud the near-term picture.
The economy continues to exhibit signs of strength as second quarter GDP increased by 4.1%, marking the best pace since Q3 2014. For the first half of 2018, the economy grew at approximately 3% which we view as a solid number, particularly in relation to the subpar GDP growth which has persisted over the last several years. The consumer in particular appears to be in good shape. Consumption grew by a healthy 4% during the quarter, perhaps buoyed by a still strong labor market. During June, a greater than expected 213,000 jobs were added to the economy, this following on the 244,000 additions for May. Consumer sentiment also remains strong, as evidenced by Bloomberg’s Consumer Comfort metric which is near its best level for the current cycle. We also note that the savings rate was revised meaningfully higher, which can facilitate greater future consumption thereby potentially lengthening the economic cycle.
One area that appears to be weakening is the housing market. Housing starts tumbled 12.3% during June, while permits fell 2.2%, both numbers coming in well below consensus estimates. Existing home sales also disappointed in June, declining by 0.6%. Still, as evidenced by the second quarter performance, the economy is weathering the slowdown in this area nicely. While we will continue to watch this space closely, we maintain our positive stance on the economy as most other key sectors continue to perform quite well.
The corporate sector remains robust. With over 80% of companies in the S&P 500 having reported second quarter earnings, 85% of companies are beating profit estimates. Second quarter profits to date have grown by 25% on average. While some of this is clearly the result of tax cuts, what we find impressive is that revenue is also growing at a robust rate; to date second quarter revenue growth has been 10% on average for the S&P 500 index. As a result, consensus 2019 S&P 500 forecasts have moved up to $177, which puts the market’s forward PE at what we view as a reasonable 16x.
Turning to trade, President Trump recently met with European Commission President Jean-Claude Juncker. While the sit down yielded little in terms of tangible results, Trump’s far less antagonistic and more conciliatory tone was notable. Perhaps most important was the intention to refrain from the implementation of any new tariffs, which would take President Trump’s proposed auto import tariffs – which have been widely panned even by hawkish members of the administration – off the table for the time being. While more needs to be done to resolve our trade disputes with Europe, this meeting can be seen as a positive step, if only that both sides displayed a willingness and desire to deescalate tensions.
There has been less progress with regards to trade negotiations with China. The US is in the process of imposing tariffs on an additional $200 billion of imported Chinese goods, though this will not go into effect until after a late August comment period. Prior comment periods have led to exceptions which have reduced the overall dollar amount of targeted goods, so the $200 billion objective could be lessened, assuming it is levied at all. Conversely, the President has threatened to levy tariffs on all Chinese imported goods into the US, so at the moment it is difficult to ascertain what the ultimate amount of tariffs will be. Trade-related uncertainty is a primary factor keeping us from taking a more bullish a view on stocks, as it could add to market volatility until these disputes are settled.
We continue to hold the view that stocks look more appealing over the longer-term, while the short-term appears more uncertain due to ongoing trade disputes. Still, we are optimistic that trade issues can be resolved before lasting damage is done to the global economy; should this occur, we expect that investor attention will shift back to strong underlying fundamentals. In our view a strong labor market, elevated savings, and positive sentiment should bode well for consumption moving forward, the biggest driver of the US economy. Moreover, with inventories currently sitting at low levels, we believe that companies will need to restock which should provide a boost to economic activity. We believe that all of these factors should continue to support good corporate profit growth, and may provide a tailwind for equities to move higher.
We view trade disputes as the key risk to capital markets currently. If our optimism proves to be unfounded and these issues persist, or worse are exacerbated by more rounds of tariffs, it is likely that investors will perceive threats to continued global economic growth, and capital markets may become quite turbulent. While the tone of negotiations with Europe as well as our North American neighbors appears to have improved, there is more to be done, and relations with China still seem stressed. We will of course continue to closely monitor these developments, and as always we are prepared to take further precautions with our portfolios should conditions deteriorate.
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