Published on Sep. 12, 2018
Stocks Continued Their Ascent During August 2018
Stocks continued their ascent during August, as the S&P 500 hit a new all-time high and investors were encouraged by robust corporate earnings and some progress on trade. We continue to believe that strong fundamentals bode well for equities over the medium to longer term, although we would like to see more headway on trade before taking a more bullish stance.
US corporate profits continued their strong run during the second quarter, with the Commerce Department reporting after-tax profits rose 16.1% on a year-over-year basis – the best result in six years. On a per-share basis, S&P 500 aggregate earnings grew by nearly 25%, a threshold reached only once since 2010. While lower taxes were one source of strength, sales were also quite strong growing at 9.5%, indicating that underlying business conditions remain robust. We are encouraged by these results and believe that corporate profits should remain healthy for the foreseeable future, driven by supportive economic conditions.
Trade remains a wild card, particularly with China, where key issues are yet to be resolved and the Trump administration is contemplating further rounds of tariffs. However, some progress has been made with Mexico, as President Trump and President Nieto announced an agreement on aspects of a trade deal. We are encouraged by this pact, as in our view it demonstrates a desire on the part of the US to work with its partners and avoid costly trade wars. While there is more to be done in this regard, we view the discussions with Mexico as a step in the right direction.
Turkey became a focal point for global investors in recent weeks as its currency collapsed and government yields skyrocketed due to concerns about the country’s debt profile, persistent current account deficits, and perceived lack of central bank independence. While we view the situation as quite serious for the Turkish economy, we do not expect much in the way of contagion. Among emerging market economies, we view Argentina as the only other country which is similar to Turkey in terms of debt load and lack of foreign reserves. We think this explains why most other developing country capital markets have held up well despite the massive depreciation of Turkey’s currency. Moreover, we see some similarities to the collapse of the Russian ruble in 2013 following the country’s annexation of Crimea, and note that in that instance there was no meaningful contagion to other major capital markets.
Turning to monetary policy, Fed Chairman Jerome Powell made some dovish remarks at the recent Jackson Hole Economic Policy Symposium. Powell spent some time addressing why inflation might remain persistently low during the current economic cycle, and commended former Chairman Allan Greenspan for his measured pace of rate hikes when he presided over a similarly low inflation environment. He also spoke about how the Fed is trying to ascertain the appropriate neutral level of interest rates for the current cycle, and stressed caution in making this determination. In our view, all of these remarks are consistent with a central bank which is attempting to prudently navigate a measured rate hiking campaign, so as to minimize any disruption to the economy and capital markets.
We remain optimistic on stocks and believe that strong fundamentals should help support higher prices over the longer term. Corporate earnings have been robust, and we expect that a healthy economy will continue to sustain strong profits moving forward. We note that second quarter GDP growth was revised up to 4.2%, marking its best performance in nearly 4 years.
While most of the economic indicators that we track appear favorable at the moment, the slope of the Treasury yield curve is a notable exception. Currently hovering near 10-year lows, some investors are concerned that the flattening yield curve may be signaling the next recession. In our view, while a yield curve at this level is a concern, when viewed alongside other indicators we do not believe that a recession is imminent. Some of the other metrics that we believe counter the pending recession narrative include good freight volumes, sturdy retail sales, and tight corporate credit spreads.
For the short-term, our view is more tempered, primarily due to the continuing trade dispute with China. We believe that until this situation is resolved, investors will be hesitant to fully price in what we view as strong underlying fundamentals. Other factors keeping us cautious over the near-term include Italy’s upcoming budget submission to the European Commission, as we believe the two parties have contrasting views on Italy’s budget deficit and that the situation could negatively impact capital markets if the submission were to be rejected. Finally, the calendar may also be a headwind, as September has been the worst month of the year for stocks historically.