Published on Nov. 13, 2018
Third Quarter Equity Commentary
Stocks continued to move higher during the third quarter, as the S&P 500 gained 7.2%, its best performance since the fourth quarter of 2013. Investors were encouraged by healthy economic data, strong corporate profits, and some headway on international trade deals. While we are cognizant of risk factors such as trade issues with China and Italy’s budget deficit, we believe that markets can continue to advance as we head into what has historically been a seasonally strong period for equities.
Trade has been a key source of risk for markets since President Trump took office with his ‘America First’ platform. Recently though, significant strides have been made in this regard. President Trump announced the negotiation of a new North American trade agreement that would include both Canada and Mexico, and negotiations are currently taking place with the European Union and Japan. As well, the US recently signed a revised trade deal with South Korea.
To what extend these recent successes may foreshadow a potential agreement with China however, remains to be seen. The US recently imposed another round of tariffs on $200 billion of Chinese imports at a rate of 10%, which could increase to 25% next year. China immediately retaliated by implementing tariffs on $60 billion of US exports into the country. President Trump has threatened to escalate the trade skirmish by extending the tariffs to include all Chinese imports into the US, an estimated incremental $267 billion of goods. While we continue to view this issue as a risk factor for capital markets, we do not believe that the tariffs that are currently in place will meaningfully detract from US or global GDP. We therefore remain optimistic that stocks can continue to climb this wall of worry, though we are continuing to closely monitor the situation.
Italy recently submitted its budget to the European Union, which included an estimated deficit of 2.4% of GDP. Italian markets sank on the news, with stocks down approximately 3% and government bond yields rising 27 basis points. Investors worried that the projection left little margin for error as compared with the EU’s 3% deficit guideline. While this remains a potential flashpoint for European capital markets, we see little reason to anticipate much in the way of contagion for US stocks. In the years subsequent to the financial crisis, US banks have undergone stress tests, shorn up their balance sheets and bolstered their capital ratios. We think this helps explain why US stocks held up well in the aftermath of Italy’s budget submission. While this remains an issue that could inject further volatility into European markets, we do not expect that it will adversely impact US equities.
The Federal Reserve held its latest meeting in September, and as was widely expected, hiked rates by 25 basis points to a range of 2-2.25%. Projections for future rate increases are unchanged, with the Committee calling for another five 25 basis point rate hikes through the end of 2020. While some analysts were surprised by the removal of the word ‘accommodative’ from the statement, Chairman Powell diffused these concerns in his press conference by stating that he still considers policy to be accommodative, recent rate hikes notwithstanding. Despite this seemingly dovish observation, we believe that some investors were more focused on Powell’s confidence that the Fed will meet its projections for future rate increases. In this regard we note that the 10-year Treasury yields have continued to advance and currently sit at cyclical highs. We believe this is a risk factor which bears close attention as there is a threshold at which higher rates may begin to negatively impact economic growth and equity valuations. At the moment, however, we view the recent rise as a positive development with respect to it steepening the yield curve. The flattening yield curve has been a key concern for some market participants who believe that it is flagging recessionary conditions ahead.
We hold a constructive outlook on the market, as we continue to believe that a healthy economy and robust corporate profits should bode well for stock prices. GDP expanded at a brisk 4.2% clip for the second quarter, and while that level of growth is likely not sustainable, we think that solid economic activity continued into the third quarter. Consumer confidence recently hit its best level since 2000, and with unemployment at historically low levels and wages moving higher, we believe that consumption is well set up to help drive future economic activity. The corporate sector has been a key source of strength, with profits rising by 25% on a year-over-year basis for the second quarter. Analysts are predicting another impressive showing for the third quarter, with consensus estimates calling for profit growth of approximately 20%, which we view as achievable.
The trade spat with China remains a key risk for stocks. While we believe that the tariffs currently in place will not materially dent US growth, further rounds of tariffs and more retaliatory actions out of China could rattle investor and corporate confidence. Next month’s midterm elections could also potentially inject some volatility into markets. Depending on the outcome, it is possible that Democrats will be better positioned to challenge President Trump’s agenda; however, we note that many Democrats are aligned with Trump on certain key economic issues such as infrastructure spending and the new North American trade agreement. Moreover, the policy items that are likely most important to capital markets, tax cuts, and deregulation, have already been implemented. We therefore do not expect that the midterms will create material headwinds for stocks.
Lastly, interest rates and inflation, to the extent that they increase faster than currently anticipated by investors, pose a risk to the stock market. While we continue to closely monitor these risk factors, we are encouraged by what we see as a largely healthy fundamental landscape, and we think that the path of least resistance for stocks remains higher at the moment.