Strong Economic Fundamentals Support Market Growth, Despite Some Concerns

After a bumpy first quarter, the US equity market posted positive returns for the second quarter of 2018.

While political and trade concerns coupled with a strong US dollar weighed on international and emerging market equities in Q2, companies in the United States are expected to experience another few quarters of positive economic growth and continued strong earnings. This points to the United States entering its ninth year of economic expansion—the second-longest period of continued expansion the country has experienced to date.

While the fundamentals are positive and tax reform, referred to as the Tax Cuts and Jobs Acts (TCJA), remains supportive of the economy in the near-term, signs are emerging that suggest the US economy is moving into the later part of the business cycle.

2018 Q2 Returns

Top Factors Impacting Markets

There are a number of potential opportunities and risk areas for investors to consider as we move into the third quarter of 2018. These include the late-cycle signals of rising interest rates and a flattening yield curve, political uncertainty across the globe, escalating tariffs and potential trade wars, and longer-term demographic trends.

Interest Rates and the Yield Curve

In their June meeting, the Federal Open Market Committee (FOMC) again raised the federal funds rate a quarter percentage point, to the target range of 1.75% to 2%. Noting strong economic growth and inflation near their target of 2%, the FOMC indicated a high likelihood of another one to two rate hikes in 2018, with another increase almost certainly occurring in September.

After years of interest rates hovering around 0%, rising interest rates finally provide some return on cash and other safe investments, such as US Treasuries. However, rising rates also increase the cost of borrowing throughout the economy. The average mortgage rate, which was 3.88% in Q2 2017, reached 4.55% in Q2 2018.

As the FOMC has been raising the fed funds rate, shorter-term US Treasury yields have increased in response. However, the longer-term 10-year treasury yield has declined from last quarter and currently stands near 2.85%—a difference of only 0.35% from the two-year treasury at 2.50%. In other words, the US Treasury yield curve is quite flat.

A flattening of the yield curve can signal multiple things, including future expectations of lower inflation, slower economic growth, or additional Federal Reserve rate increases. At the present, immense demand for US fixed income securities by foreign investors and an aging demographic is also helping to keep longer-term bond prices up and yields down.

If short-term interest rates rise above long-term rates, the curve is said to be inverted and can be a predictor of an economic recession. Inverted yield curves have preceded the last five recessions by about one to two years.

Political Uncertainty

There are a few factors contributing to the economy’s current continued growth, including US businesses’ increased support of the TCJA, a slight boost to the economy, and increased consumer confidence. Nevertheless, questions regarding the TCJA’s long-term impact and rising concerns about the political climate in the United States have stirred the US markets this year.

2018 is a significant midterm election year, and with elections comes uncertainty—something markets don’t like. Since the mid-1990s, during midterm election years, the US market has typically seen a dip in the summer followed by an upswing once the election results become apparent, regardless of the result.

Uncertainty has also been a factor weighing on European markets, particularly with political crises in both Italy and Spain adding doubt to their future and the future of the European Union.

Trade Wars and Tariffs

In addition to political uncertainty and rising interest rates, many equity markets across the globe have sold off because of escalating fears of a trade war between China and the United States.

The recent enactment of US tariffs on $34 billion of Chinese goods and the corresponding amount of Chinese tariffs on US goods is notable. However, these numbers are still relatively small compared to the total trade between the two countries—which was an estimated $648.5 billion in 2016. The conflict continues to deepen though and, in late June, the White House said it would consider 10% tariffs on an additional $200 billion of Chinese goods.

Although it’s too early to realize the full impact of the tariffs’ enactment, trade wars typically result in increased costs to both parties. Since trade-related rhetoric began accelerating earlier this year, the Chinese and many other Asian stock markets have significantly underperformed the US market. However, it’s worth noting that exports make up approximately 8% of US GDP, while they make up 19%, 25%, and 36% of the GDP in China, Canada, and Mexico, respectively.

Demographic Trends

Unemployment in the United States has been below average for the past few quarters—a typical late cycle indicator—and this trend is expected to continue into the third quarter. While unemployment rose from 3.8% to 4% in Q2, this increase was largely due to greater labor-force participation, as new entrants were drawn to the strong job market.

At the same time, the number of people aged 18-64, which is the prime working-age population, has grown by only .04% over the last year and is expected to grow by only .03% next year. This is much lower growth than the United States has historically seen.

Without significant changes in birthrates or immigration rates, this trend is expected to continue, potentially resulting in a shortage of the labor needed to continue supporting the country’s longer-term economic growth. Outside of the United States, much more supportive demographic trends can be found, particularly in emerging markets like China and India.

In the mid-1990s, neither India nor China had a middle class population. At present, China’s middle class has reached 12% while India’s has reached 30%. By 2030, the middle class in both countries is expected to hit 70%. This shift represents hundreds of millions of new consumers, adds significant global demand, and provides attractive long-term prospects for these faster-growing countries. As a comparison, the middle class population in developed economies is only projected to grow at 0.5–1% per year for the foreseeable future.

Looking Ahead

The US economy is currently experiencing the second-longest period of economic expansion in its history—approaching 109 months, when the average duration is 27 months. While the economy looks to be moving into the late-cycle phase, the near-term fundamentals are supportive of continued growth.

Political uncertainty, increasing interest rates, and a flattening yield curve may point to higher market volatility. However, investors can prepare now by watching market and economic trends and diversifying their portfolios as needed.

Opportunities

In the near-term, US companies should see strong earnings supported by positive economic fundamentals. Longer term, emerging market equities may provide attractive opportunities due to a quickly growing middle class and positive demographic trends.

While traditional fixed-income investments are susceptible to volatility as interest rates gradually rise following the Federal Reserve’s intended path, rising rates provide increased yield on safer, short-term income investment such as certificates of deposit and US Treasuries. Floating rate loans and alternative income securities can help diversify and reduce portfolio interest rate risk.

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To learn more about your portfolio’s areas of opportunity or the potential impact of global events, contact your Moss Adams advisor.