US Economy Remains Strong, but Headwinds Are Developing as the Cycle Matures

On the heels of robust economic data, the US equity market posted strong positive returns for the third quarter of 2018 and remains the best performing equity market this year. Abroad, developed international markets recovered slightly this quarter but remain negative year-to-date. Emerging market equities continued to struggle as a strong US dollar and escalating trade tensions, particularly between the US and China, weighed heavily on market performance.

With unemployment below average, inflation, GDP, and housing prices in typical range, and consumer sentiment above average, the US economy is in the midst of its second-longest expansion since the Civil War. The longest occurred in the 1990s and lasted 10 years–a length we may hit if the expansion continues through July 2019. That said, there are several data points to suggest the US economy is firmly in the later parts of its economic cycle.

2018 Q3 Returns

Top Factors Impacting Markets

Though US recession risks appear low in the near-term, as we move into the last quarter of 2018, there are multiple factors influencing global markets for investors to watch, with both short- and long-term implications.

Strong Economic Fundamentals

In September, the US unemployment rate hit 3.7%—the lowest level since 1969 and well below the Federal Reserve’s 4.5% estimate of the natural rate of unemployment. According to the Bureau of Labor Statistics, the ratio of unemployed persons per job opening was 0.9 in July, a series low, signifying there was greater demand for labor than supply available. Low unemployment, while a sign of a healthy economy, is also a common indicator of an economy in the late cycle.

Despite the tight labor market, wage growth has been slow to rise, though it ticked up to 2.8% year-over-year in September. Competition for workers tends to result in rising wages, which in turn leads to expectations for higher inflation. Although workers haven’t been getting much in the form of wage increases, and that’s not great news for the individual, it has helped keep down costs for businesses and, subsequently, tempered inflation which is at a relatively low 2.3%.

While wage growth may be less than expected given current economic conditions, consumer sentiment remains well above average. Spending is a typical result when consumers feel positive on the economy, which is important as consumers fuel around 70% of the US economy.

Additionally, the fiscal stimulus created by tax reform, commonly referred to as the Tax Cuts and Jobs Act (TCJA), remains supportive of economic growth. Corporate earnings growth has exceeded expectations and, according to International Monetary Fund (IMF) estimates, the TCJA is adding 0.7% to GDP growth this year and will add 0.8% in 2019.

Midterm Elections

Going into the US midterm elections there had been considerable discussion and speculation over which party would control the houses in Congress and what economic issues will be of focus for the next few years. As history has proven, we saw that in the lead up to the election, the market was a bit volatile as investors tried to understand potential market and economic implications of one party winning over the other.

Fresh off the midterms, as expected, we’re seeing that markets tend to perform well, regardless of the outcome. Since 1800, the S&P 500 has been positive the 12 months following a midterm election 78% of the time. We likely see this pattern because there’s generally more certainty of the government’s direction for the next few years, even though there may be different impacts on specific sectors or companies.

Rising Interest Rates

The Federal Reserve raised rates another 0.25% in September, which was the third rate increase so far this year. The Federal Funds rate is now at a target range of 2.00%-2.25%. In their statement, the Fed reiterated its view of a robust economy, citing the continued strength of the labor market and strong economic activity, with inflation remaining near 2%. Although there may be potential risks to the economy stemming from escalating trade wars, weaker housing, and higher oil prices, we believe it likely that the Fed will raise rates again this December. They’ve also stated their intent to raise rates an additional three times in 2019.

As shorter-term rates have risen, the S&P 500 is now yielding around the equivalent of a one-month Treasury bill, which hasn’t been the case since early 2008. The global low-interest rate environment over the last decade has pushed a lot of investors into the equity markets to get the returns they needed. As short-term rates continue to rise, this may lead to declines in the equity markets as capital flows out of equities and into safer fixed income investments.

When an economy is in good health, the rate on the longer-term fixed income investments will be higher than short-term ones. The extra interest is to compensate for the longer time period money is tied up and for the risk that strong economic growth could set off a rise in prices.

Since the Fed began hiking rates in December 2015, we’ve seen long-term rates rise by much less than short-term rates, flattening the US Treasury yield curve. Lower long-term rates typically suggest concerns about long-term growth—concerns that the economy won’t be growing enough to create inflation to require the extra interest, for example. However, long-term US Treasury rates can also reflect the global supply and demand for safe income. It’s hard to tell which force is pushing harder to keep long-term yields low at this point—the immense demand across the globe or weak future economic expectations in the US.

Trade Wars and Tariffs

Escalating trade tensions and tariffs between the US and China and other trading partners are creating considerable uncertainty across global markets.

On September 24, 2018, the US implemented tariffs on $200 billion worth of Chinese goods, bringing the total amount of tariffed goods to $250 billion—roughly half the amount the country sells to the US. China responded in-kind by implementing tariffs on $60 billion worth of US goods the same day. Several other US trading partners, including Canada and Europe, have also responded to new US tariffs by targeting important US exports. Companies in sectors such as aerospace, automobiles, machinery, semiconductors, technology, and tobacco could be most impacted by further escalation.

Asian equity markets have seen significant volatility this year, as increasing trade barriers are a particular problem for export-oriented nations, such as Hong Kong, South Korea, and Singapore. While the US has much less economic exposure in the way of exports, and the equity market has held up thus far, rising tariffs point to increased costs. Big US corporations such as Micron, Walmart, Ford, Caterpillar, and Proctor & Gamble have all warned tariffs may raise their costs—and subsequently prices—in the coming year.

Looking Ahead

The US economy is in good shape heading into the last quarter of 2018, and the near-term fundamentals are supportive of corporate earnings and continued growth.

However, headwinds such as rising interest rates, inflationary cost pressures, and lack of clarity surrounding global trade pose threats to the economy in the midterm. Market volatility should be expected as investors attempt to price in the implications of these factors.

Opportunities

For the rest of the year, US companies should see continued strong earnings supported by constructive economic fundamentals, and, historically, the US market has done well post midterm elections as we’re seeing. We believe emerging market equities, though currently under pressure, represent the best long-term growth prospects due to attractive valuations, a quickly growing middle class, and positive demographic trends.

While volatility will occur, it’s very difficult to predict the timing or magnitude of any market shift. Investors can be prepared by keeping a well-diversified portfolio.

Having an allocation to alternative assets uncorrelated to the traditional stock and bond markets can reduce overall portfolio volatility and provide other sources of return in times of market stress.

For risk-averse investors, rising short-term rates allow for more attractive yields on safer, short-term income investment, such as certificates of deposit and US Treasuries. Floating rate loans and alternative income securities can help diversify a portfolio and reduce overall interest rate risk in a rising rate environment.

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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.