Monthly Markets Memo - August 2018
by Dan Zalipski, CFA & Scott Rosenquist, CFA
The markets seem to be playing a game of tug-of-war, or should I say “tug-of-trade-war”? On one end of the rope you have a solid U.S. economy backed up by strong corporate earnings growth. On the other end you have an ongoing trade war, rising interest rates, and an economic crisis unfolding in Turkey. The U.S. markets have pushed higher throughout the quarter, with the S&P 500 near its January high. The international markets continue to struggle as they cope with the UK’s ongoing Brexit negotiations, trade tensions with the U.S., and a strengthening dollar that dampens international returns.
Turkey is in the throws of an economic crisis and has seen a sharp decline in the value of their Lira. Emerging markets have reacted negatively to this development on fears it could spill over into other markets. Turkey’s economy is relatively small, about 4% of the size of the U.S. economy. For now, their problems seem to be self-contained, but we wouldn’t be surprised to see them remain a headline risk in the near-term.
Fixed income markets have found their own tug-of-war between the threat of rising rates (which push prices down as yields increase) and a flight to safety (which can push prices up and yields down) as investors seek shelter from the increased volatility. Investment grade fixed income, both treasuries and corporate bonds, have trimmed some of their year-to-date losses this quarter, but remain in negative territory for 2018.
Trade wars, crises, and yield curves are seemingly dominating the discussions in the investment world as of late. This month, we take a break from those topics to check in on the markets and economy from a fundamental perspective. First up, earnings:
As of this writing, 91% of the S&P 500 companies have reported their 2nd quarter earnings. More than 70% reported positive surprises to both sales and earnings, in other words they exceeded analysts’ expectations. Earnings growth is on track to clock in at its second highest pace since 2010, with an average growth rate of 24.6%. Among the sectors, the biggest contributors to this growth is coming from energy, technology, and financials. The energy sector is benefiting from a sharp rise in oil prices. Technology companies are seeing strong revenue growth, and firms within the financial sector are benefiting from higher interest rates. In addition to these sectors, the market is broadly supported by last year’s tax reform, the ongoing reduction of regulatory burdens, and an overall strong economy.
The economy is doing well. Unemployment remains low with the unemployment rate having bounced around the 4% level throughout 2018. Reports this summer highlighted, that for the first time on record, the number of job openings exceeds the number of job seekers. Companies are struggling to find enough qualified workers. Concerns of wage increases triggering a rise in inflation have not materialized. Those workers who are finding jobs are beginning to spend. Retail sales saw a surprise jump in July and the Bureau of Economic Analysis reveal that both personal income and consumption are trending higher.
Turning from consumption to production, the Institute for Supply Management’s (ISM) Manufacturing report is released every month with details sourced from surveys of manufacturing supply executives. These reports cover topics such as new orders, backlogs, production, inventories, and prices. This information is used to determine if the manufacturing sector is currently expanding or contracting, and July’s report marks the 23rd consecutive month of expansion. In fact, one of the biggest concerns among manufacturers is related to high demand as they are having trouble filling and delivering orders to their customers. The reasons vary, but many cite the previously mentioned difficulty of finding qualified workers. The labor shortage has also spilled over into the trucking industry, where a trucker shortage to the tune of 51,000 drivers is contributing to increased shipping costs across multiple industries.
Housing is another major component of the U.S. Economy. The sector has been supported by short supply and healthy demand. Home builders are experiencing higher costs for both land and materials and have been favoring the higher-margin luxury segment to combat the rising input costs. This has contributed to a shortage in the ‘affordable starter home’ market, which only drives home prices higher. As shoppers in this market tend to be more price sensitive, higher prices can have a chilling effect as demand has cooled over the summer. While the falling demand may help reduce home prices on the margin, buyers are finding that rising mortgage rates (related to market-wide rising interest rates) are increasing their costs to borrow and purchase a home. Mortgage applications are in decline. With the Fed set to raise interest rates two more times in 2018, its likely we’ll continue to see mortgage rates increase, further threatening demand. This merits further attention as we monitor for potential spill-over into other areas of the economy.
"The individual investor should act consistently as an investor and not as a speculator." - Benjamin Graham (known as the ‘father’ of value investing)
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