Overview and Perspective
After a third quarter that saw U.S. stock prices, as represented by the all-inclusive Russell 3000 Index, rise 7.13%, the index is now up 10.57% for 2018 following a 21.13% increase in 2017. Investors have now begun to question the staying power of this bull market in light of numerous concerns:
- U.S. stock market valuations are above-average as a result of the 9-yr. bull market
- Rising interest rates: the 10-yr. Treasury bond is at its highest yield in seven years and the Federal Reserve plans to continue raising short-term rates in 2019
- Government spending is creating a huge debt burden for the U.S. that may lead to even higher interest rates in the future
- Inflation is beginning to move up as unemployment is the lowest in 49 years, oil prices are at a 4-yr. high, and the Consumer Price Index is trending above the Federal Reserve’s 2.0% target rate
- The dollar is strengthening against foreign currencies making international sales less valuable to large U.S. companies and therefore hurting earnings
- The trade war with China and disputes with our Eurozone trading partners will be harmful to U.S. companies as tariffs act as tax increases
- The midterm elections could disrupt the economy if divided government is the result
From our perspective, there are many reasons to believe that the bull market in stocks in the U.S. will not be coming to an end soon. The powerful economic forces driving the U.S. economy combined with historically low unemployment and consumer optimism will likely lead to increased profitability for U.S. companies. The permanent change in the corporate tax rate structure in 2018 should allow domestic companies to remain competitive vs. their foreign counterparts for years to come.
Stock market valuations are elevated but not at extreme levels that would cause us to prefer bonds over equities. Interest rates, while rising, are well below the levels that historically lead to bonds being favored over stocks. Corporate bond yields would need to rise another 1% to reach the 25-yr. valuation parity with stocks. Inflation levels are not yet problematic as modest wage inflation is a sign of a healthy economy and energy prices are rising primarily due to supply disruptions around the world (e.g., Iran and Venezuela).
We believe that despite the length of the bull market in U.S. stocks, which has gone on since the Great Recession ended in 2009, the age of the rally is not as important as the current economic backdrop in determining whether the bull market is on its last legs. Decreased regulatory burdens and lower tax rates are encouraging our domestic companies to spend on capital improvements (Goldman Sachs reported that capital spending by S&P 500 companies totaled $341 billion in the first half of 2018, up 19.2%, the fastest growth in capital spending in at least 25 years) and hiring. Historically, bull markets do not “die of old age” but end due to impending recessions. As the Federal Reserve raised their GDP estimate from 2.8% to 3.1% for this year (which would be the highest annual GDP rate in 14 years) and bumped up their growth forecast for 2019, the odds of a recession in the next couple of years is remote. Additionally, a reliable predictor of impending recessions, the Index of Leading Economic Indicators, still reflects a positive outlook for the U.S. economy.
While the bull market in the U.S. has overshadowed the poor performance of international markets this year, we believe the inexpensive valuations found in foreign markets will eventually lead to better performance as their economies continue to experience falling unemployment and positive GDP projections. Households across the eurozone have experienced their highest growth of disposable income over the last ten years. Although the eurozone economy has slowed slightly over the past year, labor markets remain tight, as some countries and sectors are showing labor shortages. The strong dollar has certainly hurt international investing thus far this year, a reversal from last year’s excellent showing which had a weak dollar as a backdrop. Just as the U.S. has benefitted from a long period of below-average interest rates, foreign markets are experiencing an interest rate environment far superior to the U.S. (e.g., Germany’s 10-yr. bond yields 0.57% vs. the 10-yr. U.S. Treasury yield of 3.23%). In addition, international stock market valuations are compelling when compared to the U.S. On a trailing Price/Earnings (P/E) basis, the valuation gap between U.S. and non-U.S. stocks remains close to the widest levels in 45 years. As the renegotiation of the NAFTA treaty (now called United States-Mexico-Canada Agreement, or USMCA) among the U.S., Canada, and Mexico provided a better outcome than the previous agreement, so may the ongoing negotiations between the U.S. and its European allies. A positive near-term outcome to China negotiations will likely be much more challenging but may ultimately prove beneficial to the U.S. and Chinese economies.
Elections and Markets
One area of heightened concern to investors is the potential market impact of the midterm elections in the U.S. History has shown us that the period preceding the elections has often been a difficult one with markets tending to sell off due to the uncertainty caused by possible government policy and agenda changes. As markets are discounting mechanisms that prefer stability and predictability, the prospect of upheaval in the legislative branch prompts some investors to raise cash until the results of the elections are known. While the mudslinging surrounding midterm elections may create some headwinds for stocks, the positive news surrounding corporate earnings, jobs, income, and consumer spending should help support the longer-term upward trend. History has also shown that corrections in midterm election years are often followed by solid positive returns in subsequent years, and we could very well see that being the case in this cycle.
As indicated in the chart above, the S&P 500 Index posted a positive total return in each of the calendar years following the previous 18 midterm elections. The total returns have ranged from 1.38% (2015) to 37.43% (1995). The average gain was 19.13% although the previous three midterm elections have been followed by more muted returns.
The Third Quarter
The tug of war between politics and fundamentals continued in the third quarter. U.S. equities continued to perform well, harnessing momentum from strong U.S. growth and profits, but in a reversal from last quarter, U.S. large caps led with a return of 7.7%, versus 3.6% for small caps.
Although domestically-oriented small cap stocks may have benefited from trade tensions in the second quarter, large cap stocks are still enjoying boosts from the tax cuts. Every S&P 500 sector was positive this quarter, with the best performers, Health Care (+14.5%), Industrials (+10%), and Telecom (+10%) leading the way. Materials (+0.4%) and Energy (+0.6%) lagged. Emerging markets stocks struggled to a lesser degree than in 2Q18, but still declined 0.9% as shocks in Turkey and Argentina were met with rate hikes, which echoed across other emerging markets in response to weakening currencies against the U.S. dollar. In fixed income, the Federal Reserve raised the federal funds rate for the third time this year, prolonging a challenging environment for bonds. U.S. core fixed income was flat, and the U.S. 10-yr. Treasury yield rose 0.20% over the course of the quarter. However, global high yield, with its sensitivity to economic strength, was more resilient, returning 2.0%. Commodities were the laggards of the period, losing 2.0%.