Welcome to the Stearns FinancialPoolside Chat.
The economic expansion has deepened and synchronized around the globe, with the participation of nearly every major world economy. The positive factors are broad, including improving labor markets, accommodative monetary policy, supportive financial conditions and favorable sentiment. Taken together, we conclude these factors suggest the global expansion should persist.
International stock markets have done well versus U.S. stock markets in the first six months, although all of the outperformance in overseas stocks (for U.S. investors) is related to weakness in the U.S. dollar. Positive comments from Fed Chair Janet Yellen this week spurred another upward move in overseas emerging markets.
What might be the strongest influences to stock markets in the last half of 2017?
- The outlook for U.S. corporate earnings is strong.Consensus expectations for year-over-year earnings per share growth is 8% for the second quarter and 11% for the full year. BCA Research is forecasting EPS growth may reach 18% on a four-quarter moving basis later this year before moderating in 2018.
- Modest increases in interest rates.The current signals from the U.S. Federal Reserve are for slow and gradual increases in interest rates. We believe our “muddle through” interest rate increase scenario remains the most likely in the coming year. Lower levels of interest rate increases forestall future pressure on higher price/earnings ratios for stocks.
- The Institute for Supply Management (ISM) indices suggest stronger U.S. economic growth.The ISM manufacturing and nonmanufacturing indices recently hit multi-year highs, leading us to believe that U.S. economic growth could reach 3% for the second quarter.
- The U.S. political landscape has many wildcard scenarios.Congress continues its debates on health care reform. The timing of new health care legislation will influence tax reform discussions set for later this year – we’ve previously cited corporate tax reform as a positive factor supporting the current valuation levels of U.S. stocks. Republicans are far behind schedule, and failure to make progress may eventually jeopardize their prospects for the 2018 mid-term elections.
- Geo-political risks remain elevated, despite the apparent defeat of ISIS.The good news is some hot spots (politically and militarily) around the globe have become somewhat less risky, especially in Europe. North Korean tensions are still worrisome.
The slow-as-molasses U.S. economic recovery has created fewer dangerous bubbles than previous recoveries. However, Cornerstone Macro research suggestskeeping an eye on these six potential “bubble” factors that could create dangers in various sectors of the economy:1) increasing real unit labor costs, 2) increasing house prices, 3) increasing auto debt levels, 4) increasing commercial real estate prices, 5) elevating corporate debt levels, and 6) excessive profit dispersion.
Key Points to Consider
The Bloomberg Consumer Comfort Index dropped 1.5 points last week, its fifth decline in the past six weeks.Ned Davis Research suggests the recent downward trend in the index is a “potentially adverse sign for consumer spending.”Bloomberg noted that the souring of sentiment was likely due to “subdued wage growth and disappointment in Washington politics.”
The aging U.S. economic expansion can’t add as many jobs? Surprise, the U.S. economy added a seasonally adjusted 222,000 jobs in June, the largest increase since February, and stronger than expected by economists.Revisions showed job growth was better in April and May than previously thought. The U.S. economy has created an average of 194,000 jobs over the past three months. That compares favorably to a monthly average of 166,000 during the first quarter, and an average pace of 187,000 per month for all of last year.
The U-6 broader measure of unemployment rose to 8.6% in June from 8.4% a month earlier.This counts not just unemployed workers in the labor force but also Americans too discouraged to enter the job search and part-time workers who would prefer to work full time. During much of the expansion, the rate was relatively elevated compared with the normal unemployment rate, but it has settled back near historical norms despite the continued rise of the “gig” economy (more part-time work like Uber). The rate averaged 8.3% the two years before the Great Recession began.
Frequently Asked Questions
Q:Why is the Federal Reserve planning to shrink its balance sheet? What does this even mean? How will this impact my investments?
A: The Federal Reserve plans to shrink its $4.5 trillion balance sheet by halting the reinvestment of maturing Treasury and mortgage-backed bonds.The bond assets were purchased in the years following the Great Recession to lower interest rates and stimulate the economy. With the labor market approaching full employment and the economic expansion reaching 96 months, the Fed believes it is an opportune time to take action. Shrinking the balance sheet will reduce the Fed’s stimulus measures and help “normalize” interest rates, reducing anxiety over Fed-induced asset bubbles (including those more potentially dangerous bubbles that are forming cited above from Cornerstone Macro) and hyperinflation.
We do not expect a significant disruption in the bond market.The Federal Reserve is hoping to limit its impact on the markets by pre-announcing their intentions and setting monthly limits. The initial reduction will be $10 billion per month and will gradually increase at three-month intervals, preventing a race to the exit in the bond market. The extra supply will put upward pressure on interest rates, a negative for bonds, but yield-hungry investors and pension funds should offset some of this pressure.
We believe the U.S. equity bull market should not be affected.Tighter monetary policy action does not mean an end to the bull market. History shows that equity markets continue to rally during initial stages of policy tightening and higher interest rates. We expect any repricing in the U.S. stock market should be a short-term correction, as stocks remain supported by strong corporate earnings growth and a resurgent global economy.
The Fed will need to balance its policy actions.Interest rate hikes and the balance sheet reduction tighten monetary policy and pressure interest rates. The Fed is likely to act slowly and deliberately to prevent a policy mistake that ends the economic expansion. Expect a slower pace of rate hikes and plenty of “Fed speak” during the balance sheet reduction process.
SFG’s Take:The Fed’s decision to shrink its balance sheet reflects their confidence in the U.S. economy. The policy action will slowly remove the Fed’s direct influence on the markets. Since the Fed is sailing in largely uncharted waters, Chairwoman Yellen and the Fed Governors will be extra vigilant regarding the impact of their actions and rhetoric on the markets and economy. Overall, the decision to begin to shrink their balance sheet will grant the Federal Reserve greater flexibility in setting future policy.
Summary
U.S. economic news still looks good. We will be watching the coming second quarter earnings reports (the #1 driver of stock prices over time) with great interest.
Overseas economies and stocks have been depressed for a while and are in an earlier recovery stage. SFG continues to consider our balance between U.S. and overseas stocks.
We continue to find interesting “alternative” investment areas that have less connection to traditional bonds and stocks. We are being very deliberate in our reward versus risk analysis of these options.
Our approach at this stage of the economic cycle can be summed up by three themes: diversification, underweighting or avoiding areas of higher future concern, and a focus on high-quality investment themes.
~ Dennis, Glenn,John & PJ
(the SFG Investment Committee)
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