2017 Third Quarter Overview
For the third quarter, the Dow Jones Industrial Average posted a gain of 3.32%, the S&P 500 Index posted a gain of 2.57%, and the NASDAQ posted a gain of 3.87%. Year to date, the Dow Jones Industrial Average posted a gain of 8.03%, the S&P 500 Index posted a gain of 8.24%, and the NASDAQ posted a gain of 14.07%. (1)
It Was An Interesting Quarter
There were plenty of distractions and walls of worry to climb in the third quarter. First, we have only begun to measure the damage caused by hurricanes Harvey, Irma, and Maria. Florida and Texas incurred direct hits, and Maria devastated Puerto Rico. Needless to say, to some degree, economic metrics over the coming months will reflect the impact of these storms.
Having said that, I also believe we will observe pockets of strength across these metrics that result from spending on services, infrastructure and construction. Not surprisingly, many clients have asked me if such natural disasters could be the catalyst for a mild recession and should this be a cause for alarm with regard to investment strategies. The short answer is no, in my opinion, current economic momentum is strong enough to sustain such temporary setbacks, and hence why I believe the markets behaved with stability.
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On the 2 nd of May, the Labor Department reported that 147,000 private sector jobs were created in the month of April, and 138,000 payrolls in all. The unemployment rate declined to 4.3%. Payroll data for March was revised lower by 37,000 payrolls. The labor participation rate rose to 62.7% as people returned to the workforce. (5)
On the 29 th of June, the market considered the most recent weekly jobless claims report, and the four week moving average. Within many pieces of correspondence, I’ve discussed the importance of weekly jobless claims and the four week moving average as being a historically accurate leading economic indicator. (5)
The level of initial jobless claims came in at 244,000 for the week. Following revisions, the latest four-week average was 254,250 claims, just off historic lows. Continuing claims declined from a quarter ago, at 1.948 million, again, just off a recovery low. The unemployment rate for insured workers declined to 1.4%, which remains the lowest rate seen yet in the recovery. This marked the 119 th consecutive week for a jobless claims reading below 300,000 – the longest streak since 1970. (5)
New unemployment claims are compiled weekly to show the number of individuals who filed for unemployment insurance for the first time. An increasing (decreasing) trend suggests a deteriorating (improving) labor market. The four- week moving average of new claims smoothes out weekly volatility on the underlying trend. (5).
The ISM manufacturing index (formerly known as the NAPM Survey) is constructed so that any level at 50 or above signifies growth in the services sector. (3)
On the 3rd of July, the Conference Board released the March ISM Manufacturing Index, and it showed a reading of 57.8. This was higher than last month’s reading of 54.9, which was the highest reading since August of 2104. New orders were strong at 63.5, and the backlog orders index posted a rare high reading of 57.0. Strength in orders suggests future strength in employment. (3)
Leading Economic Indicator (LEI) – According to Bloomberg.com, the Leading Economic Indicator, or LEI, is a composite index of ten economic indicators that should lead overall economic activity. The report released on the 21 st of December rose 0.4% from the prior month’s reading of 1.2%. This bodes very well for future economic activity. Through the December report, 92 of the last 103 readings have been positive or unchanged for the LEI since April of 2009. The concept of this index is to project future economic conditions over the next three to six months. (3)
Gross Domestic Product
Gross Domestic Product (GDP) is the broadest measure of aggregate economic activity and encompasses every sector of the economy. (4)
On the 30th of June, the final estimate of GDP growth for the 1 st quarter was released and showed economic growth expanding by 1.4%. The previous reading showed expansion of 1.2%. The consumer was the driving force behind the number, spending at a 1.1% rate, up from 0.6% in the previous estimate. Overall corporate cash remains near an all time record high as a percentage of GDP. (4)
Consumer Confidence is important because the pattern in consumer attitudes can be a key influence on markets, as such spending drives two thirds of economic activity. On the 27th of June, the Conference Board’s consumer confidence index stood at 118.9. This was just off the strongest reading since December of 2000. The current conditions component at 146.3 hasn’t been this high since June of 2001. The expectations component was also very strong at 100.6. This was a very strong consumer confidence report. (6)
The year over year gain for this index stood at 6.4% as of the 26 th of December. All 20 cities showed year over year gains, and the month over month gain for the index stood at 0.7%. This is the strongest run for the index in over four years. (2)
New Home Sales
On the 23rd of June, the latest report on new home sales was released. The new home sales reading was up 2.9% and showed that 610,000 new homes were sold in May. This was one of the best monthly rate increases observed in the recovery. With revisions for April higher by 24,000 units, this index continues to show strength in housing. It remains a seller’s market, with a thin 5.3 months supply on the market as of the end of February. New home sales average prices are up 16.8% since April of 2016. (7)
Pricing power appears to be stable for new home buyers with the month's median at $345,800. Regionally, the West and South are leading the way in strength. (7)
Income and Expenditures
Personal consumption is an important metric to monitor. On the 30th of June, it was reported that personal income was higher by 0.4% month over month, and consumption was up 0.1% month over month. Normally, higher levels of confidence eventually translate into healthy patterns of spending, and such bodes well for the third quarter of 2017. The PCE Price Index, a measure closely watched by the Federal Reserve, was up 1.4%. This reading stood at 2.1 as of the end of the first quarter, however many economist argue this supports recent measures by the Federal Reserve to raise interest rates, as inflation is evident at the core level excluding food and recent volatility seen in the energy market. (4)
Tensions between the United States and North sides became increasingly incendiary, and yes this too became a source of worry with regard to the market and the economy. In spite of this, the markets responded resiliently and I believe that remains due to the stronger than expected fundamentals that remain in place, underpinning valuations. According to Bob Carey, the Chief Market Strategist at First Trust, the estimated year over year revenue growth rates for the S&P 500 Index were 5.0% for 2017, and projected at 5.2% for 2018. Energy, information technology, materials and consumer discretionary were the top four contributors to current and projected revenue rates of growth.
In late September, Janet Yellen suggested that inflation was a “mystery”. Frankly, I’m not sure why such is a mystery, because to me anyway the answer is pretty clear. Quantitative easing did not work. Quantitative easing flooded the banking system with cash. However, rather than being a boost to the M2 money supply, the excess monetary base growth went into “excess reserves”, money that banks hold as deposits, but do not lend. Think of this as money in a warehouse. To what degree did a warehouse of money help the economy?
Furthermore, the tight lending restrictions that came with Dodd Frank, and the previous Administration, provided further disincentive for banks to manufacture loans. As if that weren’t enough, the Federal Reserve itself compelled banks to hoard excess reserves, through the payment of an artificially high rate of interest on excess reserves left on deposit.
In essence, the Fed printed it to stimulate the economy, the government said “don’t lend it, or else”, and the Federal Reserve said “we’ll pay you not to lend it”. And we wonder why QE didn’t work.
On the political front, Congress failed again to repeal and replace the Affordable Care Act. This was important on its own merits, but it was also important because it delayed efforts to reform the Tax Code as well. Ultimately, the Graham-Cassidy Heathcare Bill did not muster enough votes, and President Trump suggested that efforts to repeal and replace would have to wait until 2018.
In what I thought to be a positive move, the Trump Administration negotiated across the isle for keeping the government funded and operating through the end of the year. This was important because A) it sent a message that deals will be struck where they can be found, and B) it removed the threat of a “shutdown” distraction from the tax reform debate.
As of the publication of this newsletter, the finite details of the reform measure remain unclear. We do however know that corporate taxes could be cut dramatically, and a one time tax upon repatriated dollars could pave the way for an enormous transfer that had before now, been discouraged under the previous Tax Code. Inflation and interest rate sensitive sectors such as energy, banking, financials, and real estate will be watching closely as this measure unfolds.
One potential drawback of the tax reform package could be that it coincides with other inflationary pressures. Recently, the Federal Reserve announced plans for unwinding its balance sheet. As that unfolds, we can expect treasury yields to rise. Through tax reform, consumers and corporations may find greater amounts of capital for discretionary spending. Also resulting from corporate tax reform, could be the expansion of the currency base through repatriation. Such could have a negative impact on traditional fixed income investments. This would include high duration, low credit quality, long maturity bonds and bond funds, leveraged REITs, and other rate sensitive categories of securities.
This would be a fantastic time to review your investment portfolio for efficacy, and exposure to risk, relative to your goals. Remember, investing is a goal oriented process. It’s a marathon, not a sprint. In times like these, when natural disasters, geopolitical matters, and legislative developments can rattle confidence, its best to take a step back and re-focus on long term goals. Those who remain optimistic and focused on achieving long term objectives will likely be rewarded. Stay optimistic and stay invested.