This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, EVP, Chief Investment Officer.
Summer chores are a fond memory. Most days, my father would leave a list of them for us on the kitchen table with the expectation that they'd be complete when he arrived home. He was a Master Gardener, which meant his children were master weed pullers. In the days before mulching and rolls of weed barrier cloth, he had children to weed gardens every day and so we did. One of the more technical aspects of pulling weeds was the determination of what was weed or flower. Given my father's penchant for perennials and English gardening this was not always easy. This skill was learned through trial and error. Errors came with another review of the difference from the Master Gardener.
And so it is with our current global economic and market news. Determining weed from flower always gets more difficult as the current phase of a growth cycle ages. While it may seem like the time to pull up investments, given the current news, it might just be that markets look like June perennials that bloom in late September (which still look like weeds to me).
During the week of July 23, we received a first look at U.S. economic growth during the second quarter (this is preliminary and subject to change; the next revision comes out August 29th). While slightly below forecasts, the 4.1% growth rate was almost double the last four quarter average. The increases in capital expenditures and consumption led to much faster growth than we've seen for some time. This second quarter growth also pushed the U.S. economy above $20 trillion for the first time.
Growth was led by a $168 billion increase in personal consumption and an uptick in government spending as well as exports. Faster growth is good news especially when being reported with a muted inflation measure. Despite growth advancing at this healthy pace, the Fed's favorite measure of inflation, the “core” Personal Consumption Index was up only 2%.
This data suggests that the economy is benefitting from better global growth despite concerns about trade wars and a more nationalistic foreign policy. These issues however, look like weeds to the Master Gardener, concerned that they'll overwhelm the benefits of tax reform. We don't think so. While trade tariffs are messy and have dramatic impact on very specific industries, they don't seem likely to overwhelm the faster growth rate. Tariffs implemented to date are expected to shave less than .2% off of growth. When the year is done, it is most likely that this year's growth rate is better than last by over 30%.
Yesterday, the Fed Chair, Jerome Powell, had an opportunity to summarize the Fed meeting that took place over the previous two days. The gist of his commentary was that the economy remains sound, employment growth strong and, therefore, its policy of raising rates every once in a while remains intact.
Master Gardeners however, continue to talk about higher interest rates dampening the benefits we're seeing in growth. We don't think so. The inflation report mentioned earlier suggests that while growth has improved, prices remain relatively stable. To be sure, more volatile commodity prices will create some issues (higher gas prices impede consumption), but those prices have risen due to higher demand which is another example of stronger economic growth.
It is more likely that interest rates continue to grind higher over a longer period of time as the Fed tries to slowly manage the unwinding of its $4 trillion plus balance sheet. We expect over‐communication from the Fed and a steady course. Whether it raises rates three or four times in the next year, won't substantially change the calculus of bond investors. Keep in mind that rising rates offer the opportunity to earn more income from bond portfolios and our view is that's the perennial in the bond market garden, not the weed.
The second quarter corporate earnings reporting season is well underway and there have been some surprises among the technology companies that have driven the overall stock market higher in the last several quarters. In particular, last week, Facebook provided a revenue outlook that was weaker than expected and as a result the stock dropped by over 24% initially, lopping off over $150 billion in market capitalization. Weed or flower? Facebook's stock had appreciated by over 140% in the last three years! It will fight the law of large numbers—when you have over 2 billion users, it's hard to grow from there. However, it is a media company whose primary source of revenue is advertising and the age of digital ad growth is still in the early stages.
We can look at the technology sector more broadly through a tech sector exchange traded fund, symbol ‐ XLK, as a good representation of the group's price action. The top 5 holdings in the fund are Apple, Microsoft, Facebook, Alphabet and Visa. Before the decline of the last week, the ETF was up over 16% from the beginning of the year. As of Friday morning, it is still up over 10%.
So, while momentum investing has taken it on the chin in the last two weeks, it was time for a breather. We believe the later we get in this growth cycle, the more likely we are to see a move toward quality stocks—those with better free cash flow and balance sheets. Apple is a good example. It produces over $200 billion in free cash flow each year due to operating margins exceeding 40%. When it announced earnings, the stock was up over 7%. The market value of Apple exceeds $1 trillion, a first for any company.
Technology companies will continue to benefit from the increase in corporate spending, some resulting from last year's tax bill, but just as importantly due to the acceleration in economic growth.
It is easy to get caught up in the geo‐political news about trade wars and think we have nothing but weeds. Like my father's perennial garden, something is always blooming.
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