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.
During a recent family sailing trip, we experienced the kind of weather sailors dream of: 20‐25 knot winds from the east all day, every day. That kind of consistency over a week‐long period makes it easy to plan your course. However, it was August and that meant the occasional squall producing some rain and a stronger breeze—usually, just enough to keep us on our toes.
That seems to describe the current investment environment. We have better than 6% nominal economic growth, unemployment below 4% and inflation near 2%. Corporate earnings growth so far this year has been better than 20%! We've had this environment for a good portion of the year, which has led to stocks reaching all‐time highs.
Yet somehow investors want to focus more on the occasional squall line in the form of trade/tariffs, other Washington disturbances, Chinese economic weakness and emerging market dislocation.
They say a bull market climbs a wall of worry, which definitely seems to be the case with the most recent leg of this one. Here is an exploration of the fair winds pushing asset prices higher.
Last week, the U.S. second quarter's annualized real economic growth was revised upward to 4.2%. That means that the 2018 April to June period for U.S. economic activity was 4.2% higher than the same period in 2017, after netting out inflation. The 10‐year average for that growth rate is near 2%. So this was an unusual quarter. However, for those investors who are watching for squall lines, they say it's “late in this cycle of growth,” or note that the tax package from Congress in December of 2017 created this growth uptick and that it can't be sustained.
Well, it is late in the cycle. However, many forget that we had something of an industrial recession a couple of years ago. While the technology and health care sectors may have allowed us to maintain positive growth for the overall economy, the energy and manufacturing sectors were really beaten down. Remember oil prices at $25 per barrel and the 20‐point rally in the value of the dollar's index relative to other currencies? These were real issues facing the two sectors, both large contributors to our economy. Now oil is trading nearer $65 per barrel, which has led to an enormous increase in energy capital expenditures and, while the dollar has rallied, it is less than half as much.
The tax plan and the resurgence in these two sectors has led to almost 15% growth in capital expenditures. This is the money companies invest in themselves for future growth. Because companies are seeing real revenue growth, they are more confident in making these investments.
This spending will lead to improvement in productivity. Companies invest in their businesses by buying machines, developing real estate and hiring people. Post‐financial crisis, they do all of this with an eye on improving their operating margins. It takes a while to see the benefits in productivity growth, but they are long lasting when they happen. It is possible that today's capital expenditures extend this long economic growth cycle even further. The squall spotters will suggest that this investment is in machines and not beneficial for employment. However, with unemployment below 4% today, this doesn't seem to be a near‐term issue.
Because of improved economic performance, growth in corporate earnings and revenue have led stock prices to reach all‐time highs. Last week, the S&P 500 stock index traded at a level never seen before. Of course if you're looking for dark clouds, then this new high represents a market “top” and you become wary of the current level of stock prices. The data on market highs suggest something different. We reviewed a number of studies last week that look at how the stock market behaves after reaching new highs. Those studies suggest that it will move even higher. In fact, 70‐80% of the time, after reaching a new all‐time high, the S&P 500 index is higher 12 months later.
Of course there are issues like trade and mid‐term elections that can create less than favorable weather for the stock market. However, we don't believe they are likely to derail the benefits of tax reform and capital expenditures in the near‐term.
Pacific Ocean storms are called typhoons. They can be significantly more troublesome than the occasional squall we experienced during our trip. In fact, Japan is experiencing a storm this week, acknowledged as the worst in 25 years. Some will focus on the disruption to the microchip industry where production seems to be in the path of this storm and suggest that this is another knock on the economy.
We would look past Japan and focus on China. China's economy has performed more poorly this year, and recently their currency has declined in value by more than 10%. While many point to the trade war discussion, we think the more than 2.00% decline in short‐term interest rates from near 5% to 2+% (known as SHIBOR) has more to do with the currency weakness.
China is trying to stimulate their weakening economy. In addition to lowering rates, they've passed some tax reform and increased infrastructure spending plans for 2018 to buoy the economy's growth rate.
This is incredibly important because China is the second largest economy in the world. It is also an important player in Asian trade. We mentioned earlier the problems with emerging markets' weakness. Much of this can be tied to China's slower growth. Its efforts to stimulate the local economy will have a positive impact on these other markets as well. Some in politics will try to argue that the weaker Chinese currency is a function of its reaction to trade tariffs from the U.S. More likely, it is a reaction to lower interest rates and a weaker economy resulting from slower consumption.
If you're a sailor, squalls are part of the trade. How you prepare for them ahead of time and deal with them when they come is part of being a good sailor. Apparently the same is true for investors. We believe our investment process assists us in being prepared and allows us to deal with potential market disturbances. As sailors say to one another before they head out to sea, “We wish you fair winds.”
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