Published June 7, 2018
The summer heat has arrived in force here in Austin over the past couple of weeks. Our focus Nasdaq 100 (QQQ) index has also been hot, emerging from a three-month market correction to break out to new highs recently. The commentary below from the team at Charles Schwab does a good job of outlining some of the major positives and negatives the market wrestles with these days. We hope you find it informative.
The rally since the March lows has pushed investor sentiment higher, with the Ned Davis Research Crowd Sentiment Poll moving back into optimistic territory, a potential contrarian indicator. In addition, corporate earnings season has wound down, eliminating a tailwind of good news associated with tax and regulatory reform.
Economic expansion not on oxygen yet!
According to the National Bureau of Economic Research (NBER), the current economic expansion is now 106 months old – making it the second longest expansion in the past 100 years – and well above the average of 58 months – leading to much “latter innings” discussions But remember, expansions don’t die of old age alone – they typically die from excess; in the form of inflation, monetary policy, capacity utilization, etc. So, while the length of the current expansion is extended, economic gains haven’t been. According to Yardeni Research, real gross domestic product (GDP) has grown about 22% from the 2009 trough, well below the 50%-plus gain at the high end; and the second-lowest gain in any expansion since 1960.
After the typically-weaker first quarter growth rate for the economy, we’ve seen a pickup in the data for the second quarter. Regional manufacturing surveys such as the Empire and Philadelphia Fed surged in May, with the former moving from 15.8 to 20.1, while the latter spiked from 23.2 to 34.4. Additionally, retail sales staged a bit of a comeback, with the Census Bureau reporting that April sales rose 4.7% over the year ago period, with the previous two months being revised higher.
Retail sales looking good
Industrial production also surprised on the upside, with the Federal Reserve reporting a 0.7% increase, while capacity utilization ticked higher to 78.0% from 77.6% (but notably remaining below the 80% level that both indicates capacity constraints and a level that has typically been reached in advance of a recession).
Industrial production continues to rise
While capacity utilization indicates expansion has room to run
Likewise, housing has rebounded but not sharply and the National Association of Realtors continues to bemoan lack of inventory, while the National Association of Homebuilders Confidence Index rose to 70 from 68 – showing no signs of the sharp declines seen in the advance of previous recessions.
Builder confidence remains high
But risks remain
The economic expansion appears to have some legs but there are certainly risks that could short-circuit continued growth. A possible trade war remains at the top of the list, with negotiations on multiple fronts ongoing. Some take comfort in ongoing talks, but we’re going to need to see some progress in the next several months or the risk of damaging trade policy being enacted could escalate.
On a more fundamental level, escalating inflation alongside tightening financial conditions remain more relevant risks to the bull market. Markets are taking some comfort from the recently-released Fed meeting minutes, which highlighted that the Federal Open Market Committee (FOMC) would be comfortable with a “temporary period of inflation modestly above 2%” in keeping with its view about “symmetry” (allowing for a somewhat symmetrical period of above-target inflation in light of how long inflation was below target). But there remains a risk that the Fed could end up behind the curve and having to tighten more quickly if inflation accelerates more sharply
Global stocks and economy reconnecting
The signals for a potential global economic acceleration aren’t quite as encouraging. The preliminary Purchasing Managers Indexes (PMI) from around the globe for May were released this week. They are the earliest read on May economic activity in a wide range of countries and are closely watched by investors following the economic soft spot seen earlier this year.
The global PMI (a combination of the PMIs of over 30 countries) slid in February and March due in part to some temporary factors, then stabilized in April with a slight rebound. May appears to have brought an erosion in that rebound based on the preliminary reports released this week. The current PMI reading points to a solid, but no longer accelerating, pace of global economic growth.
Why is the PMI so closely watched? As you can see in the chart below, stock market performance (in orange) and the global composite PMI (in blue) have generally tracked each other over the past 20 years since the inception of the PMI. Global stock market performance has rarely disconnected for long from the underlying trend in the global economy measured by the PMI.
Another temporary disconnect between global stocks and economy may be reconnecting
The orange and blue lines appear to be reconnecting, as they have done three times already this cycle. The three times the lines disconnected were after the Federal Reserve’s quantitative easing (QE) programs ended. Although those bond buying programs appeared to do little to lift global economic performance as measured by the PMI, the monetary stimulus did lift stocks resulting in temporary disconnects between the performance of stocks and the economy during the duration of those programs.
In 2017, rising expectations of fiscal stimulus bolstered investor optimism and pushed global stock markets higher. That wave of optimism seems to have waned with the enactment of fiscal stimulus (the tax cuts in the United States) in January. Since January, stocks again appear to be moving toward reconnecting with the economic growth environment measured by the PMI.
Historically, a reading on the global PMI of between 52.5 and 55.3 has been consistent with single-digit annualized global stock market gains, as you can see in the table below. The current reading is near the center of that range. If there was no change in stock prices or the PMI, the orange (stocks) and blue (PMI) lines would reconnect in September as year-over-year stock market performance would tend to moderate into the single digits. Alternatively, if the PMI rebounds or if stocks pullback 5%, the lines could reconnect more quickly.
PMI range and stock market performance
While it may seem disappointing to see a slide in the PMI, the global stock market correction since January accompanying the slide in the global PMI has meant that global stock market performance no longer appears to be widely disconnected from economic fundamentals. This suggests to us that while volatility is likely to persist, the economic environment would tend to support modest stock market gains rather than the correction turning into a bear market.
Having fought off a strong effort from the bears to end May, investors turned with optimism into the month of June with a solid Monday showing. Stocks gained +0.5% on strength in retailers and tech stocks. Apple (AAPL) held its developers conference where future product enhancements appeared to encourage investors. Microsoft (MSFT) also continued performing well with a $7B+ purchase of software developer site, GitHub, being well received by investors. Tuesday brought a flat day for stocks though tech/consumer shares outperformed once again, driven by a solid day from Amazon (AMZN). Stocks charged higher for a fourth straight session Wednesday with investors shrugging off a rise in interest rates to post a +0.9% gain. Financials rose on the higher interest rates while a pullback in the surging U.S. dollar offered support for shares of commodity-based companies. The gain was undone on Thursday, at least for the Nasdaq, with a general selloff in tech shares after a strong recent move higher. The broader market indexes remained flat, however, as the tech pullback was offset by strength in energy and other recently faltering sectors. Friday brought a little changed market with investors keeping an eye on the weekend’s meeting of the G7 trading block. The meeting was seen as likely being contentious given recent U.S. trade tariff moves.
Stocks held firm for the week with the S&P 500 ticking higher by +1.68% while the Nasdaq 100 (QQQ) rose +0.98%. The small-cap Russell 2000 (IWM) charged further into new high ground with a +1.64% lift.
Warm wishes and until next week.