from the June investment comments from Provident Investment Management
Investors in 2018 haven’t had much to cheer about. The stock market is about flat. The resumption of normal volatility seems abnormal because prior years were so placid in comparison. Normally investors can seek relief in the bond market, but with both the Federal Reserve and a stronger economy pushing interest rates higher, many are surprised to see the value of their bond portfolios declining. This is the reverse of 30 years of experience, as ever-lower rates caused bond portfolios to appreciate.
While interest rates are clearly behind the bond market’s problems, the stock market can’t blame corporate earnings or the economy. According to FactSet Research, as of early May 81% of companies in the S&P 500 have reported first-quarter results. These companies reported a composite earnings growth rate of 24.2%. If this growth rate holds up it will mark the highest earnings growth since 34% for the third quarter of 2010 when the economy was recovering from deep recession. This is impressive growth, but we should keep in mind that roughly half of it is due to corporate tax reform that cut U.S. tax rates from 35% to 21%.
Even so, double-digit organic earnings growth this far along in what became the second-longest economic expansion in May is impressive. This earnings growth doesn’t happen without sales advancing, and the 81% of companies reporting grew sales 8.5%. This is the highest growth rate since the third quarter of 2011. Analysts have updated their 2018 projections and now expect earnings growth of 19.5% and sales growth of 7.2%.
The global economy looks strong. In the U.S., first-quarter GDP advanced 2.3%, down a bit from the 3%+ levels of the prior three quarters, but the best showing for a first quarter since 2015. Since the recovery got going there has been a repeating trend of relatively weaker first quarters, as some analysts have questioned the seasonal factors used to adjust the raw data. In any event, consumers held back growth with a modest 1.1% spending increase, likely taking a breather after a 4% advance in the fourth quarter and in the presence of harsher winter weather in Q1. Most encouraging for future growth is the 6.1% advance in nonresidential fixed investment, reflecting business investment in buildings, equipment, software, etc. This investment sows the seeds for faster growth as it gives businesses and their employees the tools they need. Trade also got into the act as exports advanced 4.8% and imports slowed to a 2.6% growth rate.
The international backdrop is solid. The International Monetary Fund estimates that global growth for 2018 will come in at 3.9%. After 2.4% growth in 2017, the Eurozone expects about the same performance, 2.3%, in 2018. China continues to report its steady growth of 6% or more, and even if the statistics are a bit too consistent to believe, there is no question that Chinese consumers and businesses are doing well.
So why is the stock market struggling to advance? The key lies with the Federal Reserve as investors try to gauge the pace of future interest rate increases. In April, the Fed got to check off both boxes against its dual mandate: low but positive inflation and (perhaps) full employment. In that month the index measuring personal consumption expenditures, the Fed’s preferred inflation gauge, hit 2.0%, a long-sought goal over this expansion. Further, unemployment broke below the 4.0% level, to 3.9%, a 17-year low, as the economy added 164,000 jobs. This is quite an accomplishment as the pace of monthly job growth has accelerated over the past year. However, the true unemployment rate may not be as low as it looks due to the significant number of workers that are working part-time jobs and want full time employment, as well as workers too discouraged to seek work. This measure fell to 7.8% in April, but remains above the low of 6.9% in December 2000.