09/05/2018
Two-thirds of the way through the third quarter and U.S. stocks are so far enjoying their best quarterly returns of the year. The S&P 500 index fell 1.2 percent in Q1, rose 2.9 percent in Q2, and through two months is higher by 6.7 percent in Q3. These gains have come despite the fact that not much has changed on the trade front. Apparent progress in negotiations with Mexico has not been matched by progress with Canada. And recent talks in Washington with Chinese trade representatives apparently yielded little progress. But trade aside, the U.S. economy remains healthy.

Second quarter GDP was recently revised higher, to an annualized rate of 4.2 percent, despite a downward revision in personal consumption. And the August 30 GDPNow estimate of the Atlanta Fed for third quarter GDP is 4.1 percent, and the August 10 Philadelphia Fed Survey of Professional Forecasters anticipates growth close to 3.0 percent in the second half. Our own forecast anticipated growth of 3.4 and 3.0 percent in Q3 and Q4, respectively. The unemployment rate once again dipped below 4.0 percent in July, and is expected to drop to 3.8 percent with the August report on Friday, according to Bloomberg. And while consumer prices have edged higher, the rise is so far not problematic. In addition, forward monthly comparisons in the Consumer Price Index calculation are set to become easier.

According to the Conference Board, consumer confidence surged to a seventeen year high in August. The Fed has proceeded as expected, raising the overnight rate twice so far, and is almost unanimously expected to do so again this month, with a 96 percent probability according to the CME Fedwatch tool, and again in December with roughly 66 percent probability. Housing and auto sales are a little disappointing, but conditions overall are solid.

Strong Earnings and a Stabilized Dollar Keeping Volatility Low

Second quarter earnings grew by 25 percent, and the S&P 500 sits near record territory in what is now the longest bull market on record. According to Factset, earnings this quarter are expected to slow to a still robust 20 percent growth, with 17.4 percent growth in the fourth quarter. By style, growth stocks have continued to outpace value thus far in the quarter, led by the consumer discretionary and technology stocks, which have been the leaders all year. But it has also been a good quarter so far for healthcare, financials and industrials. Only the energy sector has declined. And implied volatility has trended lower. After averaging 16.3 in the first half of the year, the VIX index of volatility has so far averaged just 12.8 in the third quarter.

Another recent support for stocks has been the stabilization of the dollar. After rising 5.2 percent in the second quarter, the dollar has barely budged since then, taking pressure off U.S. exporters, commodity producers, and foreign issuers of dollar denominated debt.  While emerging market stocks were down 7.7 percent in dollar terms in the second quarter, they have declined just 1.3 percent so far in the third. Stocks in China have continued to fall, but at half the rate of the second quarter. The Shanghai Composite fell 15.4 percent in Q2 in dollars, and 7.5 percent so far in Q3.

What Can Investors Expect for the Remainder of 2018?

The arrival of Labor Day historically marks the start of the sprint toward year-end. With vacations ended and investors refocused, the annual question is whether recent gains on light volume can be sustained. The litany of worries that confront investors as they return from vacation is the same as when they left, including trade tensions, mid-term elections, a flattening yield curve and European politics. And September is historically the month with the worst average return at -1 percent, and the most down days and fewest up days, according to Yardeni Research. And together with October, the next two months are historically the most volatile time of year for stocks. 

U.S. equities are by no means cheap. And valuations have improved only slightly since the beginning of the year, as stock prices have risen alongside rising earnings. Using Bloomberg data, the trailing P/E ratio has declined from 22X to 21X, well above the ten-year average of 17.6X and the five-year average of 19.4X. Looking further ahead, 2019 earnings growth is currently expected to be healthy once again, but at 10 percent it would be just half the pace of 2018 full-year expectations.

With valuations as full as they are, stocks will become increasingly dependent upon solid economic growth to push prices higher. As that dynamic continues to unfold, the nagging concern for investors this far along in the current expansion is at what point does the strong economy intersect with the Fed’s desire to prevent inflation from becoming problematic. The Fed has thus far been rather deliberate in its current tightening, and appears likely to remain so through year-end. But while inflation is currently not problematic, the Fed remains vigilant.

In his opening address to the August central bank retreat in Jackson Hole, Fed Chair Powell warned against central bank complacency in light of historical misjudgments of the natural rate of unemployment. In other words, it may be a mistake to wait too long for empirical evidence of inflation when the unemployment rate appears to be close to, and possibly below, its long run sustainable rate. Powell’s speech was generally interpreted as being dovish regarding the expected future path of the overnight rate. But a close reading suggests that he remains vigilant to the possibility that the labor market may be close to, or already in a range that could translate into rising wage inflation, requiring a more aggressive response from the Fed.

We are not yet at that point. And economic expansions and bull markets do not die of old age. Until monetary policy becomes restrictive, and in the absence of external risks becoming more severe headwinds, a growing economy can continue to support modestly rising stock prices.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.

Past performance is not a guarantee of future results.

The S&P 500 is an index containing the stocks of 500 large-cap corporations, most of which are American. The index is the most notable of the many indices owned and maintained by Standard & Poor's, a division of McGraw-Hill.

FactSet Research Systems Inc., trading as FactSet, is a financial data and software company headquartered in Norwalk, Connecticut, United States. The company provides financial information and analytic software for investment professionals.

The Conference Board, Inc. (“TCB”) is a global, independent business membership and research association working in the public interest. TCB’s mission is to provide the world's leading organizations with the practical knowledge they need to improve their performance and better serve society.

The CME FedWatch Tool analyzes the probability of FOMC rate moves for upcoming meetings. Using 30-Day Fed Fund futures pricing data, which have long been relied upon to express the market’s views on the likelihood of changes in U.S. monetary policy, the tool visualizes both current and historical probabilities of various FOMC rate change outcomes for a given meeting date. The tool also shows the Fed’s “Dot Plot,” which reflects FOMC members’ expectations for the Fed target rate over time. 

The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a widely used measure of market risk. It shows the market's expectation of 30-day volatility. The VIX is constructed using the implied volatilities of a wide range of S&P 500 index options.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The Shanghai Composite Index is a capitalization-weighted index of all stocks on China’s Shanghai Stock Exchange.

U.S. Dollar Index: Indicates the general international value of the U.S. Dollar by averaging the exchange rates between the U.S. Dollar and six major world currencies.

The information and opinions in this article are compiled from third party sources believed to be reliable, but accuracy and completeness cannot be guaranteed by Ameriprise Financial. The information is not intended to be used as the sole basis for investment decisions, nor should it be construed as advice designed to meet the particular needs of an individual investor.

Indexes are unmanaged and are not available for direct investment.

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