The third quarter of 2018 was a very good one for U.S. stock markets with the S&P 500 recording a gain of 7.7% bringing the year to date gain to 10.6%. International markets have not performed nearly as well as the U.S. market this year as the MSCI EAFE (Europe, Australasia, Far East) Index was up 1.4% last quarter but is still down 1% YTD. Emerging markets have been the real laggards as the MSCI EM Index was down 1% last quarter and is down 7.5% year to date. International stock exposure has negatively impacted diversified U.S. investors this year.
Growth of the U.S. economy continues to be quite robust as second quarter GDP was recorded to be up 4.2%. The Conference Board’s estimate for third quarter GDP is up 3.9%. The unemployment rate is now at a 49 year low at 3.7%. Consumer confidence and small business confidence are at 18 year highs. The Leading Economic Index (LEI) is at all-time highs. Barring an unforeseen shock to the system the next U.S. recession still looks to be a ways off.
Corporate profits in the U.S. continue to be very strong. Earnings for the companies in the S&P 500 are expected to have increased by about 20% in the third quarter. Fourth quarter profit growth is expected to slow further to a still healthy 17%. For all of 2018, S&P 500 earnings are expected to be up about 20% to $162. Earnings are expected to grow another 10% in 2019 to $178. The S&P 500 is currently trading at 2,865 which equates to 16.1 times 2019 earnings versus the historical average of 14.5 times forward earnings. It can be said that the U.S. stock market is not cheap but it is not unreasonably valued in the context of 2% inflation and the 3.23% yield on the 10 year Treasury bond.
U.S. stock markets are off to a poor start in October. Economic data continues to be strong, corporate profits will likely be solid but a rapid rise in interest has spooked markets. The yield on the 10 year Treasury ended 2017 at 2.41%, by the end of the second quarter it was 2.82% and it is currently 3.23%.
The Federal Reserve is working to return interest rate policy to normal levels after the extraordinary measures taken during and after the financial crisis. The Fed Funds rate has been increased from zero, which it had been since the financial crisis until December 2016 to the current rate of 2.25%. The Fed is expected to raise this rate by an additional ¼ of 1 percent in December and by another ¾ of 1 percent in 2019. Fed Chair Powell stated last week that “we’re a long way from neutral”. This statement has been interpreted to be hawkish but Fed policy is still likely to be data dependent.
The economy is strong, corporate profits are strong, interest rates are low but rising – in general this is still a favorable backdrop for stocks. A further significant rise in interest rates would be a problem for stocks but we expect some moderation and will be watching closely. The other concern for markets is the ongoing trade wars. The administration has made peace with Mexico and Canada, but is only stepping up the heat on China. A trade war between the world’s two largest economies is not good for global growth. This has taken its toll on the Chinese stock market (down 18% YTD). Hopefully, a resolution is reached before it takes its toll on U.S. markets.