In the third quarter of 2017, both stocks and bonds generated positive returns, mirroring broad improvement in both the U.S. and global economies.  The S&P 500 Index rose 4% in the quarter to close out the three-month period at a record high while notching, remarkably, its eighth straight quarterly advance.  Despite the disruptions in the quarter that a series of hurricanes as well as ballistic missile launches in North Korea brought on, markets behaved with surprising aplomb.  By at least one measure, stock price movements in the third quarter were the lowest on record.  The Chicago Board Options Exchange’s Volatility Index, known as the VIX and widely seen as a barometer of investor fear, declined for the third straight quarter. Meanwhile, the volume of U.S. stock trading also declined to its lowest level in three years.

The third quarter corporate earnings reports, when they are released, will likely be strong overall, but will also show some points of weakness due to the effects of Hurricanes Irma and Harvey.  The trend of solid earnings growth is highly likely to remain intact, however, and investors are increasing focused on the potential bottom line benefits of the tax reform proposals, particularly as they pertain to the corporate tax rate.  For U.S.-based companies, the benefits of a lower tax rate will be felt most strongly at smaller companies, which generally have fewer opportunities than their large multi-national brethren to reduce their tax rates  (as well as fewer clever CPAs on staff).  Consequently, as tax reform has gained momentum on Capitol Hill, U.S. small-cap stocks have gained momentum on Wall Street.  The Russell 2000 Index of small companies vaulted 6% in the month of September alone to a new all-time high.

Investors are clearly betting on an economic revival, but one thing is clear: that revival is not here yet. The U.S. economy grew 3.1% in the second quarter of 2017, but probably slowed somewhat in the third quarter due to the hurricane disruptions.  For the full year, U.S. GDP growth will probably come in around the 2.0% to 2.5% range.

The Fed’s Conundrum

Many investors fear that the Federal Reserve, by increasing interest rates too sharply, will end today’s gradual expansion and foment the next bear market.  Even though today’s bull market ranks as one of the longest in stock market history—we are now eight years in—there are reasons to think that today’s moderate growth/low inflation environment could persist for years to come.

The Federal Reserve has the dual mandate of promoting full employment and maintaining “price stability” –i.e. not too much inflation or deflation.  Normally the target rate of inflation for the Fed is 2% annually.  However, since the financial crisis of 2008-2009, inflation has persistently undershot this target.  Even after years of Fed policies designed to stimulate the economy, including keeping short-term interest rates at near zero percent and buying up approximately $4.5 trillion worth of bonds in the open market (in an effort to keep longer term yields low), inflation has remained low.  Since the crisis, the main ingredients of inflation, namely wages and consumer prices, have remained subdued, causing central bankers in developed countries around the world to wonder what they need to do to nudge inflation higher.

There are several reasons why inflation remains abnormally low, and it is of course impossible to quantify to what extent each of these factors (or other factors) may be contributing.  Among the possible causes of low inflation include slack in the labor force (as the headline U.S. unemployment rate of 4.2% does not accurately reflect the true state of the labor market), an aging population requiring fewer goods and services, an increasingly outsourced or mechanized industrial base, the surging “gig” economy, and the rise in online shopping.  None of these are likely to be transitory phenomena.  In fact, each of these factors will likely intensify in the years and decades to come.

The Risks Ahead

Politically, U.S. investors face much uncertainty.  Health care policy is in flux and tax reform is being discussed but is far from decided.  There has been scant mention of an infrastructure program in recent weeks.  Instead, investor enthusiasm is building because of strong corporate financial results.  Despite the policy uncertainties, U.S. companies continue to churn out record earnings.  Investors, apparently expecting this trend to continue for some time, have bid stocks up. 

Broadly speaking, consumer confidence is high.  The most recent statistics from the University of Michigan’s consumer sentiment survey show that consumers are now enjoying their highest level of confidence since 2004.  But given investors’ increased enthusiasm for stocks in 2017, one of the biggest potential risks for the market is a ho-hum performance from the economy and corporate sector in the coming quarters.  The S&P 500 currently trades at 19 times the cumulative 2018 earnings estimates for its constituent companies, an above-average level.

So as we head into the home stretch of 2017, things are on a good track economically.  Domestically, politics remains a wild card, however, and on the geo-political front there remains plenty of scope for unwelcome developments regarding North Korea.  At least for the moment, though, investors are looking ahead to a healthy economy and still further profit growth in 2018.

Please do not hesitate to contact me if there is anything about the election, the markets or your portfolio that you would like to discuss.