After declining modestly in the first quarter, U.S. stocks (as measured by the S&P 500 Index) regained lost ground in the second quarter and reached the mid-year mark with a year-to-date gain of 2.6%. The Dow Jones Industrial Average, however, remained underwater by 0.73%, possibly because its 30 constituents are more reliant on global manufacturing and trade than the average American company. The small-cap Russell 2000 Index has led the way so far in 2018 with a gain of 7.6%, presumably because small U.S. companies are less exposed to trade issues and are more fully benefitting from their direct exposure to the robust U.S. economy than their multinational brethren.
Bonds continued to suffer a bit as the yield on the ten-year U.S. Treasury note climbed for the fourth consecutive quarter, briefly trading above a 3% yield before falling back to end the quarter at 2.84%. (Bond prices fall as yields rise.) It would not be a surprise for yields to continue to tick up in the back half of 2018 as the tax cuts feed a growing fiscal deficit which will increase the borrowing requirements for the federal government.
Strictly by the numbers, the economy and equity markets look solid. Valuations for stocks are higher than their long-term averages, but they are underpinned by very strong corporate earnings growth, 10-year U.S. Treasury note yields below 3%, and a GDP growth rate of 4.1% (for the second quarter) which is the fastest rate of economic growth in the U.S. since the third quarter of 2014. Unemployment is low, consumer confidence is strong and wages are beginning to rise.
Yet despite the strength in the economic numbers, investors remain uneasy about several factors, including rising populism around the world, the Mueller investigation, a sour geopolitical environment, our growing fiscal deficit and impending rates hikes by the Federal Reserve.
The issue that seems to be causing investors and business people the most indigestion, however, is trade. President Trump, so far, is making good on his campaign promises to punish countries for what he feels are unfair trade practices by enacting tariffs on some of the goods they export to the U.S. With the tariff rhetoric very loud at the moment, both investors and corporate management teams are uncertain about how to plan for the near future. Furthermore, tit-for-tat trade skirmishes have the potential to escalate into full-blown wars, the trajectories and knock-on consequences of which are hard to forecast and impossible for analysts to model.
In recent decades, corporate supply chains have gone global, in many cases stretching across multiple countries and continents. Tariffs levied on the goods from such supply chains would greatly complicate corporate decision-making and likely result in diminished business confidence as management teams sit on their hands, waiting for clarity.
While there are certainly some trade imbalances that deserve to be addressed, tariffs and protectionism have a poor historical record of fostering sustainable economic growth and prosperity. In the end, however, the grappling over trade may not really result in any permanent and draconian measures that will harm the world economy and may instead result in a battery of new bilateral trade deals between the U.S. and its trading partners.
As investors watch the developments on the trade front, companies are reporting very strong second quarter earnings. Despite a few high-profile misses, companies are hitting or exceeding their profit targets in the vast majority of cases. Right now, we are about halfway through the second quarter earnings season and, on average, corporate profits are up 22% over last year and revenues are 8.6% higher. The corporate tax cut is probably adding between 7 and 9 percentage points to the already strong earnings growth trend.
Thus, in the showdown between tariffs and earnings, so far corporate earnings are winning out over trade fears as stocks are set to post strong July performance.
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