Stocks finished higher for a second week in row, with the S&P 500 sitting within striking distance of a record high. News that the U.S. and China agreed to hold trade talks in Washington in October was the main catalyst for the rally. Economic data was mixed as the manufacturing activity contracted, falling to a three-year low, while non-manufacturing activity (which accounts for the bulk of economic activity) expanded and accelerated versus the pace of activity in July. August’s jobs report showed that hiring slowed, but to a level strong enough to hold the unemployment steady at a near 50-year low, with solid wage growth. A healthy consumer, positive economic growth, and low interest rates provide a good environment for stocks, in our view, although we still expect to see volatility given the ongoing trade headlines.
Summer’s Over — Is the Bull Market Too?
With Labor Day in the books, summer has unofficially concluded. Fortunately, last week provided evidence that the same isn’t true for the bull market. Volatility in August reflected the prevalent risks of the U.S.-China trade situation and a growing chorus of calls for an impending recession. These threats to the market have not disappeared with the flip of the calendar, but September has started with economic data and stock-market performance that support our view that the recent pullback is not the beginning of the end.
Stealth rebound? – Stocks moved through August in a sawtooth pattern, though the lingering takeaway from investors is likely a sour one, as a focus on trade turmoil and recession-signals from interest rates (inverted yield curve) drove the market more than 6% lower during the month. What’s gotten much less fanfare, however, is the rebound that has returned the stock market to within 1.5% of its all-time high. However, the coast is not clear. We expect tariff uncertainties and the ongoing manufacturing downturn to continue to stoke worries of an impending recession. Add to that the potential that upcoming Fed rate commentary/actions deviate from current investor expectations, and we think periodic market fluctuations will persist over the balance of the year. But investors should find solace in the fact that this is nothing new. As the table below shows, stocks have endured frequent pullbacks over the past several years, each followed by a relatively expeditious recovery.
Key takeaways on market performance: We don’t think the current bull market has reached its high-water mark because we expect economic and earnings growth to extend the expansion. While still-favorable fundamentals can reduce the severity of pullbacks, we don’t think they’ll reduce the frequency. We’re not surprised by the recent rebound, and we expect U.S. equities to hold on to reasonable gains for 2019, but the root causes of August’s indigestion are not gone.
The economy is working – The prevalence of recession worries, and the economic conditions that would precipitate said recession, are not in sync. The latest employment report showed that the U.S. economy added 130,000 jobs in August, holding the unemployment rate steady at 3.7%. A look under the hood yields a few notable details, while the broader employment story yields important takeaways for the economic and market outlook.
A few details to note: In addition to the decent monthly job gains, wages rose by 3.2% year-over-year, the 13th consecutive month above 3%. Also, the participation rate (labor force as a % of the population) increased as more than half a million workers joined the labor force. Higher wages are not only arming consumers with more dollars to spend, they appear to be drawing workers back to the labor force, which raises the overall capacity for GDP growth. We have long expected the pace of monthly hiring to moderate, but our view has been that household consumption will be increasingly supported by higher wages. That trend appears to be intact. On the flip side, hiring in the manufacturing and retail sectors was weak, likely reflecting the punitive uncertainty of the ongoing trade spat with China.
Key takeaways on jobs: Broadly, we think the labor market offers a sturdy counterpoint to the fears (amplified by the inverted yield curve) that a recession is imminent. Monthly job gains are averaging 156,000 over the past three months, and the rate of new entrants into the labor force has increased, meaning the unemployment rate can remain helpfully low and supportive of ongoing wage gains. This economic expansion is not bulletproof, but the largest share of GDP comes from household spending. Reasonable household debt levels, a 3% annual raise for the workforce, and strong prospects of keeping a job/getting a new one are conditions that support consumer confidence and consumption. So while the GDP cylinders of business capital expenditures and net trade are misfiring at the moment because they’re clogged by tariff uncertainties, the consumer is in a position to continue to supply enough horsepower to keep the U.S. economic engine firing. Bear markets are nearly always fueled by recessions, so even modest ongoing growth should be supportive of market performance from here.
September to remember? – It’s long-run performance, not daily, weekly or even monthly moves that should be the measuring stick for your financial goals. That said, proper expectations can help set the stage for appropriate investment decisions as the market twists and turns. Over the past 30 years, September has had the third-worst average monthly return behind August and June: -0.2%. September is also, on average, the second most volatile month of the year. Fortunately, October, November and December are among the best-performing months, with an average monthly return of 1.6%1. We think this September will live up to its reputation in terms of volatility given the delicate and fluid trade situation between the U.S. and China, along with the upcoming Fed rate meeting, where consensus expectations have set a high bar for lower rates.
Key takeaways on trade and the Fed: The market has shown a consistent propensity to overreact to both escalating tariff threats as well as the promise of renewed negotiation talks. We think economic reality lies in between. Total U.S.-China trade accounts for less than 1% of global GDP. U.S. goods exports to China represent less than 1% of U.S. GDP. In other words, trade activity is not, in our opinion, going to directly determine the overall health or longevity of the U.S. expansion. Instead, we are more concerned with the potential for trade uncertainties to spill over into businesses’ willingness to invest and hire, which in turn would begin to impact household consumption (which does determine the health of the expansion). We think an actual trade deal is still a ways off, but it will be important for the trade spat not to seep into business and consumer confidence at large. We’re watching closely. In addition, the Fed will be a key character in the economic and market story ahead. We think the Fed is likely to cut rates in September, with the recent jobs report not doing anything to alter that expectation. Broadly, we think the Fed’s shift to a more stimulative rate stance can extend the economic expansion – as it did in the 1990s. Recessions are often brought on by overly tight monetary policy, a condition we won’t face in the near term. This won’t, however, exempt the market from overreactions. Markets are pricing in several rate cuts from the Fed in the coming year. If economic or inflation data come in hotter than anticipated, the recalibration of Fed rate-cut expectations could drive temporary pullbacks. Don’t lose sight of the fact that good economic data is good news long-term, even if the market doesn’t seem to treat it as such day to day.
Craig Fehr, CFA
Sources: 1. Total return of the S&P 500 index. Sources: 1. Total return of the S&P 500 index.
The Week Ahead
Important economic data being released this week include inflation on Tuesday and retail sales along with consumer sentiment on Friday. The European Central Bank (ECB) is expected to cut rates on Thursday when it meets to announce its policy decision.
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