Risk of 'Blue Wave' roils markets, creates buying opportunity Risk of 'Blue Wave' roils markets, creates buying opportunity http://www.federatedinvestors.com/static/images/fed-logo-amp.png December 6 2018

Risk of 'Blue Wave' roils markets, creates buying opportunity

Economy is strong, despite recent market volatility.
Published October 12 2018
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Bottom Line The upcoming midterm election may be the most controversial in recent memory, with both Democrats and Republicans highly energized. Voter turnout should be much higher than normal, and the fear for investors is that a potential “Blue Wave” could have significant fiscal policy implications.

We’re now enjoying the fastest GDP growth in four years, the strongest corporate earnings growth in seven years, business and consumer confidence metrics that are surging to multi-decade cycle highs, unemployment at a half-century low, wages growing at their fastest pace in a decade and retail sales running at their strongest pace in seven years. Consequently, the S&P 500 hit a new record high on Sept. 21, up 40% from the presidential election in November 2016.

But the risk for investors is that a shift in Congress to Democratic control could reverse some of President Trump’s fiscal policies, such as the tax cuts, deregulation, repatriation and the immediate expensing of capital spending. This likely would result in both slower economic growth and declining share prices. That potential risk, in our view, has contributed to this recent air pocket in stocks.

The S&P corrected nearly 8% over the past three weeks, while the small-cap Russell 2000 plummeted 11% since Aug. 31, both to deeply oversold levels. Benchmark 10-year Treasury yields soared from 2.80% in late August and from 3.05% last week to our full-year target of an oversold 3.25% on Oct. 5—a 7-year high—before backing off in recent days to 3.15%. The volatility index (VIX) nearly tripled in a week to an overbought 29 on Thursday. As a result, we added 2% to our equity overweight last night (raising our equity overweight to 70% of maximum and our overall equity weight in our stock-bond model to 61%, or 95% of maximum) to take advantage of what we believe is a very compelling buying opportunity.

So against the backdrop of a circus-like atmosphere in Washington these past two years, which neither side of the political aisle appears to like, what will ultimately motivate voters next month? An end to the polarized nonsense in Washington, or a desire to continue the strong run of economic and financial-market success we’ve enjoyed since November 2016? While we believe that the majority of voters will edge toward favoring their pocketbooks, we’ll know for sure in less than a month…maybe.

Shift in voter demographics Since the presidential election in November 2016, there has been a marked shift in registered voter demographics. According to Gallup, registered Republicans have slipped from 27% of the voting public in November 2016 to 26% in September 2018; Democrats have declined from 31% to 27%; and Independent voters have surged from 36% to 44%. Why the sharp increase? In our view, the average American is disgusted with the polarization on regular display between the far-right Tea party and the far-left Herbal Tea party. They’re looking for a sensible refuge somewhere in the middle of the political spectrum, where legislation is marked by intelligent discussion and compromise, and decisions are guided by equal parts fiscal prudence and social responsibility.

Will pocketbook issues matter more to this independent plurality of voters?

GDP growth of 4.2% in the second quarter of 2018 is the fastest in four years, due to Trump’s structural and sustainable fiscal policy reforms. Over the past five quarters that Trump has been president, GDP has averaged 2.9% versus 1.5% over the previous seven quarters under President Obama. We’re expecting 3.4% growth in the upcoming third quarter (to be reported on Oct. 26), and we’re projecting full-year, trend line growth of 3% in each of 2018 and 2019.

S&P corporate earnings growth is up 25% in this year’s first half, and has experienced double-digit growth for five consecutive quarters for the first time in seven years. We expect the third-quarter earnings season, which starts today, to be up another 20%. Contrast that with the end of 2014, all of 2015 and the first half of 2016, when we were mired in an earnings recession that lasted for seven consecutive quarters.

Business and consumer confidence is at a multi-decade cycle high:

  • Conference Board’s Consumer Confidence Index soared to a new 18-year cycle high of 138.4 in September, as post-election confidence has surged from a cycle trough of 100.8 in October 2016.
  • ISM manufacturing index surged to a new 14-year high of 61.3 in August, up sharply from a contraction reading of 49.4 in August 2016.
  • ISM nonmanufacturing index increased to a new 21-year high of 61.6 in September.
  • Leading Economic Indicators (LEI) index has increased sequentially for 24 consecutive months to August’s 111.2, an all-time, 58-year cycle high.
  • National Federation of Independent Business (NFIB) small-business optimism index rose to 108.8 in August, an all-time, 44-year high.

Contrast that with five regional Federal Reserve indices that were in negative territory in the summer and fall of 2016, suggesting that the economy was decelerating toward recession just prior to the presidential election. Note also that these metrics turned on a dime after the election and have since gone vertical over the past two years:

  • Dallas: Cycle trough of -4.8 in August 2016, rising to a 12-year high of 37.2 in February.
  • Empire: Cycle trough of -5.5 in October 2016, rising to a 17-year high of 30.2 in October 2017.
  • Kansas City: Cycle trough of -5 in July 2016, rising to a 17-year high of 29 in May.
  • Philadelphia: Cycle trough of -2.9 in July 2016, rising to a 34-year high of 43.3 in February 2017.
  • Richmond: Cycle trough of -11 in August 2016, rising to a 24-year high of 30 in November 2017.

Unemployment at a new 49-year low, as measured by the unemployment rate (U-3), which fell to 3.7% in September 2018. Also, the initial weekly unemployment claims (an important leading economic indicator) for the survey week ended Sept. 15 fell to 202,000, a 49-year low.

Wages grew 2.9% in August, their fastest pace in a decade, and are on their way to an estimated 3.5% to 4% growth over the next two years.

The Job Openings and Labor Turnover Survey (JOLTS) posted a record 6.939 million job openings in July. Again, there are more available jobs than unemployed Americans who could fill them.

Retail sales are running at their strongest pace in seven years, with Back-to-School (BTS) sales in July and August rising 6.7% on a year-over-year (y/y) basis. That augurs well for Christmas sales, which tend to be highly correlated to BTS strength. Moreover, because the consumer accounts for 70% of GDP, this strong consumer spending will help to boost economic growth in the third and fourth quarters.

The S&P hit a record high on Sept. 21, up 40% from the presidential election in November 2016. We remain confident the S&P will hit our year-end target of 3,100 because of these strong underlying fundamentals. That implies a powerful double-digit rally from yesterday’s deeply oversold trough at 2,710. We are using the equity market’s current air pocket, for which we have been patiently waiting these past few months, as an opportunity to add to both large- and small-cap domestic growth stocks. We remain overweight value. 

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Tags Equity . Markets/Economy . Growth .
DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

Small-company stocks may be less liquid and subject to greater price volatility than large-capitalization stocks.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

The Conference Board's Composite Index of Leading Economic Indicators is published monthly and is used to predict the direction of the economy's movements in the months to come.

The Consumer Confidence Index is based on a survey by the Conference Board that measures how optimistic or pessimistic consumers are with respect to the economy in the near future.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

The Institute of Supply Management (ISM) nonmanufacturing business activity index is a gauge of production activity derived from a monthly survey of U.S. businesses.

The Empire State Manufacturing Index gauges the level of activity and expectations for the future among manufacturers in New York.

The Federal Reserve Bank of Dallas' monthly Texas Manufacturing Outlook Survey is a measure of the current level of activity and expectations for the future.

The Federal Reserve Bank of Kansas City surveys manufacturers in its district monthly to gauge the level of their activity.

The Federal Reserve Bank of Richmond surveys manufacturing and services businesses monthly to gauge their level of activity and expectations for the future.

The Federal Reserve Bank of Philadelphia gauges the level of activity and expectations for the future among manufacturers in the Greater Philadelphia region every month.

The National Federation of Independent Business (NFIB) conducts surveys monthly to gauge how small businesses feel about the economy, their situation and their plans.

VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility.

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