Second-quarter fundamentals strengthen
Bottom Line The S&P 500 has rallied by more than 10% since April 2 to a nearly 6-month high, fueled by expectations of a powerful second-quarter increase in both economic and corporate profit growth of at least 4% and 20%, respectively. The longer-term fundamental picture remains very constructive, with a healthy labor market, accelerating growth in both consumer spending and manufacturing, and an improving net trade picture.
But we could also be entering a period of heightened volatility, given a variety of near-term headwinds that may prompt corporate managements to offer relatively tepid second-quarter earnings guidance for the balance of 2018. These worries may include: uncertain monetary policy from the Federal Reserve; President Trump’s escalating trade and tariff war; a stronger U.S. dollar; surging oil prices; rising inflation; a flattening yield curve that risks inverting as a possible recession signal; the fiscal-policy fear of a so-called Blue Wave in the upcoming midterm elections; growing geopolitical risks in the U.K., Italy, North Korea and Iran; and the Mueller investigation’s potential for a black swan event.
Consequently, we continue to believe that equity markets could experience some increased turbulence and a 5-8% summer air pocket during the third quarter to reflect this litany of concerns, which is why we took some chips off the table last month. We fully expect, however, to eventually put that dry powder back to work later this year as we gain greater visibility on these issues and as the financial markets have appropriately discounted them.
Labor market solid Amid numerous consumer confidence metrics that are at or near multi-decade cycle highs, the labor market is strong. Recent highlights include the Job Openings and Labor Turnover Survey (JOLTS), which posted a record 6.84 million job opening in April, marking the first time in the survey’s 17-year history that there were more available job openings than unemployed Americans who could fill them. Also, at 3.8%, June’s official unemployment rate (U-3) matched a 49-year low, while initial weekly unemployment claims (an important leading indicator) fell to 207,000 for the survey week that ended July 14, similarly hitting a new 49-year cycle low.
Retail sales rebound After a tough January and February, retail sales have been on a tear over the past four months, with the trailing 3-month annualized rate of nominal sales growth at 7.9%. We enjoyed the best Christmas retail sales season in five years in 2017, followed by the best “Mapril” results in six years this spring, which we believe will be followed by a strong Back-to-School (BTS) season. Because the consumer accounts for 70% of GDP, this newly energized spending will help to boost economic growth in the second quarter.
Manufacturing remains strong The national ISM index is sitting just off a 13-year cycle high in June, all seven of the Fed’s regional indices that we monitor have rebounded during the second quarter from a tough winter, and capacity utilization matched a 3-year high in June. Inventory rebuilding appears to be accelerating, and core capital good shipments turned positive in April and May after a choppy winter, which should help to boost second quarter GDP.
Net trade improving The trade deficit declined a larger-than-expected 6.5% in May 2018 on a month-over-month basis to -$43.1 billion, nearly a 2-year low and down 22.3% from a 9-year cycle high of -$55.5 billion in February 2018. This narrower trade gap likely will help to boost second-quarter GDP and is at the heart Trump’s recent efforts to negotiate more equitable trade treaties with China and other countries to help goose economic growth here at home.
Raising our second-quarter GDP forecast The fixed-income and equity investment professionals who comprise Federated’s macroeconomic policy committee met on Wednesday to evaluate the dichotomy between strong underlying fundamentals and challenging near-term headwinds.
- The Commerce Department revised first-quarter 2018 GDP down from 2.2% to a final gain of 2%.
- Second-quarter GDP will be flashed on Friday, July 27. Due to the sharp improvement in both net trade and consumer spending, we are raising our second-quarter GDP estimate from 3.5% to 4.1%. The Bloomberg consensus is now at 4.2%, the Blue Chip consensus has raised its estimate from 3.2% to 3.9% (within a wide range of 3.1% to 4.6%), and the Atlanta Fed’s widely followed GDPNow model raised its estimate to 4.5% from 3.8% over the past two weeks.
- Due to the increasing tail risks associated with the tariff tantrums, as well as higher interest rates, inflation and energy prices, and the stronger dollar, we are reducing our third-quarter GDPestimate from 3.1% to 3%, while the Blue Chip consensus is ticking its estimate down from 3% to 2.9% (within a range of 2.4% to 3.5%).
- We are similarly lowering our fourth-quarter GDP estimate from 2.9% to 2.8%, while the Blue Chip consensus remains unchanged at 2.8% (within a range of 2.3% to 3.3%).
- Our second-quarter increase offsets the second-half reductions, so we are keeping our full-year 2018 GDP estimate unchanged at 2.9%, while the Blue Chip consensus is inching its estimate up from 2.8% to 2.9% (within a tight range of 2.7% to 3%).
- We are nudging our full-year 2019 GDP estimate down from 3% to 2.9%, while the Blue Chip consensus remains unchanged at 2.6% (within a range of 2.1% to 3%).