Economic Commentary | Second Quarter 2018
While the broad economy continued to improve during the quarter, trade tensions with both China and Europe once again dominated investor attention. In addition, global central banks have shifted toward tighter monetary policy, which will make further economic gains harder to achieve. As a result, we saw quite a wide range in returns for our stock asset classes this quarter, with the US outperforming international indices. For the three months ending June 30, 2018, the large cap S&P 500 index gained 3.4%, the mid/small cap Russell 2000 index was up 7.7%, the international MSCI EAFE index was down 1.2%, and the emerging markets MSCI EM declined by 8.7%.
There were many positive indications of health for the US economy over the course of the quarter. The US consumer is alive and well, thanks to an extremely strong labor market. The number of unfilled jobs continued to rise as unemployment hit an eighteen-year low of 3.8% in May, which was reported in June. This was achieved even while more people were looking for work as shown by the higher labor force participation rate. As the labor market has tightened, employers are increasingly having a hard time finding qualified workers. The Department of Labor reported that the number of available jobs exceeded the number of unemployed Americans for the first time in eighteen years. The June jobs report marked the 92nd straight month of jobs gains, which was the longest such stretch in history. Looking beneath the headline numbers, the U6 rate, a measure of underemployment, hit a 17-year low, further pointing to a skills mismatch between available jobs and those able to fill them.
With confidence near a 17-year high, consumers opened their wallets to boost retail sales. Both the manufacturing and service sectors remained near their recent highs, well into expansion territory. Despite very healthy demand, the housing market continues to be constrained by a dearth of skilled labor, land shortages, materials cost increases, and higher mortgage rates. That said, we did see stronger than expected reads on housing starts and new home sales to close out the quarter.
Despite admonitions by the Federal Reserve and the International Monetary Fund as to the likely negative impact of a trade war on our economy, President Trump has announced tariffs on a wide variety of products over the course of 2018. The first tariffs were imposed on aluminum and steel imports from the EU, Canada, and Mexico. All three trading partners have countered with their own tariffs on various imports from the US.
The tariffs on imports from China into the US did not take effect until after quarter-end, but it was clear during the quarter that the US and China had begun to escalate a trade war in tit-for-tat exchanges. When the two leaders met at the end of April, China’s Xi Jinping rejected American demands to reduce the US’ trade deficit and to curb China’s plan for a host of industrial upgrades in AI, electronics, electric cars, and aircraft. Whenever either Trump or Jinping would hint at conciliatory measures, international markets would rally with relief; however, these sorts of reactions were short-lived in the face of further tough trade talk between the two countries. While China has lived in the shadow of the US economy for the duration of the modern era, Jinping has now successfully positioned the country to respond to the US with strength. With Chinese GDP growth coming in at an annualized 6.8% for the prior quarter, Jinping continues to implement his country’s reforms and steer the economy to a more dynamic and market-oriented model.
Despite the evolving trade war, the world’s economies are now on firmer footing. This gives central banks around the globe the leeway to implement efforts to normalize monetary policy, beginning the process of prudently removing the heroic stimulative measures employed during the global financial crisis.
In the US, the Federal Reserve has raised short-term rates seven times since the end of 2015, with another one or possibly two rate hikes to come by the end of 2018. Inflation in the US is heating up and approaching the top of the Fed’s comfort range. The Personal Consumption Expenditures index, the Fed’s favorite inflation gauge, rose to the Fed’s target of 2% by the end of the quarter. While this might have triggered an acceleration in removing monetary accommodation, Jay Powell has since indicated that the Fed governors may be comfortable with slightly higher inflation in the near-term to protect the economic recovery.
Rates on the ten-year Treasury inched above 3% in mid-May while thirty-year rates hit 3.2%, indicating that investors finally began to price in inflation. However, by the end of June, rates on both of these benchmarks fell back below 3%. Some investors have begun to worry about an inverted yield curve ~ one in which rates on the short end of the yield curve are higher than those on the long end. In mid-April, the spread between two-year and ten-year Treasuries was only .42%, which is the tightest it has been in more than ten years. This sort of interest rate environment has historically presaged a recession, which is why the very idea of it is capturing the attention of market followers. It’s hard to see how we end up in a recession anytime soon with such steady and broad-based economic growth.
In Europe, the central bank recognized that economic momentum had moderated and therefore opted to leave rates steady rather than tightening monetary policy. The Eurozone’s First Quarter GDP, released in mid-May, showed healthy growth of 2.5% compared to the prior year. Another welcome piece of news is that the Eurozone was able to end eight years of bailouts for Greece as it finally restored economic growth after the much-hated austerity measures were enforced.