Economic Commentary | Third Quarter 2017

Despite a plethora of reasons for investors to fret, the stock market has continued to forge ahead in recent months.  During the third quarter, we saw tensions rising between the US and North Korea, several attempts at healthcare reform fizzling out, a central bank that is removing monetary stimulation, and three separate major hurricanes making landfall in the US.  Investors seemingly shrugged off these concerns, and for the three months ending September 30, 2017, the large cap S&P 500 index increased 4.5%, the mid/small cap Russell 2000 index gained 5.7%, and the international MSCI EAFE index rose by 5.4%.

Heightened political tensions and monetary policy uncertainty abound across the world, but the underlying global economy has continued to gain traction.  In the US, both the manufacturing and service sectors expanded at a healthy clip; consumer confidence, already high at the beginning of the quarter, improved further; the final read on second quarter GDP came in at a very strong 3.1%; and S&P 500 corporate earnings continued to surprise to the upside.  One disappointment during the quarter was the housing market, which stalled due to a shortage of skilled labor.  However, the elements that have propelled recent housing gains remain in place:  higher personal income, as more people are employed at higher wages, along with mortgage rates that are historically quite low.  Thus, we expect that the housing market will resume its recovery in the coming quarters as economic forces compel new entrants into the residential construction industry.

With the US economy in its eighth straight year of expansion, 16.6 million jobs have been created since 2010, driving unemployment down to 4.4%, which is near a sixteen-year low.  Consistent with the higher reads on personal income that we’ve seen throughout 2017, wages rose by an annualized rate of 2.5% last quarter.  As more people were employed at higher wages, personal consumption ~ which makes up nearly 70% of our economy ~ grew by 3.3% for the last quarter.  In addition, business spending, which has been a laggard for quite some time, rose last quarter by 8.8%, the fastest pace in almost two years.  These gains in consumer and business spending drove the 3.1% growth in US GDP.

The Federal Reserve has a dual mandate:  targeting inflation at approximately 2% while steering the economy towards full employment.  Although inflation remains subdued, the Fed’s focus on the prevailing low unemployment level has led to tighter monetary policy.  Thus, we’ve had four rate hikes since the economy recovered, the last two of which have been in 2017, with another expected in December.  In addition, the Fed announced plans to reduce its vast holdings of treasuries and mortgage backed securities, which are valued $4.5 Trillion.  The Fed’s current plan is to begin reducing its balance sheet by $10 Billion per month this year and then by $50 Billion per month by next fall.  We are looking forward to this new phase of the recovery, when easy money will be removed from the economy and corporate fundamentals will once again be the most important factor in determining stock prices.

The recovery in the global economy, like in the US, is well on track.  China’s economy continues to stay on course to meet its long-term objectives, with last quarter’s GDP growing by 6.9%.  Although we have few direct investments in China, we track China’s economy because it has such a large impact on the global economy.  Economic growth in the eurozone economy, where we do have large investments, rose 2.2% last quarter, exceeding expectations.  In addition, the German elections, which were held in September, added to optimism across Europe, as Angela Merkel remained Germany’s Chancellor.  Despite a growing populist movement across the globe, recent elections have favored more centrist approaches.