The American Economy continues to show signs of improvement and the growth picture has improved. As a result the equity markets have moved significantly in the first half of the fourth quarter. Economic results showing the health of the consumer, industrial sector, and globe have trended higher throughout Q4. This along with strong corporate earnings announcements since the end of Q3, have provided fuel for higher equity market prices. While many thought the leadership in the market was due for a change toward value, this has not occurred, and better earnings continue to drive the growth markets higher.
The consumer has regained his confidence after a brief pause in September and the consumer confidence index is making new highs this year. Personal consumption has also accelerated to higher ground. Housing is a bit of a mixed bag with starts now trending lower for the third month in a row, although new home sales are at a new high for the year creating demand for new housing. Starts are likely to follow. The Industrial and manufacturing sector is also back making new highs. Industrial production had paused in the third quarter but has now moved to new highs for the year in the first part of the fourth quarter. The purchasing manager’s index (PMI) which monitors the activity of Corporate America’s demand for new goods and services accelerated to new highs in September and October but have since paused. Foreign sales of American goods and services continues to be a bit of a problem with only slight improvement thus far this quarter. Employment in America continues to be robust with unemployment at all-time lows for this economic cycle. Unemployment now stands at 4.1%.
It is clear that the consumer and industrial purchasing manager are optimistic and spending money and driving this economy forward. The globe is also getting better and the manufacturing engines in the emerging markets are starting to run at a moderate pace after sitting idle to some degree for the last 8 years. Europe, Canada, and Japan are also showing reasonable improvement in their economies and their consumption. The globe hit bottom approximate eight years ago and this extended period has allowed even the very troubled European economies an opportunity to whittle at their problems.
The economy is clearly not moving at a fast enough pace to create inflation, particularly given the secular themes of deflation that are very prevalent in the globe. CPI in America remains sub – 2%, and PPI remains sub- 3%, but has turned a bit higher recently. The yield curve has flattened as central banks talk about raising rates but have yet to make much of a dent in the posture they adopted over the last eight years. The two-year treasury has risen 21 basis points thus far this quarter to 1.5%. The five-year similarly has risen to 2.06% from 1.95%. The 10 year is flat at 2.3% and the 30 year has declined from 2.81% from 2.86%.
Earnings reports for the third quarter have been remarkable and for the most part have exceeded expectations broadly. As an example we saw surprises to the upside from Apple Computer, Royal Caribbean, Amazon, Netflix, Caterpillar, Procter & Gamble, IBM, United healthcare, Bank of America, MasterCard, Boeing, and Microsoft. Earnings for the S&P 500 are expected to grow 25% this year. In this sort of environment is easy to see why growth stocks are leading the market.
Technology and healthcare have had the strongest earnings growth this year followed closely by consumer stocks and financials. While there is a strong recovery in earnings going on in energy and materials, the earnings in these troubled sectors remains a fraction of what they are capable of earning and a fraction of what they are valued at presently. Hence the upside in the stocks remains capped.
The outlook for financial assets continues to favor stocks over bonds commodities cash and real estate. Valuations in fixed income markets remains at all-time highs with poor value in almost all areas of the bond market. With little to no inflation, investors struggle to find a reason to own commodities of any type. Real estate is likely the second best asset class right now even though Cap Ratios suggest poor value. Real estate tends to have its best move early in an economic cycle and tends to taper off toward the middle of the cycle and does poorly at the end. Real estate investors need to be careful in the current cycle.
The leadership in the equity market will follow current trends with the financial sector finally moving toward the head of the class as these institutions leverage and monetize their assets, and they are done paying their earnings back to the government in fines.
While most sell side analysts are pessimistic on healthcare the fundamentals remain in place for continued pricing power and higher earnings. Strong earnings this year for technology is likely coming from demand that has been pulled forward from 2018 as corporations became optimistic with Mr. Trump’s plans for tax breaks and better trade policies. If enacted a corporate tax cut will likely stimulate further spending on technology and industrial equipment.
There is reason to be optimistic.