2017 THIRD QUARTER COMMENTARY

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If you were to ask me to highlight just one indicator, in particular, to judge whether there’s been a major change in the (US economic) trend, absolutely it’s going to be the jobless claims.”
(Jim O’Sullivan of High Frequency EconomicsMarketWatch forecaster of the year for 6 years)

ECONOMY – US

Despite Gross Domestic Product (GDP) growth of about 1% during the first quarter, the economy is near full employment and 2017 GDP growth for the entire year is estimated to exceed 2%.  Total non-farm employment has been healthy, averaging monthly gains of 181,000 over the past 12 months. Chart A below shows that unemployment claims are currently running at the lowest level since 1973.

The Conference Board Leading Economic Index for May increased 0.3 % to 127.0 (2010 = 100) suggesting the US economy is “likely to remain on, or perhaps moderately above, the projected trend of about 2% growth for the remainder of the year.”  These strong numbers combined with very low unemployment claims leaves little reason to doubt that the economy can achieve a 2% growth in GDP for 2017.

 

In addition to economic and liquidity conditions, stock prices are influenced by four fundamental factors:

  • Corporate earnings expectations
  • The price of money (i.e. interest rates)
  • The price of the US dollar relative to other major currencies
  • The price of oil

All four are currently positive for equity investments, as reflected by the near record high in major stock indices.  Interest rates are accommodative and inflation expectations that would force rates up have not appeared.  The dollar has been declining since the beginning of 2017, and oil prices are not expected to spike higher any time soon.  We believe the Fed will be successful in moving interest rates up slowly so as to avoid any issue of liquidity.

CORPORATE PROFITS

First quarter corporate profits of the S&P 500 Index stocks increased about 14%, the strongest quarterly gain since the third quarter of 2011.  The revenue growth rate for the first quarter of 7.6% was the highest since the fourth quarter of 2011.  For 2017, revenue and earnings are forecast to increase 5.4% and 9.9%, respectively.  The earnings inceases projected support the current price action in the market and confirm the Long-Term Secular Bull Market trend.

BOND MARKET

With a growing economy and strong corporate profits, interest rates should be firm and rising in line with the demand for funds to support the economic growth.  Instead of rising, the yield on the benchmark 10 year Treasury bond has been falling throughout 2017.  See Chart B

The bond market has a long history of predicting the direction of the economy and falling interest rates generally have indicated a lower growth trend.  Although the outlook for earnings growth is positive and the economy is expanding, there are still deflationary forces putting downward pressure on bond interest rates:

 

(1) Interest rate repression: Foreign central banks in Japan and Europe are still repressing rates.  (The German 10 year bund rate is less than fifty basis points (0.05%) vs. over 2% for the US 10 year Treasury bond.)

(2) Supply / Demand:  Central banks have flooded the world with liquidity intended to stimulate economic growth, which has increased the demand for higher quality US bonds.

(3) Inflation expectations: Perhaps institutional bond investors do not believe inflation will rise enough to push interest rates higher in the near-term.

In fact, recent decline in 10-year bond rates suggests that inflation projections do not warrant higher interest rates.  Chart C below shows the 5 year forward inflation expectation rate tracked by the Federal Reserve Bank of St Louis.

Slow economic growth, low inflation, declining prices of oil and most other commodities may result in lower interest rates for longer than most models have predicted.  Indeed, as long as the rate of inflation remains around 2%, interest rates on the 10 year Treasury may be range bound in the 2% to 2.65% range.

OUTLOOK

The bullish scenario remains intact, supported by reasonable valuations, strong earnings growth and ample liquidity, with large holding of cash still to be invested.  The Fed’s goal is to normalize interest rates without causing a recession and would probably slow the pace of rate increases at the first sign of a negative impact on markets. (Fed members are well aware that most recessions have been preceded by excessive rate increases which restricted liquidity.)

Some other factors supporting the current level of stock prices include:  (1) Stock buy-back programs by corporations that have reduced the supply of shares outstanding by as much as 20% since 2000.  (2) Reduction in some costly regulations.  (3) Proposed corporate tax cuts as well as tax inducements for repatriation of capital held by US corporations off shore.  (4) Infrastructure programs are likely to be implemented over the longer-term.

In sum, owning equity interests in strong, profitable corporations is a well-established strategy for successful long-term investing despite inherent price fluctuation and current valuations reflect fair value given the positive outlook for rising earnings and dividends.

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