In a relatively quiet week stocks edged higher, with small-cap companies outperforming. A couple of high-profile mergers lifted investors’ sentiment early on. However, indexes gave back some gains on Friday after chipmaker Broadcom warned that the U.S./China trade tensions are dampening demand. Oil attempted to rally following attacks on two tankers near the Persian Gulf, but finished the week lower on worries of lower global demand. On the economic front, U.S. retail sales showed a rebound in consumer spending in May following a slow first quarter, providing evidence that consumers are still well-positioned. As major indexes have rebounded near all-time highs, our outlook remains positive, but we expect higher volatility as well.
Skating Towards the Puck
It was a big week for sports fans as the St. Louis Blues clinched the National Hockey League’s Stanley Cup in game 7 against the Boston Bruins. In an equally rousing playoff finale, Toronto, previously known as a hockey town, won its first NBA title when its Raptors edged passed the Golden State Warriors. In both sports, the teams’ ability to anticipate the future direction of play, be it hitting a puck on the ice or passing a ball on the court, was key to scoring.
In a similar attempt, both equity and bond markets tried to reposition themselves this week in anticipation of where economic growth is heading. Ten-year Treasury yields sank to their lowest levels since 20171, signaling concerns of an economic downturn. Meanwhile, equities edged higher for a second straight week, reflecting a more positive outlook. These two diverging views illustrate that, when it comes to interest rates, it’s hard for investors to accurately predict where the puck is heading.
Fortunately, by understanding economic signals, knowing the rules of play, and being aware of penalties and risks in the economy, we believe investors can make progress towards their goals in times of uncertainty.
- The signal: Retail sales show a rebound in consumer spending
The lynchpin of the 10-year expansion is consumer spending, which accounts for two-thirds of GDP. After averaging 2.6% growth in 2018, consumption spending fell to half that rate in the first three months of 2019, as a seemingly strong GDP was propped up by mostly temporary factors, namely inventories and imports. Last week’s release of the lackluster May jobs report, punctuated by slowing wage gains, added to market concern that consumer spending might be weaker than previously thought.
For this reason, this week’s retail sales numbers were closely watched by markets as an indicator of consumer health. And good news it turned out to be, as May retail sales were stronger than expected. Even better news was that the previous months’ retail figures were revised sharply higher. All told, retail sales suggest that consumer spending rebounded in the second quarter to a healthy 3.5%, topping even last year’s pace.
There are three reasons why we think consumers are still well-positioned in the later period of this cycle. One — though job growth is slowing, it still appears strong enough to keep the unemployment rate near 50-year lows. Two — consumer prices have risen slowly, and wage growth is still at a full percentage point above inflation. Three — household debt is below the historical average and interest rates are low, giving consumers latitude to borrow in order to supplement spending, if needed2.
- The rule: Steady inflation and solid economic growth is key to the Fed’s monetary policy
In hockey, there are game rules that limit the puck’s movement around the rink. In the same way, inflation limits the ability of the Fed to change the pace of interest rates. When inflation rises more strongly than expected, the Fed is less apt to cut rates and stimulate the economy. This week a second closely watched indicator, the Consumer Price Index (CPI), showed May inflation slowed to 2% last month from 2.1% in April. In our view, low inflation allows the Fed to be flexible and to raise or lower rates as warranted by economic conditions.
Recent data has shown that as the effects of the tax cuts fade, the economic growth from last year’s strong pace has cooled, and this has increased expectations that the Fed will cut rates at least twice this year. Economic growth is slowing, and we think that the economy will expand at about 2.3%, in line with the 10-year average. This is strong enough growth to extend the cycle and for share prices to rise, in our view. Over the 10-year expansions, in years where growth was below average, equity return increased 9.1%. That is lower than the 13.4% experienced during years with above-average growth rates, but robust compared with historical averages3. Therefore, slower growth by itself is not an indication of the end of a cycle as long as fundamentals and earnings remain positive. We expect equity returns to continue to climb, with some slipperiness in share prices along the way.
- The penalty: Trade tensions remain elevated
In hockey, penalties are assessed when players disrupt the speed and fairness of the game. Similarly, elevated trade tensions between the U.S. and China have added to market concerns that economic growth will be penalized by increasing tariffs. News of progress towards a trade deal rallied share prices earlier this year. More recently, negotiations between the U.S. and China have been at an impasse, and there are signs that trade tensions are taking a toll on both countries. China’s industrial production sank to 17-year lows in May, even as the country used a combination of tax cuts and business loans to stimulate its economy over the last year. U.S. industrial production, though rebounding slightly in May, has also wavered in recent months, as companies face headwinds from tariffs and slower growth.
We expect the market to continue to see bouts of volatility from trade tensions and slowing (though still-positive) economic conditions. Corporate earnings and economic fundamentals are still positive support for rising share prices, and long-term investors should use periodic dips in the market as opportunities to increase diversification by adding quality assets at cheaper prices.
- To score: Focus on long-term financial goals
Markets have tried to anticipate where the Fed will hit the puck when it comes to interest rates. Currently, we do not expect economic conditions to weaken enough to require a rate cut. However, if signs of a worsening outlook materialize, the Fed may cut rates to extend the economic expansion. Alternatively, rates could increase if the pace of inflation accelerates more than expected. Regardless of where interest rates move, investors can take steps to ensure that they are skating in the right direction. We believe having an appropriate mix of stocks and bonds for their comfort with risk helps investors strike the right balance of offense and defense in their portfolios to assist with their financial goals over the long term.
Sources: 1. Bloomberg, 2. Federal Reserve, 3.Federal Reserve Bank of St. Louis, Morningstar Direct, price returns as measured by the S&P 500
Article written by: Nela Richardson, PhD, Investment Strategist for Edward Jones.