What a ride it has been. We swept into 2018 on a surging tide of economic growth and strengthening corporate earnings. Investors were giddy. The recently enacted tax cut added to the exuberance, just as the global economy more broadly looked set for another year of strength. The Dow Jones Industrial Average and broader S&P 500® Index each added more than 2,000 points in the first couple weeks of January.
But the high spirits didn’t make it through the month.
Concerns about inflation crashed the party at the end of January, knocking at least 10% off of the major stock indexes. We’ve bounced higher and fallen again over the ensuing months. Concerns about trade and short-term scares related to geopolitical surprises have also taken a toll. The bull market has been stuck in correction territory ever since—and will remain there until it can get back to those January highs.
All this has happened against a backdrop of tightening monetary conditions as the Federal Reserve (Fed) has been raising interest rates and reversed the extraordinary bond-buying program it kicked off to help fight the financial crisis. Now, the Fed is no longer reinvesting the proceeds when the bonds on its balance sheet mature, leaving the market to soak up all the bonds the Fed is no longer buying. Tightening monetary conditions have typically added to market volatility.
So where does all this leave us as we stare down the back half of the year? In much the same place: Caught between the tailwinds of strong economic and solid earnings growth and the headwinds of an uncertain trade situation and increasingly tight monetary conditions. Throw in the historical volatility around a midyear election, and it looks like investors would do well to keep their seatbelts fastened tight.
Strong economy/active Fed
The current economic expansion is now officially the second-longest in the post-WWII era. While we believe that the U.S. has entered a late stage of this long business cycle, we don’t see a recession on the horizon any time soon.
Growth figures for the second quarter aren’t ready yet, but the Atlanta Fed’s closely-watched GDPNow forecast is for a 4.1% expansion. The jobless rate is at historical lows—there are now more job openings than there are unemployed people—and inflation is finally picking up, with several different measures now near or above the Fed’s 2% target rate.
That means the Fed is likely to be more active the rest of this year than was expected at the start of 2018.
“We anticipate the Fed will hike rates two more times this year, given movement in both of the Fed’s mandates—inflation and employment. Other global central banks—notably the European Central Bank—are also moving toward policy normalization, which means the tide of global liquidity is receding,” says Liz Ann Sonders, chief investment strategist at Schwab. “As they say, when the tide goes out, it’s time to start looking for the naked swimmers.”
So expect more volatility.
Outlook for U.S. stocks
Data-provider Thomson Reuters predicts earnings for the companies included in the S&P 500 Index grew 21% in the second quarter, down from 27% in the first, and will grow an additional 23% in the third quarter and 20% in the fourth. The question for markets is whether this is sustainable. Are those high growth rates already priced in? Are the expectations bars being set too high?
“Earnings are the mother’s milk for stock prices, but at high earnings growth rates, stocks often have middling returns as they tend to anticipate the moment when earnings stop getting better, and start getting worse,” Liz Ann says. “Tax reform provided a huge jolt to earnings in the first quarter and to estimates for the remainder of this year. But comparisons will begin to get more difficult, so expect a slowing in the year-over-year growth rate in earnings.”
“As a leading indicator, the stock market typically does a great job sniffing out important economic or earnings inflection points in advance,” she says. “This is why at market tops the data typically looks great, while at market bottoms the data typically looks abysmal.”
“In any case, if a few things go right in the near-term, including an easing of trade tensions, stocks could break out on the upside,” she says. “But given the tightening monetary conditions, rising inflation, tight labor market, and the potential for more tensions on the trade front, a breakout on the downside is also possible.”
For more from Liz Ann, read her 2018 Mid-year U.S. Equity Outlook: Headwinds and Tailwinds Facing Off.
The globally focused MSCI AC World Index is close to where it started the year, and data from the Investment Company Institute shows that investors have been net buyers of stocks even as the trade disputes escalated in the second quarter.
“This suggests that investors see the tariffs enacted so far as a result of the recent trade tensions as relatively small, tame and unlikely to end growth,” says Schwab’s Chief Global Investment Strategist Jeff Kleintop. “The danger is that the trade tensions could escalate into bigger and substantially more damaging moves in the coming months.”
“Separate from that, international stocks—including emerging markets—have typically outperformed U.S. stocks in the later stages of the economic cycle,” he says. “That has been the case in five of the six global economic cycles of the past 50 years, and in all of the past three cycles for the shorter index history of emerging market stocks.”
For more from Jeff, read his 2018 Global Mid-Year Outlook: From Sugar High to High Tariffs?
Bond market outlook
The Fed’s monetary policy recently reached an important turning point: Rate hikes are coming faster and for the first time in several years, short-term interest rates in the U.S. are above the rate of inflation. The two-year Treasury note yield was 2.55%, as of June 22, compared with a core inflation rate of 1.8% through the end of April. Policy has moved from easy to neutral and is now entering the “real” tightening stage.
“However, it looks like the risk of higher interest rates has largely been priced into U.S. bond markets,” says Kathy Jones, chief fixed income strategist at the Schwab Center for Financial Research. “At about 3%, the 10-year Treasury yield reflects further tightening by the Fed. The most recent set of economic projections released by the Fed on June 13th indicated a median estimate of 3.4% for the peak of the federal funds rate for this cycle and a longer-run estimate of 2.9%.”
“Until there are signs of slower growth or rising risk aversion, we continue to favor maintaining average portfolio duration in the short to intermediate term, but we’re getting closer to a stage in the business cycle where modestly extending the average duration will begin to look more attractive,” Kathy says. “For now, the risk/reward trade-off in the yield curve looks most attractive in the two- to five-year range.”
For more from Kathy, read Mid-Year Bond Outlook: Last One Out, Turn Off the Lights.
Takeaway for investors
As we said in our market outlook at the start of the year: Discipline is warranted. Further gains may be possible, but investors should also be prepared for more volatility.
“In the past, long-term trends have often reversed in the later stages of the economic cycle,” Jeff says. “This makes rebalancing portfolios—trimming leaders and adding to laggards, and restoring the portfolio’s long-term strategic asset allocation—particularly important this year.”
What You Can Do Next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
- Watch Schwab experts discuss other market and economic topics in the Stock Market Report.