While economic growth has slowed, as the third-quarter GDP estimate showed last week (from 2.0% to 1.9%), several risks have lessened since the Fed first lowered interest rates in July, namely the de-escalation of U.S./China trade tensions, uncertainty on the Brexit front, and weakness in manufacturing that appears contained. In our view, the U.S. economy remains on solid footing, supported by a strong labor market, still-rising corporate earnings, and low interest rates.
Fresh Data Show There's Still Steam in the Stock Market Engine
Stock prices climbed 1.5% last week, reaching a fresh record high[1.] The climb was fueled by slowing but still-positive economic and corporate data, which beat market expectations. We expect the four growth trends highlighted in recent data to outweigh ongoing risks from trade uncertainty and slower domestic and global growth, keeping the bull market moving forward, albeit at a slower pace.
1. A healthy labor market supports consumer spending
The economy added 128,000 jobs in October, well above the consensus estimate and stronger than the 100,000 jobs needed to support new entrants into the workforce each month. U.S. job creation was able to sidestep the impact from the GM worker strike and the loss of temporary U.S. Census jobs. The unemployment rate rose slightly to 3.6% from 3.5% the previous month, a half-century low, as more workers were lured into the labor market. Average hourly earnings grew by 3% from a year ago, besting consumer-price inflation over the same time period.
Good news was also found in strong upward revisions to the August and September employment figures, which combined for 95,000 additional jobs. All told, the October gains and two-month revision boosted the three-month average of jobs created to 175,000 from 157,000 previously. This is a deceleration from the monthly average of 223,000 jobs created in 2018, but still supportive of our view that a healthy labor market, modest wage growth, and solid consumer spending can continue to power the economic expansion
2. Driven by the consumer, GDP growth is slowing but still positive
New GDP data released last week showed that the economy grew by an estimated 1.9% in the period from July through September, slightly lower than the 2% pace posted in the previous three months. Consensus estimates before the release expected a more marked slowdown, reflecting concerns that trade uncertainty and sluggish manufacturing was taking a toll on the economy. Yet consumers continue to show resilience in the face of these concerns, as consumer spending, which makes up the lion’s share of the economy, rose by 2.9%.
This was a deceleration from the 4.6% posted last quarter but appears strong enough to keep the economy near the average of this 10-year expansion, now the longest in U. S. history. Moreover, spending was broad-based, with big ticket durable goods up 7.6%, signaling that consumer confidence remains strong in the face of trade uncertainty. This confidence also showed hope in residential investment, where for the first time in six straight quarters, the housing sector was a positive instead of negative driver of growth. Low interest rates, stronger home sales, and a pickup in new construction are signs that housing could remain on the plus side of the ledger.
The economic picture was not all rosy. In fact, consumers looked like the only highlight, with business investments and exports subtracting from third-quarter growth. In contrast to consumers, business sentiment has been notably downbeat, reflecting weakness in manufacturing, trade tensions, and the overhang of decelerating global growth. Also released last week was the IHS Purchasing Managers’ Index, a measure of sentiment in the manufacturing sector. It was softer than expected and continued to show signs of contraction in goods production.
We see manufacturing as a key pocket of weakness in the economy; however, we also see signs that the sector could be stabilizing. In 2015, the ISM showed five consecutive months below the 50-index level without the economy slowing to a recession2 (a below-50 reading is associated with contractions). So far in 2019, there have been three months of below-50 readings, but this month the employment and new orders subindexes sequentially improved. The IHS Markit survey, a broader measure of manufacturing that includes smaller firms and more sectors, is above 50 and is signaling modest growth ahead, in our view, not a recession2.
3. Monetary policy is "in a good place" for the bull market to continue
As expected, the Federal Reserve delivered on a third straight reduction in benchmark interest rates, reducing the federal funds target to 1.5%-1.75% from 1.75% -2.0%. Beyond the cut, there were other notable elements of the Fed's announcement. By stating that monetary policy was "in a good place," the Federal Reserve chair signaled a pause in future rate cuts to assess the state of the economy with current stimulus measures already in place. The past three rate cuts were viewed by the Fed as insurance against rising risks from trade uncertainty and slowing global growth rather than a mechanism for stimulating the still solid economy. Rate cuts have helped reshape the yield curve from inverted, a historically reliable recession indicator, to mostly flat – a signal that is consistent with modest economic growth continuing, in our view.
The Fed's message to markets contrasted with the markets’ view that the Fed would cut at least one more time in the next six months. The Fed's view, however, seems consistent with economic data on the economy and jobs released this week, with both showing signs of fortitude despite looming risks. However, The Fed's effort to boost inflation closer to its 2% target continues to be a work in progress. Core PCE, a measure of inflation preferred by the Fed, slipped to 1.7% in September, from 1.8% the previous month. The Fed's concern that too-low inflation could reduce economic activity has been a leading justification for cutting interest rates. Monetary stimulus can take several months to be reflected in economic fundamentals, justifying the Fed staying pat on rates for now, unless there is a meaningful growth and inflation slowdown, in our view.
4. Corporate earnings are underpinning growing but more volatile share prices ahead
Not to be outdone by economic data, the corporate sector is also showing earnings growth. Approximately 80% of firms that have reported third-quarter earnings so far have beat analysts' estimates, with companies in the energy sector being notable laggards2. Corporate results thus far have also reinforced our view that earnings will continue to grow modestly. However, share-price growth will need to advance in the face of headwinds from geopolitical concerns, like trade and Brexit, and the broad-based global slowdown, making it a bumpy climb in our view.
Last week the economy reassured markets that it was still on solid footing, beating expectations even as risks tied to trade and slower global growth persist. In our view, investors can keep their portfolios on track when risks are elevated by staying invested in the late stages of the bull market, adding high-quality investments during bouts of volatility that help diversify portfolios, and maintaining an appropriate mix of equities and fixed income as a ballast against occasional swings in the market.
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