Back to School
August 20, 2019
It is that time of year again where summer is winding down and the start of a new school year is underway. Parents are busy filling backpacks with school supplies, buying school clothes and getting families back in a routine. The same readjustment is also happening in the financial markets due to the Federal Reserve, China Trade issues and overall soft economic data around the globe influencing a reset in valuations. For most investors, uncertainty and fear arises but for patient investors this volatility can be managed if we put the current facts into perspective. Here are a few economic data points:
Today the Fed Funds rate is between 2-2.25%. The Fed just lowered rates by .25% and is anticipated to lower them again in September. Economic growth is positive and expectations for 2019 GDP growth are trending around the 2% level. Although it is lower than last year, 2% is a healthy growth rate for the largest economy in the world especially considering parts of Europe are in a recession and China is slowing. According to the Conference Board, which tracks leading indicators of growth, this is down from almost 3% in 2018; however, consumers continue to feel confident. Core inflation remains near the Fed’s target of 2% leaving only a small amount of room to continue lowering interest rates. Ideally, the economy continues to expand, and earnings growth accelerates but it would probably take a resolution of the trade war with China to have a significant acceleration in the economy. The most probable scenario in the short term is slower growth but not a recession with the Fed remaining supportive of continued low interest rates.
The biggest threat to the Fed’s low rate environment will be pressure coming from wage growth. The overall 3.6% unemployment rate is a record low and looking deeper into the numbers, almost every category of employment is surpassing what some economist defined as full employment. From a business cycle perspective, the late stages see a softening of employment and buildup of inventories, but the consumer remains strong. It is likely the US remains in the late innings of this business cycle if companies can find enough new workers without pushing wages significantly higher. According to data from the Atlanta Federal Reserve Bank, the weighted three month average wage growth numbers are north of 4% per annum and have accelerated over the course of the recovery.
According to official trade data from the White House, the trade deficit of both goods and services between the US and China is roughly $378 billion per year. Exports to China were $179.3 billion compared to $557.9 billion of imports. To put this in proper perspective, based on numbers from the Bureau of Economic Analysis, the value of all goods and services produced in the United States climbed to $20.89 trillion. From a percentage standpoint, the US depends on China for .8% of our total GDP and for China the US represents 2.2% of their total GDP. So far tariffs up to 25% are being levied on US $250 billion of goods imported to the US from China with threats of more to come if Beijing doesn’t do a deal. This level of tariffs will impact both countries but in the big picture it is more of a headwind that slows growth. If tariffs are placed on all goods it is important but not likely to devastate either economy. China seems content to wait out the US elections in an attempt to secure a better trade deal.
The S&P 500 is currently trading at a PE ratio (price/earnings) of 17. During the past year, we saw a low of 14 in December. Although PE ratio is not a good predictor of future returns in the short run it helps to keep things in perspective. Historical PE ratios from the past 50 years have averaged approximately 16 so we are not extremely overvalued at the moment. With earnings expectations (in the denominator) going down throughout the year, the overall ratio will increase if the price remains the same. If you consider the overall valuation of the market, international blue chips are actually more attractive on a PE basis. Recently, Fidelity announced an increased allocation to international stocks in target date funds in order to take advantage of that opportunity.
While this readjustment in the markets continues, just like the kids getting back into a school routine, it will return to normal, but this will take time. The important thing to remember is that market volatility is a normal part of investing, particularly at this stage of the economic recovery. We continue to believe that long-term investors are more likely than not to be rewarded for time in the market, but this requires patience and the ability to look beyond short-term market uncertainty.