SECOND QUARTER, 2018
THE ECONOMY: U.S. ECONOMIC GROWTH CONTINUES UNABATED
The U.S. economy as measured by the gross domestic product (GOP) continues with uninterrupted growth. The fourth quarter 2017 grew at 2.9%. The first quarter, historically our lowest growth quarter, was estimated at close to 2%. GOP should solidly exceed 3% for the balance of the year. The government deficit will grow this year which will boost GOP. Rising household income, job gains and credit utilization are underpinning solid growth in consumer spending. Housing construction should continue to move forward, albeit at a somewhat slower pace. Manufacturers are benefiting from stronger exports as the global economy continues to improve.
The U.S. Bureau of Labor Statistics reported that America added 313,000 new jobs in February, the biggest gain in nearly two years, and 103,000 in March. At the same time a modest 0.1% rise in hourly earnings suggests that inflation is not an imminent threat. So what could go wrong? The week after threatening Japan and China with trade tariffs, President Trump also directed threats of a trade war with Australia.
President Trump has since back peddled and said that the trade tariffs would not be exacted on the European Union, Australia, Argentina, Brazil, Canada and Mexico. However, Canada and Mexico would be free of these trade tariffs if he re-negotiated the NAFTA agreement. In Harold Davidson’s & Associates, Inc. (HDA) opinion, it is apparent that President Trump is using broad threats of trade wars as a negotiating ploy to extract a few narrowly defined concessions from a handful of trading partners. While he wants to clearly redraft the NAFTA agreement, he has the greater objective of exacting fairer trading terms with China and Japan. Hopefully, trade agreements can be reached without a trade war.
The inconsistencies in these trade tariffs are staggering. Previously it was announced that there would be future tariffs of 25% on steel imports and 1 0% on aluminum imports to the United States. Then it was announced that Canada and Mexico would be exempt from these tariffs. What seems ludicrous is the United States imports more steel and aluminum from Canada than any other country; 17 % steel and 36% aluminum. Canada and Mexico represent over 40% of U.S. aluminum imports. In our opinion, nobody wins in a trade war.
The return of moderate inflation, slightly below 2%, means the Federal Reserve, which raised rates a quarter of a percentage point on March 21, will likely raise rates two more times this year in June and December.
In 2018, HDA projects retail sales, excluding gasoline and autos, will grow 4.7%, better than 2017’s 4.1% pace. Consumer’s wealth gains will lead to more home improvement projects and will keep sales of building materials rapidly expanding. E-commerce will have yet another banner year, growing 15%, while in-store sales should do all right at 3% growth, their best showing since 2014.
U.S. auto sales will taper modestly after years of strong growth. The new tax law makes it easier for business to purchase motor vehicles, which will help the industry in a year that will see consumer demand ease to close to 16.9 million new vehicles sales in 2018 versus 17.25 million in 2017.
Firmer global growth and lower U.S. taxes can solidly lead to modest acceleration in business spending this year provided that a prolonged trade war doesn’t break out. Business confidence is extremely high, while after-tax corporate earnings are strong and rising as the benefits from last year’s sweeping tax cuts are realized. The only foreseen problem is if the U.S. and China trade issues crimps world trade volumes. Barring that happening, core business fixed-investment spending is projected to increase 7% for 2018 following last year’s 5.3% increase. Favorable depreciation guidelines for capital equipment purchases by business further contributes to these estimates.
THE STOCK MARKET: FIRST QUARTER COMES IN LIKE A LION, GOES OUT LIKE A LAMB … FOR NOW
At the beginning of the first quarter of 2018, the S&P 500 Index continued its upward trajectory from the previous year, at an accelerating rate. After gaining 7% in less than a month, the market ran out of steam, losing 10% in about a week. The market then finished the quarter as if nothing happened, rising 1 %; however, the quarter was a volatile one and it seems that volatility may be here to stay. The measure of volatility, or the VIX, leaped 80% at one point during the first quarter. The VIX reached a level not seen in three 3 years due to concerns about an uptick in inflation as well as the Federal Reserve’s future tightening cycle. Earnings reports during the quarter were extremely positive as global economic growth remained strong and the boon of the tax reform bolstered profits. The $1.5 trillion tax cut, which includes a reduced repatriation rate, incanted domestic companies to bring cash back home and use it to reinvest in their employees and businesses. On the demand side, consumer confidence and spending remain strong, and sustain the favorable outlook for the U.S. economy. Using an 21X Price Earnings Ratio (P/E) multiple on the consensus S&P 500 estimate for 2018 of $140 equates to a year-end value of 2940, or 1 0% upside from current levels.
During the quarter ending March 31, 2018, HDA established new positions and sold stocks for our clients. We swapped a technology hardware company for a cloud delivered, enterprise software company, with a focus on customer relationship management. We also added exposure to the healthcare industry by establishing new positions in a diagnostics company and a managed care company. Sales outpaced purchases during the quarter as we realized profits and raised cash during the tumultuous market swings in the quarter. Sales during the quarter included a railroad operator, a media company, a discount retailer, a semiconductor company, a package delivery company, and a recreational vehicle manufacturer.
The composition of the assets currently managed by Harold Davidson & Associates is as follows: Cash and cash equivalents- 5%; municipal bonds- 4%; corporate bonds- 1 %; bond mutual funds- 8%; equity mutual funds – 17%; common stocks -52%; and real estate equities – 13%.
THE BOND MARKET: FEDERAL RESERVE INCREASES THE TARGET RATE DURING THE FIRST QUARTER, 2018, AND NEW FED CHIEF MAKES HIS DEBUT
The Federal Reserve’s Federal Open Market Committee (FOMC) raised the benchmark lending rate by a quarter percentage point to a range of 1.5% to 1.75%. This represents the sixth increase in the target rate since the FOMC’s tightening cycle began in December, 2015. The new Federal Reserve Chairman, Jerome Powell, is expected to increase rates two more times this year, in line with the Fed’s original plan, due to the favorable medium-term economic outlook and the expectation for inflation to rise toward the Fed’s 2% objective. Due to the fact that the U.S. job market appears to remain strong and at full-employment, wage increases will likely follow, putting upward pressure on inflation. Rising trade tensions and the possibility of a trade war could have a negative impact on domestic economic activity and cause prices to increase, which may require the Fed to revise its plan and raise rates more than anticipated. The yield on ten-year U.S. treasuries spiked over 20% during the first quarter but settled back and ended the quarter at 2.7%. The yield curve flattened during the quarter as a flood of shorter issuances hit the market. As a result, our bond purchases are concentrated on quality, shorter-term maturities. Inventories for both high quality corporate and municipal fixed income securities remain tight and we selectively substitute purchases of individual bonds with institutional quality bond mutual funds offering favorable yield.
THE REAL ESTATE MARKET: LIMITED SUPPLY OF COMMERCIAL AND RESIDENTIAL PROPERTIES IN AN INCREASING INTEREST RATE ENVIRONMENT HAVE FORMED A CHALLENGING MARKET FOR BUYERS
The commercial real estate market remains strong. Investor demand continues to outpace supply for good quality commercial real estate investments. Nearly all sectors of the commercial real estate market remain at or near peaks. As interest rates have started to increase the sales velocity has slowed as investors await sellers to adjust their pricing expectations to reflect the effect of increased interest rates on property cash flow yield. This adjustment process usually takes 3 to 6 months and we are just starting to observe the initial stages of these price adjustments. In the retail investment sector there continues to be a sense of hesitation as investors evaluate the “Amazon effect” on soft good retailing. We continue to believe that service based necessity retail (i.e. restaurants, medical, entertainment) will continue to perform well.
The residential real estate market is being fueled by a very limited supply of available properties for sale. Nationwide buyers are facing stiff competition due to the minimal quantity of properties listed and a relatively modest amount of planned new supply. In major metro markets like Los Angeles, affordability continues to be a significant hurdle for most first time home purchasers. Raising interest rates may put further pressure on the affordability gap for both first-time buyers and potential move-up buyers. However, due to the limited supply, the residential market should remain strong for the foreseeable future. HDA continues to believe that real estate provides a sound diversification strategy and is actively looking for prudent real estate investments on behalf of clients.
SUMMARY & CONCLUSION:
The U.S. economy as measured by the GDP continues with uninterrupted growth. The government deficit will grow because of the recently passed tax legislation which will boost GDP. Good employment numbers, low unemployment, and low inflation should stimulate the economy. However, a trade tariff dispute with China could derail the positive economic environment we are experiencing. No one wins in a trade war. Using an expanded P/E multiple HDA is projecting an additional upside of 10% for year end 2018. When sellers adjust prices of real estate to reflect increasing higher interest rates, it will be the appropriate time for real estate purchases.
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“‘Economic Outlook & Investment Perspective’ is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved.”