US stocks were largely unchanged in August. Several key economic data points came in ahead of expectations, perhaps indicative of improving business conditions, at least in certain areas of the economy. The political environment however, remains volatile, with near-term deadlines approaching for both the federal budget and debt ceiling. We maintain our positive outlook on the market, and believe that ultimately the debt ceiling will be raised and investor attention will shift back to an improving global economy and strong US corporate profits.
The latest revision to second quarter GDP growth came in at a relatively healthy 3%, driven in large part by consumption, which grew by 3.3% over the period. While 3% growth is not overly impressive in terms of historical standards, it has been a difficult threshold to reach in recent years. As such, the second quarter’s economic expansion was the strongest since early 2015, and confidence remains high in both the corporate and consumer sectors. Markit’s widely followed service sector index just reached the highest level in over two years, while the Conference Board’s measure of consumer sentiment neared its best reading for the current cycle. Moreover, consumer strength is not just showing up in surveys, but in actual outlays as well as evidenced by July’s healthy retail sales numbers.
Some of this positive data has been offset by pronounced weakness in the automotive and housing industries. Auto sector output has declined at a 10% annualized rate over the past 6 months, while sales of new single family homes declined by 9% in July. Recent housing starts, permits, and existing home sales have also been disappointing.
While we do see the potential for an upside case in which growth accelerates to 3% sustainably, we continue to believe that the most likely outcome is that the US continues along the 2% trajectory which has persisted in recent years. Overall, we are not materially changing our expectations for the US economy.
In Washington, officials must confront both the federal budget and debt ceiling in the coming months. We think that the latter is far more important to capital markets, though we expect both issues to be resolved. In the case of a government shutdown if no funding plan is agreed to, historical precedents show rather modest market impacts. On average, stocks have dropped by less than 1% during the closure period. A medium to longer term shutdown could pose a more serious threat, though we think the likelihood of that is quite low. Of greater concern is the potential for a default if the government were to fail to raise the debt ceiling, as this would likely lead to financial turmoil. We do believe however, that politicians understand the ramifications of this. In the past officials have always managed to reach an agreement and we are optimistic that they will do so again, though investors will likely remain weary until the situation is resolved.
We maintain a constructive outlook on the market. The most likely scenario, in our view, is that the economy will continue to expand at around the 2% mark which has persisted since the financial crisis. There are reasons for optimism, but with wages stagnant and inflation remaining stubbornly low, we believe that the weight of evidence suggests little has fundamentally changed for the economy. Still, we think that stocks can do well. Healthy profits and low interest rates have been primary factors driving stocks higher this year, and we expect that these conditions are likely to persist over the near to medium-term. We believe that secular growth stocks and dividend payers would be strong performers under this scenario.
Our upside case for the economy is that the second quarter’s 3.3% growth rate may be a harbinger of things to come. While we would assign this possibility a low probability, the most recent trend in GDP growth looks promising. The second quarter’s growth rate accelerated to 3.3%, up from Q1’s 1.4%, and many economists are forecasting 3% or better for the current quarter. Further, all 45 major economies tracked by the OECD are on pace for positive growth this year, and US exports over the first half of 2017 grew by 6%, the best six month showing since the end of 2013. While consumption would have to remain strong in order for the US to generate sustainable 3% growth, a healthy labor market and strong consumer confidence suggest that this may be achievable. Nevertheless, it is likely that some of President Trump’s pro-growth initiatives would need to pass to support an inflection in growth, beyond what has been done already on the deregulation front. In this scenario we would expect global cyclicals and value stocks to outperform.
Though we are optimistic on the market, there is always the possibility of a downside scenario. In this case, with valuations appearing stretched, and the VIX quite low, markets appear somewhat complacent. At the same time, there are meaningful risk factors to be cognizant of, including tensions with North Korea remaining high. We also think that markets could be vulnerable to further turbulence out of the White House. Rumors that certain high ranking administration officials have considered resigning have already led to some stock market volatility, and more would not be surprising. It is for these types of risk factors that we hold natural hedges, and we stand ready to increase these holdings should conditions warrant. Overall, we have endeavored to position our client portfolios to deliver attractive returns in the base case but with enough diversification to support results in either the upside or downside scenarios.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.