It shouldn’t be surprising that US stock indices were relatively flat the first half of the year. After all, 2017 brought a stellar, unexpected gift in the form of performance returns. As the year turned over, most investors were aware that stocks can only go up for so long before one of two things happen: they correct or they pause and move sideways. Although we had a modest correction in February, most of 2018 has been characterized by stocks trading in a range without a distinct pattern. This choppy movement, called basing, traditionally has a floor below which stocks tend not to fall for very long and a ceiling that stocks tend not to exceed. Basing gives stocks a chance to take a breather and consolidate. But just as the markets can’t go up forever, so too there is an end to the basing period. At that point, if the economy and company earnings have caught up with the inflated valuation of stocks, the rally will likely resume. However, if the data weakens or there is too much uncertainty, the markets quite possibly correct.
For 2018 the floor has been all of the good things that are bolstering our economy and the ceiling represents the worries that keep investors up at night.
So where does this leave us for the second half of the year?
Republicans were smart to create the stimulus at the beginning of the year before the February correction (which was more technical than economic). The tax cuts and increased spending became the initial floor. When businesses continued to report strong earnings and unemployment dropped to the current 3.8% level, the floor strengthened. At the same time, inflation rose only marginally and consumer and business confidence went through the roof. The various independent research organizations that we consult all had the same reading – no recession in 2018. And a number of analysts venture that 2019 will be a recession-free year as well. All of this good news means stocks have been hard pressed to fall too far, even when assaulted by negative headlines.
Sometime during the second half of the year, the basing is likely to end. But before that happens, several uncertainties have to be addressed. Here are three of the major worries that form the ceiling for the second half of the year.
- A Policy Mistake: This one is on Jerome Powell, the new Federal Reserve Chair. Technically, the theory goes, if the Fed raises interest rates faster than long term bond holders believe is sustainable, the yield curve inverts, and the gap between long term and short term interest rates turns negative. This is often a signal of a pending recession. While the Federal Reserve has already increased rates 6 times, economists do not want to see rates rising faster than the economy can withstand. At the latest meeting of the Federal Reserve this month, the Fed signaled that it might be prepared to push through quarterly rate increases without a pause. That caused one strategist to fret that the Fed would “tighten until something breaks.” Clearly Jerome Powell and his cohorts will be watched very closely for any misjudgment that they might make.
- A Trade War: Trade agreements are meant to be revisited periodically, as economies, products, resources and processes change often. However, trade negotiations are usually conducted out of sight and out of mind of most investors. This time the strategy is different. Publically announced tariffs (taxes on foreign goods) have been threatened and enacted by a number of countries without serious negotiations having been completed. The loud posturing and menacing actions on all sides have made the possibility of an all-out trade war real for investors. Outright trade wars increase prices and inflation thereby slowing economic growth. They can disrupt supply chains, spreading the impact to beyond targeted goods. And they can negatively impact business and consumer confidence slowing down spending and investment. To date the bark is worse than the bite, but that is hard for investors to see in the midst of all the moves and countermoves. While we hope the new strategy works, until it does investors are likely to be nervous. And the negotiations, particularly those around NAFTA and China – could take at least until the end of the summer and potentially into the fall.
- A Slowing Global Economy: Last year the global economy roared ahead and the world enjoyed synchronized growth not seen since 2007. Growth in one country spurred growth in other countries. The strong global economy was one of the impetuses for last year’s impressive stock market gains. This year European manufacturing activity has suffered from a soft first quarter, while disruptive political parties are gaining popularity. Emerging market economies have felt the sting of the rising dollar, at the same time China struggles with high debt and over capacity. Even with the data overall being mixed, the optimism of last year has faded. While the business cycle often experiences soft patches, it isn’t until the economy gets back on track that investors often feel they can breathe a sigh of relief.
All of this means that a sustainable rally might be slower in coming this year. Americans, in general, feel good about the economy, judging that it is moving in the right direction. But investors are quicker to focus on the worries, discounting the future into the present. Our best view for the next six months is continued sideways movement with a slightly higher ceiling and a slightly lower floor. The good news is that stocks tend to break out more often to the upside than to the downside after a prolonged period of being range bound. For now we look for this pattern to continue, with the good news prevaling.
The information contained in this post is not intended as investment, tax or legal advice. StrategicPoint Investment Advisors assumes no responsibility for any action or inaction resulting from the contents herein. Betsey’s opinions and comments expressed on this site are her own and may not accurately reflect those of the firm. Third party content does not reflect the view of the firm and is not reviewed for completeness or accuracy. It is provided for ease of reference.