Despite mixed signals in the economy, investor optimism remains strong.
Investors remain broadly positive about the U.S. investment climate, according to a recent Wells Fargo/Gallup Investor and Retirement Optimism survey. 41% of investors say the market will go up in 2018. However, they are worried about the business impact of possible cyberattacks and the political climate in Washington along with the federal budget deficit. Additionally, investors worry about trade relations with China and other foreign countries.
Higher dividends and stock buybacks
Flush with savings from lower tax bills and profits from a growing economy, big U.S. companies are spending a record amount buying back their stock. This will produce more demand for stocks and drive stock prices higher.
Additionally, big U.S. companies are gearing up to pay record dividends in the coming months. Higher dividends will raise floor prices for stocks, and drive stock prices even higher.
Weaker GDP growth
Despite the good news of higher U.S. stock prices, the U.S. economy slowed more than previously estimated in the first quarter amid the weakest performance in consumer spending in nearly five years.
At the same time, the President’s mandate that federal agencies eliminate “at least” two regulations for every new one ordered is having an impact. The Trump administration is easing regulations and boosting companies’ interest in reshoring jobs to the U.S. At last count, some 22 regulations were repealed, cutting compliance costs to American companies by $8.1 billion.
Rising small business optimism
Small business optimism is soaring with more upbeat expectations for improving sales and economic conditions. When taxes and regulations ease, earnings and employee compensation increase. Small business owners are continuing an 18-month streak of unprecedented optimism, which is leading to more hiring and rising wages.
With tax cuts signed into law, high economic optimism, significant regulatory, and slowly increasing interest rates, the near-term outlook for bank profitability is very positive.
Most banks easily passed recent Federal Reserve stress tests, indicating the banks are very well capitalized and financially strong.
Flattening yield curve
The yield curve is flattening. What that means is that the difference between the interest rate of the two-year Treasury note (2.55 percent) (or short-term debt) and the ten-year Treasury note (2.89 percent) (or long-term debt) is becoming very close. There is only a difference of 0.34% between the two-year and the ten-year (as of June 23rd).
That’s less than half of what it was in early February and the narrowest it’s been since August 2007.
Banks make money by borrowing funds at short-term rates and loaning them out at long-term rates, which are generally higher. If the yield curve flattens, it becomes more difficult for banks to be profitable. If long-term rates dip below short-term rates, then the yield curve inverts, and banks stop loaning money. Businesses stop expanding because they can’t borrow money. Business activity slows, and workers are laid off, leading to an economic recession.
Inverted yield curves usually precede a recession by six to eighteen months. We have not seen an inverted yield curve yet, only a flattening of the curve. Therefore, a recession is not likely to happen soon. However, the flattening of the yield curve is probably telling us that we are likely in the later stages of the current economic expansion.
Trade war jitters
Investors are worried about trade wars. The U.S. has imposed some tariffs on its trading partners in Europe and Canada and is threatening more tariffs on Chinese and European goods. China and Europe say they are ready to retaliate with tariffs on U.S. goods.
Higher tariffs could have a chilling effect on global trade and negatively impact businesses here and abroad that are dependent on international trade. As a result, we could see a significant rise in the price of consumer goods that will have a dampening effect on business activity.
Rising inflation and interest rates
Inflation is expected to accelerate, and the Federal reserve has been raising interest rates to keep inflation at bay. Inflation slowly erodes buying power. Higher interest rates decrease bond prices. Stock prices will be under pressure. Borrowing costs and expenses for companies will go up resulting in less profit and slower growth.
Demand for Junk bonds
You would expect with all the uncertainty in the market, higher interest rates, higher inflation, and lower prices of investment grade bonds, that investors would have less appetite for “junk” bonds. However, the opposite has been true; the demand for junk bonds has surged. Junk bonds are high-risk debt with high interest rates, and junk bonds are seeing greater investor demand.
Mergers and acquisitions
A record $2.5 trillion in mergers and acquisitions were announced in the first half of 2018. AT&T has acquired Time Warner. CVS Health acquired Aetna. Cigna acquired Express Scripts. Walmart acquired Flipkart. Late stage economic cycles are usually marked by greater merger and acquisition activity, eventually followed by recession.
Please don’t misunderstand me. We are not in a recession. We are not even close to a recession and a recession is not imminent. However, a recession can be seen on the far horizon. Use this time to get your financial house in order.
Relative and absolute momentum are with U.S. stocks right now, with the S&P 500 at a 14.5% gain year-over-year. Relative momentum has shifted away from international stocks with only a 6.84% gain year-over-year. This may be caused by the great debt loads carried by emerging countries, which pay their loans in U.S. dollars in an environment of rising interest rates. Their loans become more difficult to pay off, which is a drag on their economies.
Dual momentum points to being invested in U.S. stocks at this time.