Capital Market Comment
June 11, 2018
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The volatility that has been characteristic of the investment environment since February and the events that have produced it, have added to investor anxiety and created confusion. The increased geopolitical risks with the instability in Italy, the changes in Spain, and the escalation in the “trade conflicts” with our adversaries and allies, are just a few of the factors producing daily market fluctuations and limiting upside potential. Additionally, the sharp increase in interest rates reflected in the rise in the 10-year Treasury rate to 3.10%, which quickly receded to 2.8% in 12 days, highlights the inherent volatility that has recently entered the fixed income market. Serious losses most likely have occurred. Just the one-to-two day move in the Italian 2-year bond from .46% to 2.46% was a disruptive force. The rate receded sharply when a “caretaker” government was formed – stay tuned! The Euro-world will continue to face anti-Euro forces and investors should expect this behavior to continue. Moreover, the Federal Reserve’s expected June rate increases to 1.75 – 2.0% on the federal funds rate added to interest rate anxiety. The debate about additional increases this year and the general trajectory going forward raises the level of uncertainty. Against this setting, what are the factors that are likely to influence the equity market as we enter the summer “doldrums”, so we think?
First, employment growth, which was very constructive in May with a 200,000+ gain in nonfarm payrolls, should continue in the coming months, averaging 150,000 – 200,000 with an improving participation rate. The diffusion index (percent of industries adding to employment) for May was 67.6% and the PMI Survey for Manufacturing (58.7) and Non-Manufacturing (58.6) suggest continued growth. The composite index of leading economic indicators also provided a similar view.
Second, the Federal Reserve is likely to maintain its existing policy in which a June rate increase is likely to be followed by one more this year. They will tolerate “core inflation” rising above 2%, given the symmetrical nature of their policy. It seems likely that the monetary authorities will attempt to avoid an inverted yield curve, something that has been mentioned by numerous Federal Open Market Committee members (both voting and non-voting). This avoidance remains an important factor for the sustainability of economic growth and the bull market.
Third, trade conflicts will ebb and flow. There will be bellicose and conciliatory comments, but little resolution.
Fourth, the European Central Bank will be more accommodative than anticipated earlier, due to the political and banking conflicts that have emerged. Moreover, the Federal Reserve will also be sensitive to the European credit markets and the slowing of growth in Europe and Japan in recent months. The hawks are in retreat and the doves are advancing, for now.
Fifth, the strong earnings performance in Q1 generated more favorable valuation parameters in the equity market. A 16.5 times earnings multiple for the S&P 500 on projected earnings for the next 12 months (a 6%+ earnings yield) places equities in a favorable light in contrast to the fixed income market at home and abroad. Earnings and revenue growth will continue over the next several quarters as the impact of the tax cut is felt and GDP growth accelerates. Corporate cash flow should continue to generate stock buybacks, mergers and acquisition activity, dividend increases, and capital spending. In Q1, CapX increased at a near double digit annual rate.
Sixth, the overall level of non-financial companies’ outstanding stocks continued to decline in 2018. This reduction has been the case since the recovery began. Shrinking supply tends to prop up prices. As long as prices appear reasonable, the liquidation is likely to continue.
Seventh, the upward pressure on rates may be limited over the medium term, given the attractiveness of the U.S. market relative to the overseas counterparts – Germany’s 10-year bond is at 47 basis points and Japan’s is near zero. The U.S. remains the “safe-haven”.
The strong fundamental underpinnings should prevent a severe market reaction from Geo-political fallout, while the appearance of calm should generate upward bias. Sector and stock selections will become of greater importance at this stage of the business cycle. Liquidity conditions still remain constructive and many more Americans are participating in the economic expansion. The major risk to the stock market remains a “recession.” In our judgement, that appears in the very distant future.
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors. If you have a question or need further information, please contact:
Patrick Snell, CFA, Principal & Portfolio Manager in Nashville at 615-244-8400, or firstname.lastname@example.org or
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com.
© 2018 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.