Following robust second-quarter earnings and strong economic growth, some investors may be ignoring some potential causes for concern.
Plenty is going right for markets lately. Second-quarter corporate earnings were up 24% year-over-year on average; stock buybacks were up 50%. Economic growth, as measured by real gross domestic product (GDP), was up 4.1%, the highest in recent years. The S&P 500 is nearing new highs, volatility is low and many institutional money managers are foregoing hedges against possible downside.
Despite all these positive sentiment indicators, there remain some ominous clouds on the horizon that investors shouldn’t ignore. Below are four potential shifts that could be cause for concern for equity markets as the summer glow starts to fade:
- Economic growth is expected to slow. The third quarter is unlikely to keep pace with the robust second quarter. Current forecasts put third-quarter growth at 3.1%. Recent economic surprises are to the downside. In the past two weeks, readings on manufacturing, the service sector, payroll growth, housing starts, auto sales and consumer confidence have all disappointed. A dip in oil prices could be an early indicator that global growth is slowing.
- Trade conflicts, especially with China, could escalate. Already, total U.S. exports are slowing, likely due to the stronger dollar (which makes our goods more expensive for foreign buyers) and unease with recent trade rhetoric. The dollar value of goods affected by tariffs may rise to levels that could eventually prove recessionary.
- The Federal Reserve is likely to keep hiking rates. Fed officials have indicated they could raise rates as much as two more times this year and two more next year. While many investors are skeptical the Fed will hike that much, the strong economic data gives officials little reason to pause. Unless there is a market shock, the yield curve, which is quite flat now, could invert (where shorter rates are higher than long-term rates) in the next six months. While I think the flattening yield curve isn’t as a big a concern now as some investors think, an inverted yield curve has often been a reliable indicator of recession in the past.
- Total U.S. debt and U.S. Treasury issuance is soaring. Investors seem to be ignoring this factor, but annual budget deficits are expanding at a rate where total U.S. debt to GDP could breach 100% by 2020. Meantime, government revenues are down due to tax cuts. If the debt forecast worsens, interest rates could be expected to rise, which would likely lead to higher costs of capital and lower stock valuations.
Bottom Line: While investors can understandably take heart in the positive economic and stock market conditions this summer, that doesn’t mean they should shrug off risks that may be looming.
Staying broadly diversified can help insulate portfolios against stock market swings that may catch investors by surprise. Investors who are overweight growth stocks may find this a good time to reposition into more value-priced, defensive sectors. Investors are optimistic now, but the current positive summer mood in markets may not be sustainable as fall breezes start to swirl.