THIRD QUARTER, 2017
THE ECONOMY: SLOW STEADY GROWTH IS THE ORDER OF THE DAY
The U.S. economic outlook is healthy according to key economic indicators. The most critical indicator is gross domestic product (GDP), which measures the nation’s production output. In the first quarter, the Commerce Department reported 1.4% growth, an upwardly revised figure due to unexpectedly higher consumer spending and a jump in exports. Numerous economists are projecting 3.3% GDP growth for the just concluded second quarter. While modestly on the higher side of current projections, Harold Davidson & Associates (HDA) is now modeling a projection of 2.2% growth in U.S. GDP for 2017.
Consumer confidence rose in June, but the gains suggest that many Americans expect the economy to keep expanding at a slower pace. The total nonfarm payroll employment increased by 222,000 in June and the unemployment rate was little changed at 4.4%. The unemployment rate may drop to 4.3% by year end 2017. The Federal Reserve is projecting the unemployment rate to drop to 4.2% for 2018. However, many people have resolved to work part-time and most of the job growth is in low-paying retail and food service industries. U.S. inflation rates should average 1.6% and 2.0% percent in 2017 and 2018, respectively. This is lower than the Federal Reserve’s desired rate of 2%, because of the decline in oil prices. The core inflation rate, preferred by the Federal Reserve, strips out volatile gas and food prices. The core inflation rate should be 1.7 % and 2.0% in 2017 and 2018, respectively. Normally, these rates are not as close together, but the fact that the rate is closer to 2% gives the Federal Reserve the incentive to raise the Federal Funds rate as they did in June, to 1% to 1.25%.
The June Purchasing Manufacturers Index used by the Institute of Supply Management to measure growth, rose to 57.8 (a reading of 50 or higher indicates growth.) This was the highest level attained since August 2014. Therefore, there is continuing momentum in U.S. manufacturing growth. New orders, which are often viewed as the engine driving manufacturing, continued its upward ascent in June.
U.S. sales of new cars and trucks hit a record high 17.55 million units in 2016. However, the market has begun to saturate thanks partly to a glut of nearly-new used vehicles, forcing automakers to hike incentives to entice consumers to buy. The automobile industry is now projected to sell 17.1 millio n units for all of 2017.
The European Union says economic sentiment across the 19 country Eurozone has risen to near-decade highs as the recovery gathers steam across sectors and nations. Over recent weeks there are increasing signs that growth in the Eurozone is picking up, spurred by strong retail sales and higher investment spending, and is likely to experience GDP growth of 1.7% in 2017. Even weaker members of the Eurozone participated in the growth. Speculation is intensifying that the European Central Bank will soon curtail its stimulus measures.
Leading data suggest the Euro area’s economic recovery softened somewhat in June, but remained on track for the best quarter in over 6 years in Quarter 2. Slower growth was seen in France and Germany, the two largest Eurozone economies, chiefly due to slower service sector activity. The European Union is experiencing low inflation because of lower energy prices, similar to the United States.
India will continue to see strong economic growth as the fastest growing G20 economy with gross domestic product growth of 7.1% for 2017. In China, economic growth is projected to hold up in 2017 partly thanks to the impact of earlier fiscal and monetary stimulus. The International Monetary Fund has raised its forecast for China’s economic growth this year to 6.7% citing “policy support” especially expansionary credit and public investment. Business confidence among Japan’s largest manufacturers strengthened to its highest level in more than three years and should result in GDP growth of 1.4% for 2017 aided by stronger international trade in Asia and fiscal stimulus. In contrast to President Trump’s call for protectionism, Japan and the European Union are close to signing a free trade agreement.
THE STOCK MARKET: STOCKS CONTINUE UPWARD TRAJECTORY
During the second quarter of 2017, the S&P 500 Index gained 2.63%. The Index is up 8.26% year-to-date, its best first half performance since 2013. A synchronized global economic recovery propelled stocks forward during the quarter as worldwide quantitative easing programs bared fruit. Domestically, markets remain resilient in spite of the Fed’s tightening program. Optimism over relief from impending tax reform and deregulation buoyed the stock market. Earnings reports were strong during the quarter and an uptick in bank loans offers evidence that improved business confidence is leading to capital spending. A strong housing market and tight labor market also provide support that the domestic economy remains strong. Consensus earnings estimates for the S&P 500 Index are approximately $138 per share for next year. Using an 18x P/E multiple on the S&P estimate equates to a year-end value of 2,484, or 3% upside from current levels, which we think is attainable.
During the quarter ending June 30, 2017, Harold Davidson & Associates added to existing positions and purchased new stocks for our clients. We purchased shares in three technology companies: one develops various computer software products that enable users to create, transfer, and print electronic documents; another produces machine vision products used to optimize manufacturing efficiency; and the third is the largest independent software maker. We also established a new position in a cruise line company that is benefitting from stronger demand and a growing fleet of ships. Sales during the quarter included taking a profit in a specialty retailer supplying the lifestyle needs of recreational farmers and ranchers. We also sold shares in two healthcare companies whose sales and margins continue to be negatively affected by draconian government reform and regulation.
The composition of the assets currently managed by Harold Davidson & Associates is as follows: Cash and cash equivalents – 3%; municipal bonds – 3%; corporate bonds – 1%; bond mutual funds – 12%; equity mutual funds – 17%; common stocks – 50%; and real estate equities – 14%.
THE BOND MARKET: FEDERAL RESERVE RAISES RATES AGAIN
The Federal Reserve’s Federal Open Market Committee (FOMC) voted at its June meeting to raise its target for the federal funds rate by .25% to a range of 1% to 1.25%. The move was the third time in 6 months that the FOMC raised rates. Fed officials pointed to a rebound in economic growth since the first quarter, led by a recovery in business investment and steady consumer spending. Officials are encouraged by the improvement in global economic growth and see this growth as less of a threat to derail the domestic recovery. The yield on ten-year U.S. treasuries has steadily fallen in 2017, to 2.31% from 2.45% at the end of 2016. However, the Fed’s tightening stance along with a more hawkish tone has resulted in a flattening of the yield curve, in recent weeks. As a result, our bond purchases are concentrated on quality, shorter-term maturities. Inventories for both high quality corporate and municipal fixed income securities remain tight and we selectively substitute purchases of individual bonds with institutional quality bond mutual funds offering favorable yields.
THE REAL ESTATE MARKET: REAL ESTATE REMAINS AN ATTRACTIVE INVESTMENT ALBEIT MANY QUESTION WHERE WE ARE IN THE CYCLE
The commercial real estate market has seen dramatic increases in values over the past decade fueled by low interest rates and unparalleled institutional and exchange buyer demand. Competition for real estate investments has been fierce and prices have been bid up dramatically. However, while prices remain high, during the past quarter it appears as if appreciation has stabilized and many investors moved to the sidelines. With the Federal Reserve beginning to raise interest rates, the consensus is the dramatic price appreciation of the past decade will slow. Future increases in real estate values will result from rent growth as opposed to capitalization rate compression.
The overall residential real estate market also appears to have plateaued. Values have remained stable and transaction volume has slowed. For multifamily properties, competition amongst investors remains fierce as investors perceive projected rent growth provides future appreciation potential. For single family residences buyer demand continues to outpace available inventory of fairly priced, good quality properties. Most economists project the residential market to hold steady for the balance of 2017 and then projections diverge for 2018.
Harold Davidson & Associates continues to pursue well located, strong credit tenant commercial properties, as well as good quality apartment projects for our client portfolios. We are of the opinion real estate continues to offer an appropriate risk adjusted return and are seeking, in a very competitive investment market, additional real estate assets for our client portfolios.
SUMMARY & CONCLUSION:
Harold Davidson and Associates is currently forecasting U.S. GDP growth of 2.2% for 2017. Consumer confidence continues to build and the U.S. is approaching full employment. The rate of inflation at 1.6% is below the Federal Reserve target of 2% because of the decline in oil prices. The 19 country Eurozone is experiencing increasing growth, a direct result of the quantitative easing program in place. While the S&P 500 index gained 2.63% this quarter, we are modeling another 3% growth by year end. Expectations are that real estate values will continue to increase albeit a slower rate than what has been experienced the last decade.
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"'Economic Outlook & Investment Perspective' is designed to serve as a regular forum for the discussion of pertinent economic and market issues that are of concern to individual investors. However, this newsletter is not, and under no circumstances is to be construed as giving financial or investment advice and/or as an offer to sell any securities. Harold Davidson & Associates, Inc. and its officers and employees may have an interest in some or all of the investments, industries or securities, mentioned herein. The information set forth herein has been derived from sources believed to be reliable, but is not guaranteed as to accuracy and does not purport to be a complete analysis of the investment, industry or security involved."
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