Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble. – Warren Buffett
All three major stock averages closed at record highs last week as investors continued to hold out hope that economic growth would begin to accelerate, with or without help from President Trump’s pro-growth policies. The year is almost half over and the market is still waiting for tax cuts and tax reform, deregulation and increased infrastructure spending. While the Federal Reserve Bank of Atlanta has forecast that economic growth will increase to 3.4% in the second quarter from 1.2% in the first quarter, economic data last week did not fully support this view. The most significant piece of data, the May employment report, showed the creation of only 138,000 new jobs, far below the 185,000 that were expected. Adding insult to injury, the number of jobs reported in March and April were also revised lower and job growth has averaged only 121,000 over the past three months. The unemployment rate in May fell to 4.3% from 4.4% but the decrease was due primarily to a drop in the labor participation rate. Average hourly earnings only rose at a 2.5% annualized rate, which was also disappointing. The one positive in the report was that May employment numbers are often difficult to forecast due to seasonal factors as most college graduates are not hired until June. Optimistic investors chose to look past this report toward the prospect of faster economic growth in the months ahead. The Federal Reserve’s Beige Book also painted a rather subdued picture of the economy across all of the Fed’s twelve districts. Overall, it showed that the economy expanded at a “modest to moderate” pace through late May with a slowdown in some regions and a deceleration in the rate of inflation. It also cited labor shortages as a possible cause of slower economic growth. But a Goldilocks economy that is characterized as neither too hot nor too cold with modest growth and relatively low inflation may be the perfect recipe for this market.
The rest of the economic data released last week was mostly mixed. Personal income and consumer spending both rose in April and were in line with expectations and the personal consumption expenditures index (PCE), the Fed’s preferred measure of inflation, rose by just 0.2%. U.S. home prices rose nearly 6% in March according to the S&P/Case-Shiller U.S. National Home Price Index. On the positive side, the Chicago Purchasing Manager’s Index (PMI) jumped to its highest level in over 2 years and was better than expected while the ISM manufacturing index also exceeded expectations. On the negative side, construction spending was weaker than expected in April and pending home sales fell 1.3% in April due to tight supply that caused higher home prices.
Dallas Federal Reserve President Robert Kaplan forecast 2% economic growth for the year and said that two conditions drive GDP: growth in the labor force and growth in productivity. He thinks that labor force growth going forward will be sluggish as the population ages.
For the week, the Dow Jones Industrial Average rose 0.6% to close at 21,206 and the S&P 500 Index gained 1% to close at 2,439, both new record highs. The Nasdaq Composite Index climbed 1.5% to close at 6,305, also a new record high.
It will be a particularly light week for economic data. Factory orders in April are expected to decline slightly after posting a modest increase in March. The ISM non-manufacturing or services sector index for May will also be reported.
Former FBI director James Comey will testify before the Senate Intelligence Committee on the investigation of possible collusion between Trump campaign officials and Russian officials. Overseas, the United Kingdom will hold a general election and European Central Bank (ECB) President Mario Draghi will hold a news conference after reaching a decision on interest rates.
Most of the earnings reports this week will be from small, lesser known companies. The most notable of these companies include JM Smucker, Verifone Systems and Casey’s General Stores.
While all of the major stock averages were setting record highs on Friday, government bond prices rose and the yield on the 10-year Treasury ended the week at 2.16%. Under normal circumstances, rising stock and bond prices usually do not occur at the same time. Prices on Treasuries, which move inversely to yields, generally rise when investors are concerned about weak economic growth and inflation expectations are low. Stocks, on the other hand, rally when investors are confident that growth will accelerate and they are willing to embrace more risk on the presumption that corporate earnings will improve. The yield on the 10-year Treasury has not been this low in seven months, implying that a sluggish economy lies ahead. Yet the stock market continues to trend higher, signaling that GDP growth will accelerate and corporate profits will increase. The lackluster May employment report released last week seemed to lend credence to the belief among bond investors that the economy will remain in the doldrums for the foreseeable future. The weaker than expected report could also alter the Fed’s thinking and slow the pace of interest rate hikes for the rest of the year. Although first quarter earnings were better than expected, the stock market has also priced in passage of Trump’s pro-growth agenda. But this continues to be delayed as the White House is preoccupied with the investigation into possible collusion between the Trump campaign and Russian officials as well as withdrawing from the Paris climate agreement. Time will tell whether or not the bond market has it right and the economy will continue to struggle or the stock market has it right and economic growth will begin to accelerate.