Stocks overcome rising tensions with North Korea, rally to end week higher

In recent years, annual trading in stocks – necessarily creating, by reason of the transaction costs involved, negative value for traders – averaged some $33 trillion. But capital formation – that is, directing fresh investment capital to its highest and best uses, such as new businesses, new technology, medical breakthroughs and modern plant and equipment for existing business – averaged some $250 billion. Put another way, speculation represented about 99.2% of the activities of our equity market system, with capital formation accounting for 0.8%. – John Bogle

The S&P 500 Index erased losses earlier in the week caused by renewed tensions with North Korea and wound up closing higher and eking out a slight gain for the month of August. The Dow Jones Industrial Average and the Nasdaq Composite Index followed a similar pattern and ended the week higher. Weakness in stocks occurred early in the week as North Korea fired a ballistic missile over Japan. As strange as it may sound, the devastation, destruction and human suffering that Hurricane Harvey brought to Texas may actually have reduced potential risks in Washington later this month. Congress must pass a bill to fund the government and raise the debt ceiling to avoid a government shutdown and default on the national debt. President Trump retracted his previous statement that he would shut down the government if his much-talked about border wall wasn’t funded. The tragedy in Houston and other coastal towns could also serve to unite Congress to approve an aid package and bring cooperation to pass a bill to fund the government. The two most important pieces of economic data last week were mixed. Second quarter gross domestic product (GDP) was revised higher to 3% from 2.6% on stronger consumer spending and business investment. However, the August employment report showed that only 156,000 jobs were added, less than expected, and that the unemployment rate edged higher to 4.4%. June and July payroll numbers were also revised lower and wages grew at an annualized rate of only 2.5%, less than expected. Government payrolls were the biggest reason that August job numbers were light as they have been difficult to forecast in the past and usually prone to higher revisions after the fact. Much like the current stock market, it is difficult to get a good read on it as summer winds down with high absenteeism among participants and low trading volume. It’s probably a safe bet that volatility will pick up in September.

Last Week

Housing data was also mixed last week as pending home sales fell slightly in June while the S&P CoreLogic Case-Shiller home price index rose slightly from May to June. The Consumer Confidence Index rose to its second best level of the year in August as consumers remain optimistic about the economy and the labor market. The core personal consumption expenditures (PCE) index, the Federal Reserve’s preferred measure of inflation, rose only 1.4% on a year-over-year basis, making it less likely that the Fed will raise interest rates. Expectations for a December rate hike are just 30%.

For the week, the Dow Jones Industrial Average rose 0.8% to close at 21,987 while the S&P 500 Index added 1.4% to close at 2,476. The Nasdaq Composite Index jumped 2.7% to close at 6,435.

This Week

The European Central Bank (ECB) meets to review its monetary policy and make a decision on interest rates and its asset-purchase program. The fact that August euro zone inflation rose 1.5% on a year-over-year basis, the highest rate in four months, could influence the decision-making process. It will be a quiet week for U.S. economic data as July factory orders are expected to give back their gains in June and the ISM non-manufacturing or services sector index is reported. The Federal Reserve will also issue its beige book of economic conditions across the country.

It promises to be another slow week for quarterly earnings reports as Casey’s General Stores, Barnes & Noble, Kroger and Verifone Systems are the most notable companies scheduled to report.

Portfolio Strategy

The Federal Reserve has been anxious to normalize monetary policy by raising interest rates, but inflation over the past few years has not cooperated and remains low today. The Fed has maintained all along that its inflation target has been 2%, but the core personal consumption expenditures (PCE) index rose only 1.4% in July. This indicator is the Fed’s preferred measure of inflation but other inflation measures have also indicated an absence of inflation. The current unemployment rate of 4.4% suggests that the economy is at full employment, which should lead to upward wage-price momentum as employers offer higher wages to attract and retain workers. Rising wages lead to higher prices until the Federal Reserve raises interest rates to slow the economy and reduce wage pressure. The August employment report, though, showed that wage growth was at an annualized rate of only 2.5%, less than expected, and not the least bit inflationary. Although second quarter GDP was revised upward to 3%, average GDP growth for the year has only been 2.1% after a tepid first quarter. One of the reasons for low inflation has been globalization of U.S. labor markets. Companies like Amazon not only help keep prices low but they also put pressure on traditional retailers and destroy jobs. In its haste to normalize monetary policy, the Fed has been guilty of applying anti-inflationary forces as well. It has raised short-term interest rates several times and has announced plans to reduce the $4.5 trillion of securities on its balance sheet. Oil prices have also been persistently low and could remain in the $40 to $60 range for the foreseeable future as supply outstrips demand. Simple demographics could be at work, too, as an aging workforce along with modest economic growth help keep inflation in check. If history is an accurate guide, then sooner or later a tight labor market should produce higher wage growth and lead to higher inflation.