Darrell Cronk, CFA®
President, Wells Fargo Investment Institute

“May you live long, but never grow old.” —Unknown.

June marked the nine-year anniversary of this economic recovery, making it the second longest recovery on record. While old in years, this cycle doesn’t feel all that old in its behavior.  In fact, in some ways, we are finally returning to what I like to call the “old normal.”  

The old normal to me is an environment in which we once again witness rising interest rates, rising inflation, and the cycle’s most robust GDP growth—with conversations about annual GDP approaching 3% and in some quarters once again above 4%.  We’re seeing global central banks finally discussing or acting upon tighter monetary policy instead of endlessly easing; a labor market in which, for the first time this century, the number of job openings exceeds the number of available workers; and active management regularly outperforming passive/index-only investing once again.  Hooray for the old normal! 

That doesn’t mean we are without challenges. In many ways, we have a market that, if not for trade concerns, could find a path of least resistance higher. The war-on-trade discussions continue to heat up around the three core areas of China, European Union auto tariffs, and NAFTA renegotiations. The good news in the tariff narrative is that processes are relatively well-telegraphed and follow a fairly rigid time frame, with public hearings and ample advance notice to implementation.  The bad news is that all of the deadlines are actually being met—the administration is not using the maximum amount of time permitted under the trade statutes of 232 and 301, but rather the minimum amount of time.  

That said, there are positive signs that these disputes could be resolved—creating upside potential for U.S. equity markets. A few of these positive signs:

  • Germany has proposed a deal that would eliminate all auto tariffs between the U.S. and Germany in an attempt to de-escalate the auto tariff issue. The European Union has not fully agreed to this yet. 
  • China has not immediately responded to the latest $200 billion tariff escalation proposal by the U.S.
  • Notwithstanding some recent yuan weakness, Chinese government officials have said they won’t use outright currency devaluation as a weapon of trade and pledged to keep the exchange rate “basically stable.”
  • The latest Treasury data shows that China increased its U.S. Treasury holdings last month, countering the fear that the Chinese may reduce or cease purchasing U.S. Treasury securities. 
  • The current NAFTA agreement has no fixed expiration date, which is important to know.  It still remains unlikely that the administration will exercise unilateral withdrawal provisions from the current agreement without a more cohesive plan to replace the largest existing free trade agreement in the world today. 
  • Trade will continue to be a concern for markets and should be watched closely; however, there are good reasons to not be fearful of a pending trade war.   

The fundamentals provide reason for optimism. This should be the third consecutive quarter with double-digit S&P 500 earnings growth, with year-over-year earnings growth of more than 20% on revenue growth of 8-9%. Small company stocks, as measured by the Russell 2000 Index, could report earnings growth that exceeds 40% year over year.  Share buybacks announced for the second quarter were over $440 billion, nearly double the previous record of $242 billion set in the first quarter. Companies also paid a record $111 billion last quarter in dividends, a 7.8% increase year over year, according to S&P Dow Jones. Mergers and acquisition (M&A) dollar volume hit $726 billion, more than double the level for the same period in 2017.  We saw 120 initial public offerings (IPOs) during the first half of 2018 worth more than $35 billion—the best six months of the cycle so far. The tailwind of excess cash and earnings from tax reform remains alive and well.  

While the fundamentals of the old normal are real, the tug of war between strong fundamentals and concerns over an evolving war on trade look to dominate the second half global outlook for 2018.  However, the likelihood of an all-out trade war thus far has had muted economic and capital-market impacts and to us remains a tail risk rather than a baseline scenario today. We will be watching closely for any changes within this current path. It is important to remember, when it comes to risks, that all are possible, though not all risks are equally probable.

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