The U.S. Economy – Heating Up or Cooling Down?

The U.S. economy grew by 4.1% in the second quarter of 2018 – its best quarter in four years. President Trump declared the robust growth proof that tax reform is stimulating the economy and he predicted such growth to be sustainable for years to come. But will it be? Is second quarter GDP a sign that the economy is heating up? Or is it merely one hot quarter on the road to an economic cooling?

The Effect of Trade

Given consumer spending was the largest contributor to second quarter GDP, tax reform certainly provided an economic boost. However, trade had a surprisingly large effect on this quarter’s GDP. A shift in the trade balance contributed 1.1% to growth compared to a long-term average of -0.3%. Why the big difference? The surge in exports was from other countries (mainly China) buying U.S. goods in advance of potentially higher tariffs. Considering that exports normally are a small portion of U.S. GDP, having an outsized boost from exports is both an anomaly and a reason why this quarter’s tremendous growth isn’t necessarily sustainable.

Positive Indicators

• Even without the abnormal boost from exports, the U.S. economy grew by 3% in the second quarter. That’s very solid growth this deep into an already long economic expansion.
• By all measures, the labor market is quite strong.
• With most companies having reported, year-over-year earnings growth of the S&P 500 for the second quarter should be just shy of 27%!
• Companies beating revenue and earnings per share estimates were 61% and 83%, respectively.

A growing economy, a strong labor market, and fantastic earnings – all good things. But are they sustainable? The impact of the tax cuts will likely wear off by mid-year 2019. At that point, the Federal Reserve should be wrapping up monetary tightening (with another 4-5 rate increases by then) aimed at slowing down the economy and preventing inflation. With unemployment expected to fall further, eventually there will be a shortage of labor to fill open positions. And, despite the already tight labor market, wages have not risen much. Instead of increasing wages and benefits, companies have mainly used the corporate tax cut to buy back stock (stock buybacks are the highest they’ve been in years).

What does this mean for investors?

• Economic fundamentals should be strong for the next few quarters and that generally bodes well for stock prices.
• Small company stocks have done well this year. Small stocks tend to perform better during periods of rising rates and are more insulated from trade spats and the value of the U.S. dollar.
• Growth stocks have had a great year, driven mainly by technology companies. Eventually, growth stocks will retreat, and value stocks will have their day as value companies are relatively inexpensive and tend to perform better in a slowing economy.
• Stocks outside the U.S. have struggled in 2018. However, attractive valuations favor non-U.S. stocks and as the U.S. economy slows down, the U.S. dollar should fall, giving overseas stock returns a much-needed boost.
• Bonds, facing the headwind of rising rates for much of this year, may continue to muddle along until the Fed finishes tightening in 2019. However, higher rates mean higher yields and better bond returns in the future.

While the sharp rebound in second quarter GDP growth makes for great headlines, whether the U.S. economy is heating up or cooling down remains to be seen. In the meantime, it’s important to not get too caught up in the GDP hoopla and to keep focus on the long-term when it comes to your portfolio.