Market News

Monthly Economic Update: June 2018

U.S. Economy: Trade War Poses Growth Risks to Construction, Manufacturing, Farming Sectors, Among Others

Job growth remains strong as more companies struggle to find available workers.

U.S. employers added 223,000 jobs in May, resulting in the 92-straight month of expansion in the nation’s jobs market, and the longest continuous spurt of monthly job growth on record. At 3.8%, the unemployment rate fell to its lowest level since April 2000.

In addition to retail trade and health care employers adding workers, employment in the construction, professional and technical services, transportation and warehousing, and manufacturing sectors continued their upward trend, according to the Bureau of Labor Statistics. Average hourly earnings rose by 8 cents to $26.92. Over the year, average hourly earnings have increased by 71 cents, or 2.7%.

With the U.S. economy currently in the second longest expansion in the post-war period, the pool of available workers continues to shrink. Broader measures of unemployment and underemployment have shown improvement. The U-6 rate, which includes those workers marginally attached to the labor force but have given up looking for work, as well as underemployed workers who would prefer full-time jobs, was 7.6% in May, down from a seasonally-adjusted rate of 8.4% in May 2017, according to the BLS.

Risks of Full-Blown Trade War Grows with Extension of Steel, Aluminum Tariffs

In late May, the Trump administration announced it would extend steel and aluminum tariffs to Canada, Mexico and countries within the European Union. Since March, those countries that weren’t exempt (mainly China), were hit with a 25% tariff on steel imports and a 10% tariff on aluminum tariffs. The U.S. is also threatening additional tariffs of as much as 25% on imported cars and parts.

Close to home, imposing the steel and aluminum tariffs on Canada and Mexico has added to the breakdown in discussions to renegotiate the North American Free Trade Agreement (NAFTA). In early June, Mexico announced that it would place tariffs and duties on about $3 billion worth of American goods, including a 20% tariff on pork products, and 20% duties on apples and potatoes and a 20% to 25% duty on some cheeses and bourbon.

U.S. farmers have benefited from a fivefold increase in American exports to Mexico over the last 25 years and escalating trade tensions put that growth at risk, Farmers for Free Trade said in a statement on Mexico’s retaliation to the imposition of steel and aluminum tariffs. “Farmers need certainty and open markets to make ends meet. Right now they are getting chaos and protectionism,” the trade group said.

For its part, the European Union is finalizing a list of up to €2.8 billion worth of tariffs on the U.S. that would include steel and other industrial and agricultural products, as well as bourbon, peanut butter, cranberries and orange juice. These tariffs would be set to go into effect on July 1.

The steel and aluminum tariffs are resulting in higher materials prices for U.S. manufacturers, leading them to raise prices on the goods they sell, while some manufacturers are also turning to importing cheaper materials that aren’t subject to the tariffs. Manufacturers are also concerned the escalating tariff fight with key trading partners will hurt the construction sector and cool manufacturing and construction job growth.

Nearly two-thirds (63%) of commercial construction contractors identified fluctuations in steel prices as their top material concern in the second quarter USG + U.S. Chamber of Commerce Commercial Construction Index, a quarterly index that gauges the outlook and confidence in the construction industry. That compares to 30% of contractors who expressed concerns in the second quarter of 2017 and the largest fluctuation in contractor sentiment to date, the U.S. Chamber said.

“Steel and aluminum tariffs and continued workforce shortages threaten to slow the industry’s growth and job creation,” Thomas J. Donohue, president and CEO of the U.S. Chamber, said in the press release for the Commercial Construction Index.

Similar sentiment was expressed in the recent Manufacturing ISM Report on Business. Economic activity expanded with the ISM purchasing manager’s index (PMI) increasing by 1.4 percentage points in May to 58.7. ISM’s new orders index rose 2.5 percentage points to 63.7 compared to April’s reading, remaining at 60 or above for the 13th straight month.

Manufacturers continue to cite the effects of aluminum and steel tariffs, labor shortages and transportation disruptions. Higher fuel prices and other increased costs are being passed on from their suppliers and some manufacturers also reported that they are seeking out alternatives to Chinese-sourced metals.

Real Estate: Cracks Start to Appear in Commercial Mortgage Underwriting Standards

The criteria used to underwrite loans in the commercial property market deteriorated in the first quarter of 2018, a sign that some late-cycle characteristics common in 2007 just before the financial crisis are making an unwelcome comeback. Rating agency Moody’s Investors Service cited record levels of interest-only loans and single-tenant exposure in its quarterly report on the U.S. commercial mortgage-backed securities market (CMBS).

The report, issued June 1, noted that leverage remained high and the amount of debt service coverage – or the relationship between a property’s annual net operating income to its annual mortgage principal and interest payments – deteriorated. Partly offsetting those concerns, debt service coverage and interest rates remained at historically favorable levels.

“In a reminder of late 2006-early 2007, interest-only loans represented more than three quarters of US CMBS conduit pools in the opening quarter of 2018, while full-term interest-only loans accounted for almost half of all pools,” Kevin Fagan, Moody’s vice president and senior analyst, said in a statement announcing the report’s findings. “We consider this a significant negative credit trend, as well as an important warning sign of deteriorating underwriting standards.”

Conduit loans are loans issued to be placed in a pool with other loans and securitized as commercial mortgage-backed securities. Moody’s findings indicate some potential cracks in the nation’s office market.

Asking rents are still rising but not at the same pace as tenant improvement packages landlords are willing to provide to businesses looking to lease space. According to Jones Lang LaSalle, direct asking rents increased 1.6% in the first quarter, while tenant improvement allowances rose by 3.5%. Also during the first quarter, net absorption, the net change in physically occupied office space, was at its lowest annualized level since 2010.

Moody’s report also notes that the share of properties with a single tenant or high tenant concentration continued to steadily rise in the first quarter. This has increased the exposure to cash flow volatility – a key factor in CMBS deals as interest payments received on the pool of loans is paid monthly to investors.

Moody’s said about 44% of office loans in the first quarter were backed by properties with high single tenant exposure, a peak for “CMBS 2.0 deals” – or CMBS transactions issued post 2009 in which the underlying loans were more conservatively underwritten than those prior to 2009.

Residential Market: Demand Strong for What’s Available to Buyers

Continual inventory shortages and higher prices resulted in a sales slump in April in the existing homes market. Total sales (including homes, townhouse and condos) fell 2.5% from the previous month to a seasonally-adjusted rate of 5.46 million. The pace of sales is now off by 1.4% from a year ago and sales have fallen on a year-over-year basis for two months, according to the National Association of Realtors (NAR), which released its figures in late May.

Total housing inventory is 6.3% below what it was a year ago and has fallen year-over-year for 35 months. Despite higher prices and rising mortgage rates, which reached their highest level in seven years in the week ending May 24, demand remains strong for available inventory. NAR said properties typically stayed on the market for 26 days in April, down from 30 days in February and 29 days a year ago, while 57% of homes sold in April were on the market for less than a month.

“Since NAR began tracking this data in May 2011, the median days a listing was on the market was at an all-time low in April, and the share of homes sold in less than a month was at an all-time high,” Lawrence Yun, NAR’s chief economist, said in the release announcing the latest sales figures.

As of June 7, mortgage rates have fallen for two consecutive weeks, according to Freddie Mac. That led to a seasonally-adjusted 4.1% week-to-week pick up in mortgage application activity for the week ended June 6, as tracked by the Mortgage Bankers Association’s Market Composite Index – a measure of mortgage loan application volume.

Still, reflecting the pace of home price appreciation in recent years and 2018’s higher mortgage rates, Freddie Mac noted in its Primary Mortgage Market Survey released June 7 that the growth rate of purchase loan balances has moderated thus far this year – particularly in March – indicating that buyers are having difficulty stretching to keep up with the pace of home-price growth.



Global Stocks: U.S. Markets Outperformed Most Other Developed, Emerging Markets in May

U.S. stocks were generally the place for investors to be in May with the major indexes each up for the month and small capitalization stocks continuing their outperformance. The political crisis in Italy in late May pressured stocks in that country as well as shares in other countries in Europe. Emerging markets stocks also sold off, particularly in Brazil as the country’s economy was negatively impacted by a 10-day strike by truckers protesting rising fuel prices.

Tech Shares Drive U.S. Price Gains

In the U.S., the technology sector drove monthly results in May for the S&P 500 with technology shares responsible for 76.5% of the S&P 500’s 2.16% price gains. The technology sector was up 7.03% this past month and has gained 10.60% since the start of the year. Without the sector’s contribution this year (representing 133.6% of the S&P 500’s gains, an indication of the heavy capitalization weight of tech stocks in the index), the S&P 500 (which is up 1.18% since the year began) would be in the red, according to S&P Dow Jones Indices.

The Dow Jones Industrial Average (DJIA) ended May up by 1.05%, but it is still off by 1.23% for the year. The tech-heavy Nasdaq Composite gained 5.32% for the month and is up 7.80% for the year.

Investors’ preference for technology shares, partly viewed as being insulated from trade-war risks and slowing global economic growth, also helped drive the Nasdaq Composite into record territory on June 4, closing at 7606.64. That beat a previous record the Nasdaq had set on March 12, closing at 7588.32.



It’s a reversal of fortunes, of sorts, for the tech sector which had sold off in March after the Nasdaq Composite’s record close. That sell off was driven by concerns over how Facebook handled user’s data, and whether companies such as Amazon and Google, as well as other companies with social media platforms, would face greater regulatory scrutiny.

In addition to the energy and materials sectors, information technology is expected to post faster growth than the broader S&P 500. According to FactSet, the technology sector is forecast to post second quarter earnings growth of 23.1% from the same period a year ago, compared to 18.9% for the S&P 500.

Another area of the U.S. stock market that continues to outperform is small cap stocks. The Russell 2000 gained 5.95% in May and is up 6.39% for the year. Small caps have attracted investors’ interest in recent months with the uncertainty surrounding U.S. trade policy, the lower tax rates small cap companies pay compared to previous years thanks to tax reform, and the strengthening U.S. dollar.

Based on other measures, small caps are outpacing large caps by the most in 16 years, according to S&P Dow Jones Indices. For example, the S&P SmallCap 600 gained 6.54% in May and is up 7.61% for the year. On a total return basis (including capital gains and reinvested dividends) the SmallCap 600 outpaced the S&P 500 by 9.5% in the three-month period through May. That was the biggest premium since a three-month period ending in May 2002. Outperformance between the two indexes that big in a three-month period has only happened 12 times since September 1989.

Apart from the positive factors noted above for the small cap sector in general, companies in the sector tend to have higher debt levels. This makes them more vulnerable than larger caps in a rising rate environment and tax reform also limits the amount of debt companies can deduct from their taxes, as noted in this BCJ Insights post in April.

“I think investors may be sort of cheering that tax-related benefit to small-caps without digesting the offset of that to some degree, which is that they’re more indebted and they get hurt a bit more on that interest expensing piece,” Liz Ann Sonders, senior vice president and chief investment strategist at Charles Schwab & Co., said in this June 5 article.

Europe: Italy’s Political Uncertainty Sparked Volatility, Driving Stocks Lower Toward the End of May

The Italian political crisis in late May added weight to the selling pressure to stocks in Europe toward the end of the month and sparked a sell off in other regions across the globe with the exception of the U.S. The MSCI Euro index, which includes large cap stocks across the 10 developed market countries within the Economic and Monetary Union, fell by 6.25% in May and is down by 4.30% for the year through the end of last month.

While the Five Star Movement and League parties in Italy did get approval in early June to form a new government, financial markets on the continent may continue to experience more-than-usual volatility, given that Italy is one of Europe’s largest economies, its banks hold large amounts of bad loans as well as Italian sovereign debt, and the government appears skeptical on the country’s commitment to the euro and European Union.

According to Wharton School Finance Professor Joao F. Gomes in this post, the risk of an unintended financial implosion with repercussions in European and international markets “remains very low. But we will go through yet another very disruptive year which will greatly damage the Italian economy and perhaps derail the recovery in Europe.”

Thus far in 2018 the region’s economy continues to expand, though data has been mixed. Compared to the same period in 2017, seasonally-adjusted GDP rose by 2.5% in the eurozone and by 2.4% in the EU28 in the first quarter of 2018, according to Eurostat. That followed year-over-year GDP growth of 2.8% and 2.7%, respectively, in the previous quarter.

However, investor confidence also slumped with the uncertainty in Italy and concerns over rising trade tensions with the U.S. Economic expectations from the sentix Economic Index, a survey of around 5,000 investors and their expectations for financial markets and economic developments, which fell to -13.3 in June, its lowest level since August 2012. That measure of sentiment has been in negative territory since April. The most recent negative reading shows that investors expect a serious slowdown in growth in the Eurozone, sentix GmbH said.

In addition, Germany, one of the main engines of economic growth, has been experiencing a slowdown in its services sector after business activity growth reached a near seven-year high in January, according to IHS Markit. The German Services PMI Business Activity Index fell to 52.1 in May from 53.0 in April. And the overall pace of manufacturing in the eurozone also showed further signs of cooling, with the IHS Markit Eurozone Manufacturing PMI posting a 15-month low of 55.5 in May. Input cost inflation rose for the first time in four months.

This month, the European Central Bank will likely take into account the impact of tariffs, the softer economic data and the recent volatility in stock and sovereign bond markets as it weighs whether or not it will wind down its €30 billion bond-buying program in the coming months; this may bear watching.

Rotation into Defensive Sectors Well Underway in Japan’s Equity Market

In Japan, what some consider to be a leading indicator in that country’s stock market for a potential slowdown in global growth has been playing out since the spike in volatility that spooked global markets in early February. Indexes compiled by Morgan Stanley Capital International (MSCI) show that defensive stocks have been outperforming cyclical stocks and the country’s broader market of mid cap and large cap shares.

“No one can really tell whether global stocks will go into a bear market,” Yoshinori Shigemi, a global market strategist at JPMorgan Asset Management Japan said in this May 18 report. “But when Japanese defensives outperform, it can be a leading indicator.”

In contrast to the U.S., where utilities, health care, consumer staples and real estate are all in negative territory for the year through May, these sectors in the Japanese stock market are outperforming cyclical sectors like information technology and industrials. “Japan is a cyclical stock market, and it could be reacting more sensitively to a possible slowdown in the U.S. economy,” Shigemi said.

Since early February, the MSCI Japan Defensive Sectors Index is up by 6.57% through the end of May, while the MSCI Japan Cyclical Sectors Index is down 3.31% and the broader MSCI Japan Index has declined by 1.13%.

Emerging Markets: Brazilian stocks were among the worst performers in emerging markets this past month, with the S&P Brazil BMI (Broad Market Index) declining by 16.37%., followed by Hungary which fell by 15.96%. Shares tracked by S&P Dow Jones Indices in Greece, Mexico and Turkey each posted declines of more than 13.0% – with stocks in Greece down by 14.96%.

Commodities: Oil Prices in Flux with Strong Demand, Potentially Offset by Loss of Production

According to the International Energy Agency, oil prices in recent months have been affected by market dynamics shaped by strong growth in demand, compliance within the Organization of the Petroleum Exporting Countries (OPEC) and key non-OPEC members who agreed to cut production in late 2016 and extended that agreement this past December, and the political and economic crisis in Venezuela. This has led to tighter overall market conditions.

Further implications for market balance may come from renewed sanctions on Iran (in early May, President Donald Trump pulled the U.S. out of a 2015 international agreement for Iran to reduce its nuclear facilities), which exports 2.5 million barrels of oil each day and is the world’s fifth-largest exporter, according to the IEA.

West Texas Intermediate (WTI) crude prices have risen by 11.0% since the beginning of the year through May, then declined by 2.2% for the month ending at $67.04 a barrel. Brent Crude, viewed as the international benchmark for oil, rose by 3.2% in May compared to the previous month to $77.59 a barrel. Since the beginning of the year, Brent Crude has gained 16.0%.

Brent Crude may have finished higher last month, but Saudi Arabia’s energy minister Khalid al-Falih said in late May that OPEC and its allies might increase production due to the supply strains from lack of production from Venezuela and the potential impact to the market due to sanctions on Iran.




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Sources for Financial Data:

Dow Jones Industrial Average:                                                                                                                                                       

S&P 500:                                                                                                                                                                             


Russell 2000:                                                                                                                    

S&P SmallCap 600:

MSCI Indexes:

Oil Prices:                                                                                                                                         


10-Year TIPS:                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          

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