Midterms, solid fundamentals to propel markets into 2019

William Arthur Ward wrote, “The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.”

As the euphoria inspired by tax reform faded in the second quarter, the U.S. stock market’s wall of worry continued to grow, obscuring solid fundamentals.

Amid rising uncertainty and market angst, Ward’s words can serve as a helpful guide for investors. Even seasoned professionals sometimes succumb to the fears (and hopes) of the day.

{mosads}Should investors worry? Perhaps not so much. In election years, stocks historically have traded sideways until September, turning higher as the election nears and policy uncertainty diminishes.

Markets should rally: Since 1950, the U.S. stock market has not seen a negative return in the 12 months following a midterm election. In those periods, the S&P 500 went up 15 percent on average.

After several years of “lower-quality” earnings driven largely by cost-cutting and share repurchases, stronger organic growth — the best since the last financial crisis — demonstrates that U.S. companies truly are growing.

Capital spending trends appear healthy and should be important drivers for equities in the second half of the year. Consensus expectation for second-quarter GDP growth is 3.4 percent, a meaningful uptick from the first-quarter 2.2 percent.

Fiscal stimulus from tax reform is still in the early stages of entering the economy. It is a common fallacy that blockbuster first-quarter earnings were entirely a function of the reforms. S&P 500 earnings were up 26 percent on a year-over-year (YoY) basis.

However, removing the one-time benefits from tax reform, earnings grew at a still-impressive 18 percent. Even more impressive is the 7.5 percent YoY revenue growth, among the highest since the financial crisis.

Recession risks should remain low as President Donald Trump moves into his third year: Over the past 70 years, the U.S. economy has never seen a recession in a presidential term’s third year.

These developments point to a domestic economy and U.S. equity markets that will grind higher in the back half of 2018 and into early 2019. Investors can expect near-term market volatility to remain elevated.

Heightening trade tensions and the midterm elections top the list of risks that could sidetrack investors who pay too much attention to what we view as short-term noise.

Economic fundamentals remain robust

Despite recent tariff issues, U.S. small business expansion plans continue to surge. CEO and consumer confidence remain elevated despite the constant barrage of trade concerns. A gauge of the business cycle, Manufacturing PMI New Orders, has been higher than 60 for 13 consecutive months, its longest stretch since the early 1970s. This affirms a sustained economic uptrend.

Loan delinquencies (commercial and industrial) are in decline, and lending standards are easing. While this behavior is more typically associated with the earlier days of an economic cycle than the middle portion, it shows that credit conditions remain loose despite central bank tightening.

The labor market, the plow horse of the recovery, continues to tighten. The unemployment rate of 3.8 percent is near its lowest level in 20 years. For the first time, there are more job openings than unemployed persons. Initial jobless claims as a percent of total employment are at the lowest level ever.

Compensation also continues to trend upward. Wages increased 2.7 percent and total hours were up 2.1 percent in May, making annual earnings rise by 4.8 percent over the last year. This is more than enough to keep consumer spending trends healthy for the foreseeable future.

As Ward suggests, it is important for investors to focus on the fundamentals of robust organic earnings and a strengthening economy, rather than the noise emanating from the wall of worry. In fact, it just might be time to adjust and capitalize on these tailwinds.

Jeffrey Schulze is a director at ClearBridge Investments, a subsidiary of Legg Mason. His opinions are not meant to be viewed as investment advice or a solicitation for investment. He is frequently quoted in the financial media, including the Wall Street Journal, CNBC and CNN.