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The U.S. Bull Market Has Legs, But Investors Should Be Aware That Risks Are Elevated

The summer doldrums may have come early this year, with stocks quietly moving higher and volatility hovering near historic lows. And why not? Goldilocks appears to have arrived—low interest rates, improving earnings, a strong labor market, calm inflation, and still-accommodative monetary policy. And in spite of stocks trading around record highs, sentiment remains relatively contained, with the Ned Davis Research (NDR) Daily Trading Composite remaining in neutral territory.

But, as always, there are clouds on the horizon and pullbacks are possible at any time so it's important for investors to remain vigilant in keeping a diversified portfolio with appropriate risk exposure. In keeping with the Goldilocks theme, we’ll point out three potential pitfalls, or bears, worth watching: an economic slowdown, a domestic political implosion, or a geopolitical blowup. None appear to be imminent, but either of the latter two could appear suddenly.   

Goldilocks economy, but frustrating

A little over a month in to the second quarter and it again looks like we're seeing a bounce back from a rough first quarter. Following an upwardly-revised 1.2% real gross domestic product (GDP) reading for the first quarter, the Atlanta Fed's GDPNow forecast is 3.4% for the second quarter, with the consumer appearing to lead the way. First quarter personal consumption expenditures were revised higher to a 0.6% rate of growth from the initial 0.3%; which was followed by a solid gain in personal spending of 0.4% month-over-month in April. This has helped the "hard" data play a little catch up to the still-strong "soft" data; notably the still-healthy 117.9 reading of Consumer Confidence as measured by The Conference Board.

Confidence is aided by a strong labor market, despite the weaker-than-expected payroll increase of 138,000 announced with the May Department of Labor report. The modestly softer report isn’t all that surprising as labor market tightness results in fewer available workers, which has helped bring the unemployment rate down a tenth to 4.3%. Adding to the Goldilocks economic scenario is contained inflation and still-subdued wage growth—average hourly earnings (AHE) are growing at a tepid 2.5% year-over-year. Other measures—like the Atlanta Fed's Wage Tracker—show higher rates of wage growth, which is worth watching.

Unfortunately, there is a darker side to this golden scenario. The unemployment rate is below what most economists believe is "full employment," also known as the non-accelerating inflation rate of unemployment (NAIRU), which is believed by a consensus of economists to be about 4.8% according to Macroeconomic Advisors. In theory, this means that wage inflation should start accelerating; which may be initially good for consumers, but could crimp profits and likely push the Fed to be more aggressive. Additionally, with the United States above full employment, it may be tough to get the economy to grow noticeably faster. In order to achieve faster growth, the participation rate will have to move higher—unlikely due to demographic forces; or productivity will have to increase—which doesn’t appear on the horizon.

We believe, an economic outlook of "more of the same" doesn't necessarily mean bad things for stocks, as modest growth with low inflation has tended to be a good environment for equities; much as it has during this entire recovery/expansion.

Important Disclosure
This material is issued by Charles Schwab, Hong Kong, Ltd. The information provided here is for general informational purposes only and has not been reviewed by the Securities and Futures Commission in Hong Kong.

To view the full article, please go to page top to download the PDF version.

Content provided by Charles Schwab, Hong Kong
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