In an unusual showing, stocks—as measured by the S&P 500—advanced with relative strength in the third quarter. Early October has seen a pullback which, as of this writing, has yet to be contained. Mid-October is traditionally the start of the year-end rally, and midterm election years are even more positive. We think we will see this again, but from lower levels than expected.
The third quarter was reflective of strong economic numbers. Real GDP growth advanced in excess of 4% in the second quarter, a pace that was likely maintained in the third as the U.S. consumer remained a workhorse and unemployment remained low. There is evidence, however, that growth may be slowing, with housing and auto sales topping. The most common explanation is the recent sharp rise in interest rates.
We think GDP growth will slow to the 2 to 3% range over the next two years, with no recession in sight. While this is slower than recent experience, it is still far better than the 1.75% growth trend we experienced as little as two years ago. Some have argued that the effects of recent tax cuts are about to run out. We doubt this is the case, and deregulation and capital investment plans are good omens for future growth. It is notable that credit spreads are well-contained and the 2-year U.S. Treasury yield has a positive slope. Historically, both have peaked well before a serious equity downturn and recession.
A big concern in the longer-term is whether inflation will remain in check. This will matter fundamentally to Federal Reserve policymakers in their quest to normalize interest rates. Yes, inflation and interest rates are going up, but the pace of the increases seems key. Normalizing monetary policy at a speed that does not cause the yield curve to invert is important. A further quarter-point increase in the Fed funds rate in December would seem manageable, but we expect that the occurrence of increases in 2019 will be dialed back as long as inflation remains contained.