HIGHLIGHTS:
Renewed fears sparked a bout of equity selling in October.
A healthy U.S. economy is helping generate strong earnings growth.
China trade tensions and Fed interest rate increases remain the key market worries.
Via Nova’s outlook remains positive, but risks remain.
Renewed fears sparked a bout of equity selling in October.
Volatility, the regular ups and downs in the stock and bond markets, is a disturbing but recurring part of the investing landscape. Milder declines in the stock market, between -10% and -20% from the most recent peak, are referred to as corrections, and they happen about once a year on average, according to research from BMO Capital Markets. Declines of over -20% are labeled bear markets, and there have been ten bear markets over the past 70 years. Bear markets are usually associated with economic recessions, falling profits and rising unemployment, which is why Via Nova devotes considerable attention to and analysis of the health and momentum of the economy and corporate earnings.
After a relatively quiet summer and a recovery to fresh record highs, market volatility returned with a vengeance in October pushing stocks near correction territory before bouncing higher in the final two trading days. The S&P 500 did not technically enter a correction in October, based on the strict definition of the term (just -9.9% using daily closing prices), but it was close enough for most of us. Trade tensions with China and fears of faster interest rate increases from the Federal Reserve, the longstanding market concerns, were cited as major reasons for the drop.
The S&P 500 fell -6.84% for the month, in what was a broad selloff. Nine of the eleven sectors declined paced by discretionary, energy and industrial stocks. Only the more defensive staples and utilities sectors eked out gains. Small cap, international and emerging market stocks underperformed the S&P 500 rounding out a rough month for the global stock market.
Bond returns also declined during the month, as interest rates continued trending higher. The yield on the 10-year Treasury note closed at 3.16%, near its recent high, and the Bloomberg Barclays Aggregate Bond Index fell -0.83%. In other markets, anxiety pushed the value of the dollar up over 2% higher. Energy prices fell sharply on concerns of excess supply, but gold prices rose.
A healthy U.S. economy is helping generate strong earnings growth.
The latest round of economic reports pointed to a continued healthy domestic economy. The economy grew at a strong 3.5% annual rate in the third quarter, and inflation surprisingly slowed to below the Federal Reserve’s target. The consumer data, representing roughly 70% of the economy, was vibrant, and business activity and confidence continued at high levels. Leading economic indicators rose more than expected, suggesting continued favorable economic momentum in the months ahead with a limited chance of recession. The one area of softness appears to be the housing market, which has slowed moderately over the course of 2018. Rising mortgage rates and higher building costs have been dampeners on an otherwise encouraging picture.
Third quarter corporate earnings reports are handily beating expectations. With nearly three-quarters of companies reporting, profits are now forecast to rise just over 27% compared with an estimate of just 21.5% at the beginning of October and 25% growth in the second quarter. With earnings projected to rise roughly 10% over the next year, the decline in equity prices in October made valuations, as measured by the forward price /earnings ratio, cheaper than the five-year average making the market more attractive for investors.
China trade tensions and Fed interest rate increases remain the key market worries.
Concerns about escalating trade tensions with China and the pace of Federal Reserve rate increases acted as a one-two punch for the stock market in October, and neither is likely to be resolved quickly. Markets gyrated on the latest tweaks regarding the progress or lack of progress on China trade negotiations. Talks between Presidents Trump and Xi are scheduled around Thanksgiving, but no specific details have been mentioned. The market concern is that, if trade tariffs increase, business costs are likely to rise and add to inflation pressures; both of which are headwinds to the stock market.
Higher interest rates are also a potential threat to the economy and stock market valuations, so Federal Reserve policy is an important variable. The Fed currently sees the continued strength in the economy as good news, but fears that higher inflation is just around the corner. Since Federal Reserve actions typically impact the economy and inflation only after a lag, Fed officials are concerned about moving too slowly to curb a potential acceleration in inflation. The recent rise in mortgage rates appears to have already slowed housing activity.
Via Nova’s outlook remains positive, but risks remain.
Via Nova remains positive on the economy and the equity markets for the remainder of 2018 and into 2019. The facts of a healthy economy and strong earnings growth justify a bias in favor of equities and away from bonds. The risks of recession are very low at present suggesting a favorable environment for corporate sales and earnings growth and firm support for stock prices. However, the fears of excessive monetary tightening and escalating trade tensions with China remain a cloud of doubt over an otherwise positive outlook.
Via Nova’s most likely scenario in the months ahead is that the Federal Reserve will not raise interest rates too rapidly and short-circuit the current expansion. Interest rates are still historically low, and borrowers are still able to obtain loans. While the Fed could make a policy mistake, it is not likely at this point. Still, we believe interest rates are heading higher, and so we favor stocks over bonds.
We also believe that a global trade war is unlikely. Markets often extrapolate negative initial events to a dire conclusion. We believe that is the case here, as it would be negative for all parties. The recent negotiation breakthroughs related to NAFTA and, to a lesser extent, the EU, suggest a favorable resolution is attainable. Still, we are monitoring events closely for signs of notable deterioration.
Pundits forecast that the Republicans will likely lose control of the House but retain control of the Senate in the midterm Congressional elections. History shows that the party in power usually loses seats at this time, so a shift would not come as a surprise. A split Congress often spells gridlock, which can be good for the financial markets, because taxes and regulations are less likely to change giving businesses a clearer vision for planning. Also, historically, the stock market rises following the election and continues higher through the end of the year.
Via Nova believes that, while the Congressional elections will shortly be behind us, the fear of trade tensions and higher interest rates will not magically disappear overnight, but rather will linger unresolved for a least a few more months if not longer.The Federal Reserve’s policy decisions will reflect the evolution of economic data, both positive and negative, and they have a history of reaching consensus only after considerable analysis.On the trade front, international negotiations tend to move forward at a glacial pace often measured in years.While the Trump administration’s aggressive tactics may add a sense of urgency to the discussions, we believe that significant progress with China is unlikely for at least several months if not longer.If progress continues in trade negotiations, international stocks could rebound following months of lagging performance.