by Connor Darrell CFA, Assistant Vice President – Head of Investments Equity markets endured another week of losses, with both the Nasdaq and S&P 500 entering correction territory (a correction is a technical term describing a decline of more than 10% from previous highs). International stocks continued their slide as well.
As is typical during periods of market stress, bonds generated positive returns as investors sought refuge from the volatility. Economic data released during the week suggested that rising interest rates may be impacting home buying decisions, as completed home sales declined meaningfully.
Volatility is Normal Around Mid Term Elections
After several quiet months, volatility has returned with a vengeance in October. We recently released a note that delineated some of the risks that have been blamed for the selloff, including rising interest rates, trade and tariffs, and geopolitics. We continue to believe that none of these issues are likely to fully derail the bull market, and further contend that the volatility we have experienced in recent weeks is normal for a mid-term election year. In fact, dating all the way back to the FDR administration, markets have averaged an intra year decline of 17% during mid-term election years, only to recover meaningfully over the following 12 months. Decades of market history have taught us that timing the markets is nearly impossible, and that selling too early could be just as detrimental as selling too late. The aura of uncertainty created around mid-term elections makes that endeavor even more difficult and given the strength of the underlying fundamentals that drive markets, maintaining a disciplined approach remains the most prudent course of action. Read our October Market Volatility Note
by Connor Darrell, Head of Investments Equity markets ended a bumpy week relatively flat after a strong rally on Tuesday was offset by Thursday’s selloff. A variety of geopolitical concerns – including the disappearance of journalist Jamal Khashoggi while in Saudi custody – weighed on investors’ minds. Bonds trended lower after the release of the minutes from the Federal Reserve’s September meeting, which suggested that policymakers expect to continue raising interest rates and would consider pushing them into “restrictive” territory in an effort to keep the economy from overheating.
The Fed Isn’t Going “Loco”
President Trump has made it no secret that he disapproves of the Federal Reserve’s decision to carry on with a steady pace of interest rate increases. It’s not surprising that a sitting president, who’s legacy is likely to be closely tied to the performance of the economy under his watch, would be opposed to monetary policy decisions designed to slow the growth of the U.S. economy. What is surprising however, is that he would express that opinion so publicly. In an interview this month, the President stated that he believes the Fed is “going loco” and is “out of control”.
There are a couple of things to keep in mind about the Fed’s job. The Fed’s primary function is to keep the economy from reaching extremes. That involves stepping in to reduce the pain during recession as well as keeping the economy from overheating during periods of expansion. The latter task is arguably even more important, because the worst economic periods throughout history have all been preceded by excessive risk taking and asset bubbles, which typically form during the latter stages of a bull market. Looking through the lens of history, the current interest rate environment can still be reasonably considered to be accommodative for economic growth, and the Fed will likely continue its pace of gradual rate hikes. All of this should be well understood by financial markets and should not lead to a sharp fall in stock or bond prices on its own.
by Connor Darrell, Head of Investments It was a difficult few days on Wall Street, and many investors have begun to wonder whether it is time to worry. Volatility has a way of surfacing just when investors are starting to feel comfortable, and it can make sticking to long-term plans exceptionally difficult. It seems like ages ago now, but many of us were in this same position of pondering the death of the bull market as recently as February of this year. But following the market sell-off in early 2018, markets were able to find their footing and eventually (briefly) regain new highs.
The market’s ascent occurred despite a difficult backdrop of escalating trade tensions, rising interest rates, and uncertainty regarding the future of monetary policy and the balance of power in Washington. The U.S. equity market was able to brush these things aside because companies were reporting strong earnings growth, the unemployment rate was near record low levels, and U.S. economic growth was accelerating. All these things (both the favorable and the unfavorable) are still true today. As is typical during long bull runs, the action we have observed over the past few trading days suggests that markets (potentially spooked by a modest but sudden jump in bond yields that occurred last week) are simply re-evaluating the risks we delineated above and their potential impacts on the forward outlook.
Ultimately, we are of the belief that the list of factors supporting markets far outweighs the list of potential concerns at this time, and we anticipate that markets will eventually arrive at the following conclusions:
The U.S. economy remains healthy (this is supported by the myriad of economic data we track on a regular basis and reiterated by comments made by Fed Chairman Jerome Powell just last week).
Monetary policy, while certainly moving in a restrictive direction, remains accommodative relative to history.
Interest rates are creeping up for the right reasons (healthy economic growth).
We anticipate that this bout of volatility will play out much like the last one. Our plan is to “stay the course” and believe clients will be well served to trust in their long-term financial plan. As human beings, we tend to focus on the short term. This is a natural inclination rooted in the “fight or flight” instincts that our ancestors relied upon for survival. The key to successful investing is to put these instincts aside and focus on the long term.
by Connor Darrell, Head of Investments Stocks and bonds both fell last week as interest rates moved markedly higher. The yield on the 10-Year Treasury note jumped to its highest level since 2011, and now sits at 3.23%. Interestingly, it seemed that the market movements were sparked by a “good news is bad news” type scenario, where Fed Chair Jerome Powell’s comments that the economy is “firing on all cylinders” prompted concerns of an acceleration in the tightening of monetary policy.
Rising Rates are Nothing to Fear The activity in markets last week was a microcosm of what many market strategists have feared a rising interest rate environment might create; a period of pressure on both stocks and bonds, where both asset classes struggle to generate positive returns and leave investors with nowhere to “hide”. While it is true that rising interest rates may represent headwinds in both stock and bond markets, we believe there is an emerging opportunity to utilize short-term instruments in a way that has not been available to investors in a very long time. If rate increases continue on the schedule that seems to have been hinted at by the Federal Reserve (which has thus far been very effective at telegraphing its future policy changes), the yields available to short-term fixed income investors could be safely north of 3.5% by the end of next year. At these levels, short-term fixed income can provide stability in a portfolio while still preserving an investor’s spending power.
Bond investors should be further comforted by the fact that the yield curve has begun to steepen again. Historically, an inversion of the yield curve (which occurs when short-term rates move higher than long-term rates) has been a bearish signal for the economy and for markets. However, the yield movements we have observed recently suggest that the probability of yield curve inversion has declined. Investors have not had to grapple with a rising rate environment for quite some time and volatility should be expected moving forward as a result. But there are still reasons to remain optimistic about the forward outlook, and there are tools investors can utilize to help insulate their portfolios from any bumps along the way.
US equities continued to push higher during the third quarter, fueled by strong earnings growth and an improving economic backdrop. Barring a significant pullback in Q4, the US equity market is on pace to outperform its international counterparts for the seventh time in the past ten years. The fundamental strength in the US economy has helped US stocks shrug off the questions raised by the ongoing global trade saga, but international stocks, without the luxury of corporate tax reform boosting earnings and growth, have been unable to elude the risks of shifting global trade patterns and weakening currencies. Emerging markets have had a difficult year, and though there was a marked improvement over the volatility observed during Q2, risks in Turkey and Argentina have threatened to spill over into other markets and have made investors weary.
Bonds:
Bond returns have been flat to slightly negative in 2018, and we expect the headwinds posed by rising interest rates to continue until monetary tightening is paused, which doesn’t appear to be anytime in the immediate future. Federal Reserve Chairman Jerome Powell suggested at the end of September that the Fed anticipates rate hikes could continue into 2020, which would put the Fed Funds rate at about 3% by that time; just 0.25% below the current yield on a 30 Year Treasury. President Trump has made it clear that he is displeased with the Fed’s decision to continue hiking rates, but it is important to remember that the Fed is an independent body designed to operate free of political interference, and we do not expect the president’s comments to be an influencing factor in future monetary policy decisions.
Outlook:
The fourth quarter will bring with it some intriguing potential catalysts for markets, and there are a few key things that we are watching moving forward:
1. The Shape of the US Yield Curve
One of the most consistent themes of the past several years has been the flattening of the US yield curve (short term interest rates have risen faster than long term interest rates). Historically, a flattening yield curve has been a bearish signal for markets and the economy, prompting many to wonder if the bull market was finaly winding down. However, we saw a small but meaningful break from this pattern at the end of the third quarter, and one reason for this may have been an increase in inflation expectations.
2. US Inflation
Throughout this prolonged economic recovery, inflationary pressure has been conspicuously absent. But with tightening labor conditions and rising oil prices, it would not be surprising to see inflation finally become a factor for the Fed to ponder when it considers its next policy move. Higher inflation would likely force the Fed to keep its policy of increasing interest rates intact for longer.
3. Mid Term Elections
It is no secret that the Trump Administration has made it a key policy initiative to focus on US trade policy, and the negotiating tactics that have been utilized have caused some disruption in global markets.
Depending on the impact that the mid term elections have the President’s political capital, he may be forced to take a more passive stance. If that happens, international equities (and emerging markets in particular) may find their footing as some of the uncertainty created by trade rhetoric fades to the backdrop.
VIDEO: Q3 Market Commentary – Connor Darrell, Head of Investments, shares Valley National Financial Advisors’ review of the third quarter, and a fourth quarter outlook. WATCH NOW
by Connor Darrell, Head of Investments As was anticipated by markets, the Federal Reserve increased interest rates last week and officially removed the word “accommodative” from its description of current monetary policy. While parsing words can be trivial, the Fed selects its language very carefully when crafting its statements, and the change represents a symbolic shift in how the Fed views the current rate environment. The days of “easy money” policies are now officially behind us.
Global equity markets were slightly negative in the final week of the third quarter, with U.S. markets pulling back slightly from the all-time highs achieved the week prior. Investors’ attention will now turn to Q3 earnings season, which officially kicks off next week. Factset is currently predicting Q3 earnings growth of 19.3% for S&P 500 companies, which would mark the third highest growth rate since the first quarter of 2011.
by Connor Darrell, Head of Investments U.S. large cap stocks reached new all-time highs last week as both the Dow Jones Industrial Average and the S&P 500 managed to climb above their January peaks. Financial stocks led the way due to an increase in longer-term bond yields, which bodes well for bank margins. It was also a nice bounce back week for international stocks, with both developed and emerging markets equities climbing well over 2%.
Bonds produced modestly negative returns as the yield curve steepened considerably. The yield on a 10-year U.S. Treasury bond now stands at 3.07%, and the Federal Reserve is widely expected to increase interest rates following its meeting this Wednesday. Bond yields could continue creeping higher depending on Chairman Jerome Powell’s post meeting comments on future policy decisions.
Watching Only the S&P 500 Doesn’t Provide a Complete Picture The S&P 500 is up more than 11% in 2018, climbing higher as a result of a healthy economic backdrop. However, after leading the way in what was a strong 2017 global equity market, foreign markets have struggled to keep pace in 2018. Emerging markets have been troubled by a strong dollar and some major uncertainty in some regions (Brazil, Argentina, and Turkey have been the main culprits), and developed markets have also struggled as economic growth has cooled in Europe.
Investors who (prudently) own a broadly diversified global portfolio may feel somewhat disappointed in their returns thus far this year, especially if they are using the S&P 500 as their benchmark (which we don’t recommend). But it is good to remember why diversification is so important, especially as U.S. equity markets are near all-time highs. An allocation to international stocks was additive to returns in 2017, and while that leadership was short-lived, it is impossible to predict when the pendulum will swing back the other way again. We don’t know when the next crisis will occur, but we can be virtually certain that it will eventually happen. As investors, the best thing we can do is own a variety of uncorrelated assets with positive expected return over our investment horizon.
by Connor Darrell, Head of Investments Equity markets around the globe managed to climb higher last week as they recovered from a difficult start to the month. The constant strategic pivoting in the trade negotiations between the U.S. and its global trading partners (particularly China) has been the primary catalyst for markets over the course of 2018, and we expect this to remain the case at least until the mid-term elections in November. For better or for worse, polling data may begin to influence the aggressiveness of President Trump’s negotiating tactics as he strives to rally voters and keep the Republican majority in the legislative branch. In the meantime, investors will need to keep focusing on fundamentals and accept that daily headlines may foster a particularly “noisy” few weeks.
August inflation data indicated that prices rose 2.7% year over year, marking the first month in 2018 where the rate of inflation cooled. The Federal Reserve’s next policy meeting is next week, and markets are expecting another 0.25% interest rate hike.
Monetary Policy Primer With the Federal Reserve meeting again next week, we thought it might be a useful exercise to discuss the basics of monetary policy and the role of the central bank in monitoring/influencing the economy.
As the U.S. economy emerged from the depths of the financial crisis, the Federal Reserve implemented multiple rounds of an aggressive monetary policy initiative known as quantitative easing (QE). At its core, QE involves actively purchasing bonds on the open market while simultaneously lowering the short-term interest rate in the economy. Both actions work together to keep interest rates on all maturities artificially low. The theory is that lower interest rates make it more palatable for businesses to borrow money and invest in growth opportunities, stimulating the economy. Ten years later, rates are still very low in historical terms, and the U.S. stock market has benefitted from the decade of “easy money” policies. However, as the economy heats up and evidence mounts that it can stand on its own footing, the Federal Reserve must now unwind its actions and begin pushing the economy to a more “normal” state.
The influence of the central bank has certainly expanded during the 21st century, and QE was in many ways an experimental policy. Never in history had central banks implemented such a bold and large-scale policy initiative aimed at actively combating a recession. So far, with the U.S. economy looking quite healthy, it appears to have been a success. But it should be noted that we have not yet seen this play out in its entirety, and only time will tell whether the policy was optimally implemented. The one thing that seems certain however, is that it helped to support the U.S. stock market over the past 10 years. Following the 2008 recession, the U.S. stock market took only four years to recover and reach its previous highs. This is in stark contrast to the recovery following the Great Depression, when it took more than 10 years, plus the organic stimulus of a world war, to finally reach the previous market peak.
by Connor Darrell, Head of Investments Stocks trended lower last week with U.S.-China trade tensions again taking the blame for the market’s weakness. Friday brought news that the U.S. economy added a higher than expected 201,000 jobs in August, causing interest rates to jump higher amid speculation that the Fed would be more likely to keep its current pace of rate hikes. Internationally, the uncertainty surrounding global trade has made it difficult for companies to make investment decisions and has weighed on stocks. International stock markets (in both developed and emerging countries) were down close to 3%.
Preparing for the Next Storm With many on the eastern seaboard bracing for the impacts of Hurricane Florence, it seems appropriate to evaluate what investors can be doing to prepare their portfolios for the next storm in financial markets. In the tenth year of a healthy bull market, the action plan for many investors should simply be to rebalance and re-evaluate their changing goals. A global investor who has remained disciplined throughout the last 10 years is likely to now be overweight stocks relative to bonds, and overweight U.S. equities relative to international equities simply as a result of how market returns have been distributed over that time. As a result, that same portfolio is likely to contain more risk (as a result of the higher allocation to stocks) than it did 10 years ago despite the investor being 10 years closer to retirement (which would typically call for a more conservative portfolio). As bond yields continue to creep higher, the rebalancing required to bring a portfolio back to its target allocation is likely to become easier to stomach since the relative income from bonds will be more favorable.
by Connor Darrell, Head of Investments Trading activity was expectedly below average last week, as many investors were more likely focusing on the upcoming holiday weekend than on the limited new developments in global markets. With Q2 earnings season finally winding down, trade policy once again took back the spotlight. Stocks reacted positively to improving relations between the U.S. and Mexico, but some of the positive momentum was lost on Friday when it became clear that Canada was not ready to take part in any new trade agreements.
The S&P 500 managed to climb about 1% on the week, with international markets positive as well. The bond market was largely flat.
A Note on “Short-Termism” There is an argument gaining traction that investors are too “short-term” focused, which leads to inefficient decision making at the executive level in response to shareholder demands that do not align with a long-term view of value creation. This argument is the essence of why Elon Musk made headlines earlier this month, claiming he desired to take the company private to avoid the incessant demands heavy scrutiny of public shareholders. It is also the core of a new bill being proposed in Washington aimed at taking power from shareholders and giving it to employees and the government.
Ironically, Tesla itself is a perfect example of shareholders not falling into the trap of “short-termism.” Tesla currently reports losses on its income statements on a regular basis due to its heavy investment in new technologies. In other words, Tesla doesn’t actually make any money because it invests all of its revenues back into research and development. However, the market values Tesla at about $13 billion dollars, more than it does Ford and about equal to General Motors, both of which have a much larger foothold on the automobile marketplace and are considerably more profitable. The reason that markets value Tesla so highly is precisely because there is an expectation that down the road, Tesla will be more profitable than both Ford and GM. Shareholders and the investment community at large do a tremendous job of taking a long-term view, and serve a pivotal role in keeping corporate decision makers accountable for properly running their respective businesses.
