Normally I use this piece in part to recap the events and trends from the previous quarter that moved markets. As it happened, however, the third quarter was strong but quite uneventful for markets. Stocks marched, with minimal volatility, up to their all-time highs in late September with relatively little resistance from investors, who seemingly had become somewhat complacent and comfortable. Over the summer, investors apparently focused on the strong economic data and paid little mind to growing trade tensions with China, creeping interest rates and the political battle in Washington.
Stocks Reverse Course
After notching its best single quarter since 2013, the U.S. stock market went into reverse in the first two weeks of October. As I write this, on October 17th, the equity markets had rebounded somewhat from a 7% stumble, but it is clear investors have adopted a more circumspect tone as companies begin to report their third quarter results.
While it is always impossible to quantify accurately what provoked a sudden change in investor sentiment, two issues are clearly on investors’ minds even as strong economic expansion and rapid corporate earnings growth continues unabated.
Interest Rates Climb
First, interest rates have been rising. The Federal Reserve increased short-term rates by 25 basis points to a range of 2%-2.25% on September 26thand will probably hike rates again by 25 basis points in December and a least a couple more times in 2019. Meanwhile, the yield on the 10-year Treasury note, which the Fed does not control explicitly, reached 3.23%, its highest level in seven years. The idea behind raising interest rates is to slow a hot economy and thereby to keep inflation under control. By making mortgages, car loans and corporate financing more expensive, the Fed can cool down economic growth. Investors may be starting to worry, however, that the Fed may be acting too hastily and will ultimately cause a recession if it raises rates too quickly.
Trade Worries Intensify
Second, trade tensions with China are worsening, and investors seem to be girding for the economic realities of the trade spat to start to show up in our economic statistics. Already global supply chains and certain industries have been negatively impacted. If the threatened 25% tariff on $200 billion of Chinese goods starts as planned on January 1st(up from 10% currently) many goods will become significantly more expensive overnight, potentially leading to inflationary pressures and additional Chinese retaliation. Over the summer, the U.S. reached trade accommodations with Mexico and Canada. Investors were perhaps expecting that progress with the Chinese would also be forthcoming. However, there has apparently been no headway with China as yet, and, if anything, the respective parties appear to have dug their heels in deeper.
But Economy Still Stable
As we near the end of the year, the U.S. economy remains in solid shape. While corporate earnings growth has been very strong so far in 2018, we expect a slowing in the rate of growth in 2019 as the benefits from the corporate tax cuts are lapped and financial conditions tighten.
While market declines are not pleasant, investors need to remind themselves that periodic declines of 5% or more are simply part of the equity investing landscape. In the last thirty-one years, according to Yardeni Research, the S&P 500 Index has incurred 23 “corrections” of 5% or more. Three of these declines resulted in bear markets, where the index lost 20% or more of its value off the top. Now, with the benefit of hindsight, in how many of those 23 cases did it make sense to just stay invested and not react to market volatility? 100% of them.
Please don’t hesitate to contact me if you would like to discuss your portfolio or the markets.