The first two weeks of October have seen heavy selling in the equity markets as major indexes are now approaching correction territory off their recent record highs. As of the close of trading on October 11, both the Dow Jones Industrial Average and the S&P 500® had declined almost 7% since October 3 and September 20, respectively. The Nasdaq has dropped just shy of 10% from its late-August high.
Given this market activity, we would like to emphasize the following points to investors:
- We believe economic and market fundamentals continue to remain strong.
- In our opinion, recent market volatility is being driven mostly by rising short- and long-term interest rates.
- Rate hikes will likely continue, but those will largely be due to a continued strong U.S. economy.
- The market is dealing with a different type of Federal Reserve than it has seen in recent years.
- The yield curve has steepened in recent weeks, which is a welcome development.
- While short-term volatility could continue, our equity market outlook remains favorable.
- The current bond market environment likely favors low-duration, actively managed credit-oriented strategies.
We continue to believe that the underlying market fundamentals remain strong. As we’ve stated in our previous commentaries, 2018 could very well be the first calendar year of 3%-plus U.S. GDP growth in more than a decade. In 2Q18, the economy posted its strongest showing in three years at 4.2%, and estimates for the recently concluded 3Q18 remain strong as well. Following upward revisions to the July and August Nonfarm Payroll Reports, September’s unemployment rate fell to 3.7% — its lowest level since 1969. We are also seeing continuing wage growth, which should prove favorable for consumer spending, a metric that drives about two-thirds of overall economic growth. Corporate earnings also look as though they will have another stellar quarter as S&P 500 earnings estimates for 3Q18 are currently at approximately 19% annualized growth.1 With this recent equity selloff, the S&P 500 12-month forward price-earnings multiple has dropped below 16 times, which we would view as reasonable given our belief that profits can continue to grow in the double-digit range over the next year. So while stocks have fallen, we believe the constructs underpinning them remain quite constructive.
The recent equity selloff, in our opinion, is first and foremost attributable to rising interest rates. Since the final week of August, the 10-year Treasury yield has increased more than 0.40% from 2.82% to Wednesday’s close of 3.23%, its highest level since May 2011. This has created concerns in the market that a higher interest rate environment could materially slow economic growth and erode the valuations of most stocks. While we don’t necessarily agree with these concerns, they are nonetheless impacting the markets.
We also believe much of the recent stock selloff has surrounded a changing interpretation of the Fed’s September 26 meeting. At this meeting, the Federal Open Market Committee, as expected, raised the federal funds rate to a target range of 2.00% – 2.25%. In addition, the Fed’s September statement removed the long-standing phrase “the stance of monetary policy remains accommodative” from its text, a change initially interpreted by some to mean that the Committee may be moving closer to ending the current tightening cycle, perhaps only raising rates two or three more times between now and the end of 2019. However, in the days since the September meeting concluded, recent economic news such as the September jobs reports, improving 3Q18 GDP estimates, and the favorable trade resolution of the U.S.-Mexico-Canada Agreement has led some to believe that we could see as many as four more hikes between now and the end of 2019. Post-meeting commentary from Chairman Jerome Powell also seemed to support this as he was quoted saying, “We’re a long way from neutral on interest rates.”
It is important to recognize that, in our opinion, the market views this Federal Reserve differently from others in the past. Previous Federal Reserves, such as the ones chaired by Ben Bernanke (2006–2014) and Janet Yellen (2014–2018), sustained long periods of near-zero short-term rates and also implemented quantitative easing, both of which were interpreted as being supportive of and, at times, directly bolstering financial markets. However, we believe this Powell-chaired Fed is different in that recent increases in short-term rates are directed at achieving a more historically normalized level of interest rates, best suited to match ongoing economic growth and inflationary trends — and in so doing, taking a longer-term view of the economy with less concern about short-term market disruption. This is more in line with how the Fed typically operated prior to Bernanke and Yellen. In our opinion, it’s a more appropriate means by which to administer monetary policy. However, it is not something the markets have been used to over the past decade.
At the current time, we believe there is a strong probability we will see another Fed funds rate hike in December and two or three more in 2019. While we claim no crystal ball on forecasting Fed rate increases, and of course any further hikes will be dependent on economic and inflationary developments over the next year, we do feel this trajectory is a likely one. A neutral federal funds rate of 3.00 – 3.25% over the next year or so seems rational at the present time. Most importantly, however, we believe it is vital to remember that rates will likely be rising in large part because of continued economic growth, and that will ultimately prove favorable for the equity and credit markets.
The yield curve has steepened in recent weeks, and this should be viewed favorably. There has been much speculation in recent months as to whether the slope of the Treasury term yield curve, in this case defined as the yield differential between 10-year and 2-year bonds, might become inverted, meaning that the shorter-term 2-year bond might move to a higher yield than the 10-year. Such a phenomenon has historically been interpreted as a harbinger of an upcoming recession, though this has not always proven to be the case. With the recent rise in the 10-year bond rate, the yield curve has now widened from a recent low of 0.16% on September 10 (2.89% vs. 2.73%) to 0.35% as of October 10 (3.23% vs. 2.88%) and thus moved further away from potential inversion. We would therefore view this recent steepening of the yield curve as a welcome development.
We continue to have a favorable outlook on the overall equity markets based on a strengthening economy and strong earnings growth. We believe stocks remain well positioned over the upcoming year based on the prospect of total returns in line with earnings growth, which could reach or exceed double digits. That said, investors will need to brace for more potential short-term volatility as some key technical levels in the market have been breached, meaning that overall trading could turn emotional at times, similar to how Wednesday’s action appeared to be. Hence, investors should consider a longer-term view.
Bond investors should consider staying in low-duration, actively managed portfolios capable of identifying stable or improving credit opportunities. In our opinion, the recent rise in rates is likely evidence that we reached a generational low in long-term yields back in July 2016 and that the secular rate decline that began in 1981 has now officially concluded. Therefore, remaining short on the curve will help to mitigate interest-rate risk while still allowing for the credit-oriented strategies to potentially add value amidst a continued strong economy.
1 Factset, Earnings Insight, October 5.
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