Summary
Economic data for the week was highlighted by GDP results for the third quarter that came a bit better than expected, strong durable goods orders and jobless claims, as well as mixed housing and sentiment results.
Global equity markets fell sharply again, coupled with higher levels of volatility. Bonds fared well, as investors sought out safety, causing interest rates to decline. Commodities declined as well, due to weaker energy prices.
Economic Notes
(+) The 3rd quarter advance GDP reading showed a gain of +3.5%, which beat expectations calling for +3.3%, but unsurprisingly down from the rapid +4.2% pace of Q2. The report was led by personal consumption rising at a pace of +4%, the highest level in four years, which beat expectations by about a half-percent. However, other components of the release underwhelmed expectations somewhat, including slower business investment (which only gained at a +1% rate following a +10% rate earlier in the year), as well as outright declines in commercial structures and residential housing in general. Inventories also picked up by a few percentage points, contributing to a substantial portion of GDP, but were offset by a decline in trade to some extent. Core PCE inflation rose at a pace of +1.6%, which was a few tenths of a percent below forecasts. Despite the strong headline number, this report was a bit mixed, with economic strength becoming a bit more bifurcated by component.
(+) Durable goods orders for September rose +0.8%, which outperformed the median forecast calling for a -1.5% decline. This was driven largely by stronger defense orders, particularly aircraft, which gained +120%. Removing that effect, core capital goods orders fell by -0.1%, which underperformed the expected increase of +0.5%. Core capital goods shipments were unchanged, which underperformed compared to an expected gain of +0.4%. On the positive side, August results were revised up slightly. These readings have added to expectations for better capital investment growth for the third quarter.
(-) The advance edition of the September trade balance showed an increase in the deficit of -$0.6 bil. to -$76.0 bil., wider than the -$75.1 bil. level expected. This was led by a net increase in imports for goods on both the consumer and capital side. Export gains were led by industrial supplies, while agricultural goods declined by nearly -10%—to continue a streak of losing months for agricultural exports. It continues to appear that trade activity has been accelerated in advance of potential U.S.-China tariff activity.
(0) The FHFA house price index rose +0.3% in August, which was on par with expectations. Of the nine regions, all but two experienced increases, led by the Pacific coast and New England, which gained over +0.7%; the Mid-Atlantic segment fell by an equivalent amount. The year-over-year rate of change also decelerated a bit to +6.1%.
(-) New home sales for September fell -5.5% to a seasonally-adjusted annualized rate of 553k units, below the 625k units expected and a low reading for the year. Some downward revisions for prior months up to -55k were also reported, which added to the negativity. The weakest sales occurred in the Northeast, which were down over -40%, while the Midwest saw gains of +7%. Inventory increased by over a half-month to 7.1 months supply, which is the largest level in seven years. This is another example of a variety of softer housing readings seen in recent months.
(+) Pending home sales for September rose +0.5%, which outperformed expectations calling for no change. Regionally, the West experienced solid gains of +5% for the month, while the South and Northeast saw declines. Although month-to-month housing metrics are generally ‘noisy’, the South’s results could well be due to recent hurricane activity. On a year-over-year basis, this metric has fallen by -1%, in keeping with recent spotty housing results.
(-) The final Univ. of Michigan index of consumer sentiment reading for October ticked down -0.4 points from the earlier reading to 98.6, below the flat 99.0 level expected. Consumer assessments of current conditions fell by more than a point, contributing to the decline, while expectations for the future ticked up slightly—however, both remain at a high level. Inflation expectations for the coming 5-10 years ticked up by a tenth of a percent to 2.4%.
(0) Initial jobless claims for the Oct. 20 ending week ticked up by +5k to 215k, which matched overall expectations. Continuing claims for the Oct. 13 week fell by -5k to 1.636 mil., under the 1.644 mil. expected and the lowest reading since 1969. Recent hurricane activity in the South Atlantic has been the largest catalyst for results in the last few weeks with new claims picking up in Florida and Georgia, while claim conditions in the Carolinas moved back towards normal. Otherwise, this level continues to parallel a strong labor market.
(0/+) The Fed Beige Book, covering recent economic conditions in the various Fed districts, continued to show growth running at a modest to moderate pace nationwide and sentiment continuing to appear optimistic. Consumer activity continued to grow modestly, as did manufacturing activity. Retail sales were generally strong nationwide, with the exception of the hurricane-affected Carolinas. Employment growth remains strong, while labor markets are showing continued tightening—with labor shortages broadening to beyond a few key areas. In line with moderate descriptions of broader inflation in general, wage growth was described as modest/moderate as well, although pockets of higher wage pressures existed as did constrained activity due to a shortage of labor. Also noted were some rising costs for materials and shipping. To no surprise, uncertainty over the global trade/tariff environment has cast a bit of a shadow over manufacturing sentiment, although tangible impacts at this point appear modest.
Question of the Week
What does this recent bout of market volatility and stock correction mean?
Uncertainty of future prospects is the price of admission when investing in any market—the market price of an asset is the only pressure release valve available for a continually changing perception of risk. For the most part, stronger prospects and lessened uncertainty lead to higher prices and lower volatility. It’s also true for the opposite, as heightened uncertainty and/or weaker prospects can create an environment of discounted values and typically higher volatility surrounding these values. An expectations reset is what it really comes down to, all else equal.
There have been a variety of factors at play that have heightened volatility—described in more detail below.
Interest rate levels as input to valuation. It’s helpful to look at how valuation models change when new data is received, and a key input variable is interest rates. When rates move higher, two things occur. One is that future cash flows are discounted to the present to a greater extent (lowering values), which affects any asset with an implied cash flow, such as stocks, bonds or real estate. The second is that interest-paying investments become a more attractive option as yields rise. We see this even in the market for cash, with rates on savings accounts, certificates of deposit and money market funds rising from near-zero a few years ago to around 2% today. At that level, cash is no longer ‘trash’ and offers a competitive choice for short-term capital. This same dynamic is playing out through the entire bond market, as investors continue to reassess dynamics and dissect every Fed official speech/comment for hints of what pace rate changes will take. Adapting to a new regime of more ‘normal’ rates is usually not a linear process and can result in volatility.
Interest rate path/timing. Related to the higher absolute levels of rates noted earlier, the pace to which the Fed raises rates is a key consideration, and increasingly divergent market opinions about possible paths has led to uncertainty. Historically, rapid and substantial rate increases to control a high inflation environment or overheating economy have created more uncertainty for assets than have more gradual and moderate rate movements. Despite the recent soundbite from Chair Powell that rattled bond markets, hinting the Fed may choose to ‘overshoot’ their target by raising beyond the warranted neutral rate, every Fed decision remains data dependent and precise estimates about the future should be used with caution. While the Fed directly affects rates at the short-end, long-term rates are driven by inflation expectations and credit risk. The credit risk component isn’t often mentioned in the same breath as U.S. treasuries, that are considered ‘risk-free’ assets, but the wider budget deficits become and more debt a nation takes on, perceptions of that nation’s credit risk can be negatively affected, which could cause global investors to demand higher rates as compensation. Although U.S. treasuries remain the world’s safe-haven asset, and could remain as such for many years to come, a lack of demand in recent treasury auctions, threatened (and/or actual) sales of treasuries by the Chinese and large foreign holders could push rates higher through technical effects.
Strong U.S. dollar. The value of the dollar has tended to wax and wane over the decades based on a variety of factors—and is currently experiencing a multi-year period of strength. While benefits include cheaper imports (including selected commodities, priced in dollars), the negatives surface through more expensive exports and a headwind added to all foreign stock and bond returns for U.S. investors. Earnings commentary from a variety of firms (primarily those that export more heavily) point to the dollar as a more significant headwind than tariff talk or other uncertainties. The good news is that these cycles have tended to change course after a few years, as opposed to staying in place indefinitely.
Trade tensions with China. This has been in the background for months, although the volume of goods is less meaningful to either side as a percentage of total production than it may first seem. There is hope that this saber-rattling will end up in a more subdued agreement, akin to what the U.S. has done with Mexico and Canada, and is working on with Europe. The reality also is that U.S-imposed tariffs in recent years have remained near their historical lows with taxes collected on less than 2% of imports; global tariff rates are also quite low. A higher overall rate would only bring these back a bit closer to historical norms. The concerns here go far beyond tariffs, into agreements about intellectual property, amount of latitude U.S. firms are given to operate in China, and broader theater of long-term global influence—and about the protectionism trend in many nations.
Seasonality. This is also no surprise, but equity volatility has tended to pick up after Labor Day—often dramatically. This tendency has been in place for nearly a century. In fact, October has tended to be among the most volatile months of the year, which has shown itself to be true in 2018. Although some seasonal tendencies defy explanation, a probable one is that attention evolves from the current year’s activity to hopes and dreams for the year ahead—which coincides with company earnings reports and commentary. These equity market hopes and dreams have manifested themselves as stronger-than-average market returns in November and December (the so-called ‘Santa Claus rally’), although that is never a prediction, only a historical tendency.
Economic growth and earnings. More specifically, markets have become more concerned about the durability of the current business cycle. It’s already one of the longest on record in the U.S., with continued debate as to whether were in the middle innings or further towards the end. Eventually, though, every cycle comes to a conclusion, morphs into a recession, and begins anew. Earnings growth for companies follows this same pattern, with very strong growth over the last year (over +20%) buoyed by strong fundamental revenue gains and tax cuts (the latter of which represent about a third of earnings improvement). This growth cannot go on at an infinite pace, so investors are looking for signs of leveling off or deterioration in earnings after conditions peak, although next year’s earnings growth is still expected to be around +10%. While strong, this would be a deceleration from recent years. Profit margins, which have also been quite high, are expected to move back to a more normal, lower pace, which would likely result in less robust return on equity metrics. Concerns also involve effects on growth in Europe and Japan, which has been markedly weaker and thus more sensitive to disruption and tariffs. Rates of growth in emerging markets, such as China, remain the highest in the world, but are just no longer running at the same robust pace of their infancy years.
Politics. It’s said frequently that politics and financial markets don’t necessarily correlate to each other over time, but short-term policies can affect sentiment positively (tax cuts) or negatively (imposition of tariffs and other trade policies). The market run-up to mid-term elections has often been volatile historically, and often negative, while the aftermath has been less so, and more positive.
Geopolitics. This is always a wildcard with financial markets, with certain major events surprisingly ignored, while seemingly more minor news reacted to violently. Often, these events exacerbate sentiment trends already in place. These include events involving negotiations between Italy and the EU involving its budget, spats with Turkey and the recent incident involving Saudi Arabia’s role in the death of a journalist. While not always directly relevant (absent military action), there can be indirect impacts on currencies, bank balance sheets and commodity prices.
In short, the list of reasons for market volatility is long. Some worries may turn out to be warranted, while others may not. It’s important to remember how normal volatility is. Since 1980, while the S&P 500 has earned an average annualized total return of just under +12%, half of those 38 years have featured a peak-to-trough drawdown of at least -10% during the year, and a third of those years had at least a -15% decline. (The average of all declines intra-year was -14%.) Even more importantly, per research assembled by JPMorgan, over the past 20 years, the 10 best market days have occurred within two weeks of the 10 worst days—so knee-jerk reactions can be costly.
On a fundamental basis, conditions remain generally benign. Equity prices were a bit rich prior to the recent pullback, but are now back at more reasonable levels following the price decline. According to current indicators, the risk of recession has risen, but continues to remain at low levels outright; GDP and earnings growth obviously remains positive; and interest rates, while higher than they once were, remain low compared to history.
Market Notes
| Period ending 10/26/2018 | 1 Week (%) | YTD (%) |
| DJIA | -2.97 | 1.65 |
| S&P 500 | -3.93 | 0.98 |
| Russell 2000 | -3.76 | -2.42 |
| MSCI-EAFE | -3.87 | -11.16 |
| MSCI-EM | -3.29 | -18.90 |
| BlmbgBarcl U.S. Aggregate | 0.54 | -1.93 |
| U.S. Treasury Yields | 3 Mo. | 2 Yr. | 5 Yr. | 10 Yr. | 30 Yr. |
| 12/31/2017 | 1.39 | 1.89 | 2.20 | 2.40 | 2.74 |
| 10/19/2018 | 2.31 | 2.92 | 3.05 | 3.20 | 3.38 |
| 10/26/2018 | 2.33 | 2.81 | 2.91 | 3.08 | 3.32 |
U.S. stocks experienced another bout of volatility last week, with global markets all losing several percentage points to reach official correction territory of -10% from peak levels. Additionally, further details about Saudi involvement in the Jamal Khashoggi murder and threats by the U.S. to exit a nuclear arms treaty with Russia didn’t help sentiment.
Every sector was in the red for the week, with energy and industrials leading the pack downward, while defensive industries consumer staples and utilities ‘only’ losing up to -2% for the week. Toward the end of the week, story stocks Amazon and Alphabet disappointed on the revenue side, leading for further negative sentiment.
Corporate earnings for Q3 continued to roll in, with about half of the firms in the S&P 500 now having reported, per FactSet. Results have appeared generally good, as three-quarters of firms have reported a surprise on the earnings side (with overall growth of +23% year-over-year) and half on the revenue side. Interestingly, this was seen as the worst price response to positive EPS surprises in seven years. Technology and the new communications services sectors, as well as health care, are leading the way in terms of results above estimates, while energy and materials are at the back of the pack with a far larger ratio of below-estimate results. The forward-looking P/E, after the recent equity price drawdown, is at 15.5—right in line with historical averages. There seems to be more dispersion between results than in recent quarters, with some high profile surprises and disappointments both, which hasn’t helped equity market volatility
Foreign stocks suffered to a similar degree as U.S. equities, with the additional headwind of a stronger dollar. EU negotiations with Italy over the latter’s budget remained a key point of contention—while the initial submission for next year was rejected (a historic first), ECB president Draghi attempted to calm markets with comments along the lines of ‘a solution will be found’. A few industrial metrics also fell back, and comments from the ECB made it clear that their plan to discontinue bond purchases by year-end will occur as planned. Emerging markets overall fared similarly to developed markets, with China recovering somewhat with reports of the government pledging 10 bil. in yuan for private firm credit support.
U.S. bonds, to no surprise on a volatile week for equity markets, fared well as investors sought out safe assets. Government outperformed credit, with high yield losing ground, as expected due to their correlation to equities. Developed foreign bonds performed similarly well in local terms, but lost ground due to the dollar’s strength. Yields on Italian bonds fell later in the week, as Moody’s reaffirmed the nation’s investment-grade credit rating and government officials reaffirmed their commitment to the Eurozone. Emerging market debt declined in keeping with their typical behavior during ‘risk-off’ events.
Real estate held up far better than broader equities, with minor declines for the week, and U.S. segments performing far better than European or Asian groups. Retail REITs, one of the areas suffering from the worst sentiment in recent quarters, earned sharply positive returns last week, likely as higher quality firms showed lesser exposure to Sears than first feared.
Commodities lost ground generally, in keeping with a stronger dollar, with the energy segment performing the worst. Crude oil fell over -2% on the week to end at just under $68/barrel, representing a -12% correction from recent highs of $76, over concerns of lower global demand and rising OPEC production. It also appears hedge funds and other speculators have been unwinding long positions, as forecasts point to oversupply conditions as soon as next year—partially led by U.S. infrastructure additions.
Sources: Ryan M. Long, CFA, FocusPoint Solutions, American Association for Individual Investors (AAII), Associated Press, Barclays Capital, Bloomberg, Citigroup, Deutsche Bank, FactSet, Financial Times, Goldman Sachs, JPMorgan Asset Management, Marketfield Asset Management, Morgan Stanley, MSCI, Morningstar, Northern Trust, Oppenheimer Funds, PIMCO, Standard & Poor’s, StockCharts.com, The Conference Board, Thomson Reuters, U.S. Bureau of Economic Analysis, U.S. Federal Reserve, Wall Street Journal, The Washington Post. Index performance is shown as total return, which includes dividends, with the exception of MSCI-EM, which is quoted as price return/excluding dividends. Performance for the MSCI-EAFE and MSCI-EM indexes is quoted in U.S. Dollar investor terms.
The information above has been obtained from sources considered reliable, but no representation is made as to its completeness, accuracy or timeliness. All information and opinions expressed are subject to change without notice. Information provided in this report is not intended to be, and should not be construed as, investment, legal or tax advice; and does not constitute an offer, or a solicitation of any offer, to buy or sell any security, investment or other product. FocusPoint Solutions, Inc. is a registered investment advisor.
Notes key: (+) positive/encouraging development, (0) neutral/inconclusive/no net effect, (-) negative/discouraging development.