Our Views on Recent Market Volatility

10.12.2018 - Ronald J. Sanchez, CFA

Throughout much of this year we have talked about the potential impact the Fed could have on the equity market as it “normalizes” its monetary policy and raises short-term interest rates. Those effects have become apparent, creating several difficult days for investors, and the volatility could persist.

But these setbacks are not unusual in a bull market — since 2009 we have already experienced 29 days in this market cycle when the market has pulled back by 3% or more. We recognize these moves are unnerving, and they might make it feel like the end of the bull market. But after each of these 29 pullbacks, the markets eventually regained their footing and continued to march higher.

What Happened? Expectations Reset

Prior to this week, equity markets were up about 11% for the year. The recent sell-off erased about half of these gains, affecting the best-performing and worst-performing stocks alike. Although markets are still up 5% for 2018, the message is clear: investor confidence has been challenged as they reassess the balance of risks.

So far this year, markets have been anchored by three key convictions:

  • Economic and corporate fundamentals remain strong.
  • Inflation should remain contained, allowing the Fed to be deliberate in removing monetary policy accommodation.
  • Trade fears can be pushed to the back burner in light of a booming domestic economy.

Several events in past few weeks have challenged these beliefs.

First, the IMF lowered its expectations for global economic growth, citing concerns about trade negotiations. Second, at the corporate level companies are facing higher input costs, concerns about reduced demand from China and volatility in foreign currencies which are lowering expectations for earnings growth. While not yet pervasive, these factors appear to be contributing to a more cautious tone as we enter earnings season. Together, the prospects of weaker global growth and concerns early into earnings season have prompted investors to reconsider the potential downside trade tensions might cause.

The Fed Raises Questions About Monetary Policy

In the background, two other factors came into play. In the announcement following the Fed’s most recent meeting, it removed a longstanding reference to “accommodative” monetary policy. Statements by chairman Powell and other FOMC members also indicated that the Fed’s ultimate rate goal could not be clearly defined.

These statements raised concerns about the clarity of guidance provided by the Fed, resulting in more uncertainty about monetary policy. In addition, stronger economic data rekindled fears about the impact rising rates and inflation might have on corporate earnings, as well as on the broader economy.

Entering a Less-Quiet Part of the Cycle

We do not believe this week’s downturn foreshadows an end to the cycle, but we do believe it ends an unusually quiet period for the markets. Equity and bond investors must now navigate uncertain territory as the Fed returns to normalcy.

Our perspective:

  • We still see strong fundamentals in the US economy as recent services and manufacturing data substantiates solid growth.
  • Despite revisions, earnings are still expected to grow 19.3% in the third quarter. If that happens, it will mark the third strongest quarter since early 2011. 
  • While interest rates have moved higher out of the 2.8% - 3.0% range, in line with better US growth expectations, data this week points to inflation falling back toward the Fed’s target, which should allow the Fed to be deliberate in normalizing monetary policy.
  • We don’t expect trade concerns to derail corporate earnings momentum; however, earnings season will provide more clarity on any material impact from trade tensions.
Our View

While there are countless scenarios that could play out from here to the end of the cycle, we believe the probability of an abrupt or shocking end to the cycle is relatively low. The risks posed by geopolitical uncertainty and the future path of monetary policy are offset by a fundamentally stronger economy with few imbalances.

That said, we believe stocks can continue to perform well in this environment and return to a more normal return profile, a moderation from double-digit returns we have seen in recent years. We expect to see more dispersion between and within asset classes, which should reward proactive asset allocation decisions and selective investment choices. 

This communication is intended solely to provide general information. The information and opinions stated are as of October 12, 2018 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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