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10.12.18
Investors need seatbelts during a wild week for equity markets
The last week’s market highlights:
Quote of the week:
“If you can make one heap of all your winnings
And risk it all on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss.”
–“If,” Rudyard Kipling
And risk it all on one turn of pitch-and-toss,
And lose, and start again at your beginnings
And never breathe a word about your loss.”
–“If,” Rudyard Kipling
Each week, we present our featured topics in the context of the major themes listed below from the Nuveen Q4 Outlook:
- U.S. economy: Still running ahead of its peers.
- Global economy: Trade a bigger concern outside the U.S.
- Policy watch: Trade risks haven’t bitten the U.S. yet, but that may change.
- Fixed income: Continue to position for rising rates.
- Equities: The price is right outside the U.S.
- Asset allocation: Finding pockets of opportunity.
Equities/Fixed Income: Investors think “TGIF”
So much for the recent stretch of quiet, profitable equity markets.
Throughout the third quarter, and for the first seven days of October, there were no instances of the S&P 500 Index moving more than +/- 1% on a single day. Over that period, stocks rose a healthy 6%. Not surprisingly, the VIX (also known as Wall Street’s “fear index” and a common gauge of volatility), hovered near multi-year lows.
But this week investors got an early taste of Halloween—albeit with far more “tricks” than “treats.” The S&P 500 plunged 3.3% on October 10—its biggest one-day decline since February—and 2.1% on October 11. A Friday rebound trimmed the week’s losses to 4%.
So what drove last week’s equity market volatility? We think investors fear that (a) the U.S.-China trade dispute will hurt corporate earnings and (b) rising interest rates could slow the economy.
With respect to the first point, we hear continued cautious rhetoric from CEOs regarding the impact of tariffs on input prices. And the producer price index, a measure of input-cost inflation for companies, rose 0.2% in September after stalling in the summer. That data point, released on October 10, underpinned worries about trade’s negative effect on corporate bottom lines and may have sparked the mid-week sell-off.
As for the second concern (rising interest rates), both short- and long-term rates have indeed climbed amid stellar U.S. economic data. This has reinforced expectations for further Fed tightening in light of stronger growth forecasts. Because higher rates increase borrowing costs for both companies and consumers, they can serve as a headwind for the economy.
While equities sold off, U.S. Treasury markets benefited from the decidedly “risk-off” mood. The 10-year note, which began the week at 3.23%, closed at 3.16% on October 12. (Unlike the stock market, the bond market was closed on October 8 in observance of Columbus Day.)
We think it’s unlikely markets will remain in risk-off mode for long, based on our outlook for strong third-quarter earnings growth and a U.S. economy still expanding well above its long-term potential. Nor do we expect the recent market volatility to dissuade the Fed from raising interest rates in December.
Markets seem to agree with our view. As of October 12, the market-implied odds of three Fed hikes by June 2019 hit 50%.
Special mid-term election section: Don’t expect much market movement
In 1948, the Chicago Daily Tribune was so convinced Thomas Dewey would defeat Harry Truman that it famously published a banner headline declaring Dewey the victor before all the votes were counted. Fast forward to 2016. Few prediction markets or polls-based statistical models gave Donald Trump more than a 1 in 3 chance of becoming president. (No wonder Yogi Berra once said, “It’s tough to make predictions, especially about the future.”)
Of course, we’re not in the business of predicting the outcomes of individual Senate or House races. But we do believe that, barring an emergency, the next U.S. Congress will pass little, or no, major legislation. (This is partly because Washington is already deep into deficit spending. According to the Congressional Budget Office, the 2018 deficit will reach $804 billion, which is large by historical standards.)
That said, November’s elections, while certainly important politically, aren’t likely to influence near-term economic forecasts, at least not directly. In our view, here are the three most probable scenarios and possible market responses, if any:
1) Democrats retake control of the House, and Republicans keep the Senate (60% probability). Because financial markets have largely priced in this scenario, investors will probably take this one in stride.
2) Democrats retake control of the House and Senate (20%). If this occurs, markets may start to price in potential re-regulation in 2021, higher individual corporate and individual tax rates, and the possibility of single-payer health care. The yield curve could flatten as longer-term Treasury yields fall amid slower economic growth, and the dollar could weaken.
3) Republicans maintain control of the House and Senate (20%). This is the status quo scenario, potentially leading to Affordable Care Act reform, permanent individual rate cuts, and extra fiscal stimulus through 2020. These developments could boost stocks (especially cyclicals) and lift interest rates.
If Republicans no longer control all or part of Congress (scenarios 1 and 2, respectively), we’d expect the clogged legislative pipeline to affect the budgeting process over the next few years. That raises the prospect of debates over government shutdowns and of debt-ceiling brinksmanship. While evidence of political dysfunction, such actions are unlikely to meaningfully hurt economic growth or—given the market’s apparent “immunity” to gridlock—investor confidence.
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