November 2018 | Marco Fragnito | Managing Principal
- The month of October experienced large increase volatility and the first 10% drop in the S&P in two years.
- The US Federal Reserve notes positive economic strength as strong case for rate increases.
The month of October has always been an interesting month in the stock market, why that is exactly, nobody really knows. It could be that some of the market’s most historic sell-offs occur during the month of October: the 1929 crash, the 1987 crash (Black Monday) and most recently the 2008 financial crisis. It appears this past October has to a degree lived up to its predecessors, experiencing a large increase in volatility and the first 10% drop in the S&P in over two years.
We headed into October with the best quarterly gain for the S&P in five years, up 7.2%, a new trilateral trade deal between United States, Mexico and Canada (USMCA) and with 50% of companies reporting earnings were up on average 25% versus expectations of a 20% increase. Further evidence of overall positive news of economic strength, Federal Reserve Chairman Jerome Powell, ventured to say at a speech on October 3rd, that he had a “remarkable positive outlook” for the US economy, suggesting a “historically rare” period of low employment and inflation. Investors interpreted his comments as a sign that the Fed is a long way from being done on raising rates, potentially a major negative for equity markets. In combination this with news, the mounting tensions between Italy and the European Union budget committee, the suspected murder of Saudi journalist, Jamal Khashoggi, at the Saudi Arabian embassy in Turkey and the looming mid-term elections—markets sold off. The S&P 500 lost 6.9% of its value, while the NASDAQ fared even worse losing 9.2%.
International markets were just as weak or weaker than domestic markets. The STOXX Europe 600 lost 5.6%, while the Shanghai Composite dipped 30% below its January high, followed by Hong Kong, South Korea and MSCI Emerging Market all falling into bear market territory. Numerous other industrial nations experienced market corrections as defined by at least a 10% drop from the highs.
Data on the economy continued to point to robust growth and optimistic Fed commentary led to higher yields on US Treasuries. With unemployment touching a 50-year low, manufacturing expanding at a strong pace and the service sector expanding at the fastest pace since 1997, the yield on 10-year Treasury notes hit 3.23%, the highest level since 2011. The yield on 30 US Treasuries hit a 4 year high of 3.38%. Consumer confidence reached its highest level since 2000 and the GDP grew at a further 3.5% in the third, providing momentum into the fourth quarter and holiday season.
With continued low inflation readings as measured by the Federal Reserve preferred measure of inflation, this PCE index, which saw an increase of 1.6% versus an expected increase 1.8% in the latest GDP report. We would argue that a case can be made for the Fed to pause and wait for more economic data before continuing to raise interest rates. A final reason to consider pausing is while crude oil climbed above $80/barrel it tumbled 10.8% in October and had dropped below $65/barrel this week, a sign of contained inflation in the months to come.
While market corrections and increased volatility can be unnerving to investors, we should expect this to be the case. The last few years have led to shallower corrections and reduced volatility due to the low level of interest rates, this will not be the case in a rising interest rate environment. We should expect long term rates to continue to rise over time as the long secular bull market in US Treasury bonds is over and we have entered a long term upward trending environment for interest rates. Therefore, we continue to recommend that fixed income investors seek alternatives to meet their fixed income needs. As for the equity markets, we remain bullish long term. Lower taxes, further deregulation and ultimately more negotiated trade deals with our trading partners should continue to see markets rise as revenues and earnings offset the rise in long term interest rates. There are always factors that can change our outlook such as the midterm elections, protracted trade disputes and geopolitical unknowns but rather than guess we will continue to count on our data driven approach to determine the best asset mix for portfolios.Sources: Wells Fargo Advisors. Monthly Market Commentary, November 2, 2018. Bureau of Economic Analysis. Gross Domestic Product, 3rd quarter 2018 (advance estimate), October 26, 2018. CNBC: Oil slips after US output hits new record, stockpiles rise, November 7, 2018. CNBC: The Stock Market lost nearly $2 trillion in October. Here’s what happened, October 31, 2018.