Each quarter, we like to review the factors that influenced the financial markets during the previous months of the calendar year and look ahead to what we can expect in the coming months. With so much attention on the recent market sell off and volatility the last few weeks, this 4th Quarter newsletter will focus on the recent market selloff and what to expect in the future.
Concerns about rising interest rates, trade conflicts, elevated valuations, and slowing growth have driven down major global stock indexes. It is not yet clear how long or deep the selloff will prove to be—indeed, markets are currently staging something of a recovery. Yet, investors are wondering what’s driving the volatility and if it portends a more challenging period ahead.
“Some of the tailwinds that have thrust U.S. equity markets to record highs in 2018 could become headwinds over the next year or so,” recently commented Jeff Rottinghaus, a U.S. large cap portfolio manager with T Rowe Price. “While the environment should remain supportive for investing, it could become more challenging.”
Despite the downturn and the pickup in volatility, the backdrop for world equity markets remains generally favorable. U.S. economic and corporate profit growth have been very strong in 2018, but some valuations are elevated, and slower growth is likely as interest rates rise and the impact of recent tax cuts fades.
Interest rates and inflation are still very low in Japan and many developed European countries, where equity valuations are attractive and corporate earnings growth is likely to continue. Although emerging markets have significantly under performed this year, their fundamental valuations are attractive relative to the U.S. and most developed markets.
Rate Hikes, Inflation Concerns
A key driver of the recent declines is that expectations have been growing that the U.S. Federal Reserve will continue raising short term interest rates, which has led to a spike in bond yields. The fact that the Fed is also in the process of reducing its balance sheet as it winds down its quantitative easing program is also pushing yields higher, as is the U.S. government’s ongoing large-scale issuance of Treasury securities to finance its budget deficit.
Expectations of continued Fed rate hikes have been growing because of the strong performance of the U.S. economy, jobs growth, and accelerating wages, which are fueling concerns about inflation, even as current inflation signals remain tame. Higher import prices due to U.S. tariffs could also put upward pressure on prices.
Rising inflation increases the likelihood that the Fed will increase short term interest rates to prevent the economy from overheating. Higher short-term rates translate into higher borrowing costs, which can dissuade consumers and businesses from making purchases and investments, weighing on companies’ profit margins and potentially slowing the economy. At present, the Fed is projecting that it will raise rates once more in 2018 and three times in 2019.
Trade Tensions Not Abating
The ongoing tensions between the U.S. and China over trade are causing considerable unrest in markets. The two countries have been implementing—and threatening to broaden—tariffs on a wide variety of imports from each other, and there is no indication that tensions will soon ease.
Over decades, large U.S. companies, particularly manufacturers, have developed extensive global supply chains, relying on worldwide sources of lower cost production. Higher component costs due to tariffs could bring higher inflation over the long term. However, companies would eventually learn how to maximize their returns under the new rules.
Inflated Valuations Make Companies Vulnerable
U.S. stocks, particularly large cap and growth stocks, have been trading at elevated levels. Given that equity markets have been rising for almost 10 years (after bottoming in March 2009) and that economic and corporate earnings growth have also been strong for a long period, these high valuations may reflect a view that current favorable fundamentals will remain for the foreseeable future. If this is the case, markets could be vulnerable to any developments that imply a weaker economic outlook.
Recent declines in the so called FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google), which have led the U.S. stock market for some time, may have contributed to the wider sell off. Other high performers, such as car maker Tesla and Chinese companies Alibaba and Tencent Holdings, have also seen their shares retreat from their best levels. While many of these stocks seem to have favorable fundamentals, it would not be unusual for them to experience a period of weaker performance. Over all, the market’s pullback is being generally driven by the technology sector and Internet companies
European equity valuations are modestly attractive compared with the U.S., while UK equities are trading at a discount to most global equity markets, probably due to ongoing uncertainty over Brexit. In Asian and Pacific developed markets, valuations are generally attractive compared with the U.S., but earnings remain vulnerable to any slowdown in global trade. Japanese equities, in particular, are supported by strong relative valuations, positive earnings growth, and gradually improving corporate governance.
Equity valuations in emerging markets are more attractive than those of developed markets as equities have sold off on the back of trade concerns and currency weakness and have significantly underperformed as a result. In the six-month period ended September 30, 2018, the MSCI Emerging Markets Index trailed the S&P 500 Index by about 20 percentage points in dollar terms (8.73% for the MSCI Emerging Markets Index versus 11.41% for the S&P 500 Index).
Looking Forward and what happens Now?
Although downturns are always disconcerting, occasional periods of turbulence are to be expected. It should be noted that despite the sell off and the pickup in volatility, the backdrop for world equity markets remains generally favorable.
It is impossible to predict with certainty whether the selloff will prove to be a temporary dip or something more serious. What’s more, timing the market is notoriously difficult. A failed attempt to time the market can hurt long term investment performance in two different ways: first, by selling assets when they have lost some value and going to cash, effectively locking in those losses; and second, by missing out on at least some of the gains when the market bottoms and starts to rebound.
While the economic and capital market environment is more favorable than it’s been for some time, investors should not reasonably expect the market’s positive returns to continue indefinitely. The strong performance we’ve had in the last few years, it would not be surprising to see lower stock market returns in the years ahead. We still believe Equities are still the best choice for investors seeking long term capital growth.
Conclusion
Markets rise, and markets fall, but unless there have been changes in your circumstances or you’re coming up on a milestone in your life such as retirement, stay with the plan. By itself, a long run in stocks isn't a good reason to bail out of the market. With all the volatility in the market, we can't stress the importance of diversification enough.
As details continue unfolding, we’ll be sure to keep our pulse on what lies ahead in the markets. In the meantime, please contact us to let us know if major changes have happened or are about to happen in your life. We want to make sure we are meeting our clients' expectations and part of that is making sure their financial portfolio and risk tolerance matches up with their goals.
Important Information
This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are those of the authors as of October 2018 and are subject to change without notice; these views may differ from those of other Financial Professionals.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision. Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. All charts and tables are shown for illustrative purposes only.
T. Rowe Price is the original author of this article.
The opinions contained in this material are those of the author, and not a recommendation or solicitation to buy or sell investment products. This information is from sources believed to be reliable, but Cetera Advisors LLC cannot guarantee or represent that it is accurate or complete.