Volatility has ramped up a bit in the traditionally-slow final weeks of summer, which could be a preview of a bumpy fall for investors.
Solid economic data and strong corporate earnings should allow the bull market to continue, but fiscal and monetary uncertainties present risks.
August narrowly avoided the first loss for global stocks this year; but underlying fundamentals still look generally positive.
Good bye and good riddance to Harvey
Rain is finally coming to an end but the impact, both human and economic, will go on for far longer. We are confident that the area around Houston will rebound, and have been heartened by the outpouring seen from the region and the entire country; but at this point it’s too early to determine the ultimate economic impact. Generally, what’s occurred in the past has been some distortions in economic data in the near term—e.g., we could see a tick up in jobless claims coming from the region as businesses are unable to reopen. However, we are likely to see an uptick in economic activity in general over the next six months or so as the rebuilding efforts kick into high gear. The Wall Street Journal reported that over 500,000 vehicles may need to be replaced, which could lead to an uptick in auto sales. Overall, the losses and subsequent stimuli may roughly even out and have little impact on long-term growth. Importantly, we don’t suggest investors try to trade around potential hurricane effects.
Lazy days coming to an end
The last few weeks of summer are traditionally a time when most of Wall Street heads for the beach, Congress is in recess, and the only event of any consequence is a bunch of central bankers pausing from their fishing to pontificate in Jackson Hole, Wyoming. Indeed we’ve seen lower trading volume over the past few weeks, but August has been anything but boring. While we don’t want to read too much in to late summer action, recent action may be a preview of what investors will see this fall.
Volatility has moved higher—albeit still historically low—as geopolitical and domestic political issues have rattled investors at times.
Volatility has seen increased action
Source: FactSet, Chicago Board Options Exchange. As of Aug. 28, 2017.
And this was before Labor Day, after which Congress comes back into session and European officials get back to work. One positive effect of the recent uptick in volatility is subdued investor sentiment based on most traditional indexes, which reduces the likelihood of a potentially-dangerous “melt-up.”
Looking to the fall, fights in Washington over the debt ceiling, the budget, tax reform, and various other issues; a Federal Reserve that is normalizing monetary policy; and plenty of geopolitical risk could mean some continued choppiness in the market, if not a sharper pullback. However, we believe any corrective phase would be within the context of an ongoing secular bull market and could help to set the stage for the next move higher.
Economy still supports the bull
Limited risk of an economic recession keeps us in the bull market camp, notwithstanding the aforementioned near-term risks.
US leading economic indicators charge ahead
Source: FactSet, U.S. Conference Board. As of Aug. 28, 2017.
Bear markets have rarely occurred outside of economic recessions. But of course past performance is no guarantee of future performance, with the 1987 October stock market crash being an example of a technical bear market occurring outside of the context of a recession. Barring an exogenous “black swan” shock, we think any corrective phase will be limited in both time and magnitude.
One of the strongest areas of the U.S. economy continues to be the labor market despite a lackluster August Labor Report. The last report from the Bureau of Labor Statistics (BLS) showed that 156,000 jobs were added, fewer than expected but still solid and August has tended to be a month that has been revised higher, while the unemployment rate ticked modestly higher to a still-low 4.4%. Additionally, while the monthly labor report is considered a coincident economic indicator—and the unemployment rate is a lagging indicator—the leading indicator of jobless claims continues to indicate a robust employment environment.
Unemployment remains low…
Source: FactSet, U.S. Labor Dept. As of Sept. 1, 2017.
As jobs continue to be added…
Source: FactSet, ADP Global Reports, U.S. Labor Dept. As of Sept. 1, 2017.
And claims indicate continued strength
Source: FactSet, U.S. Dept. of Labor. As of Aug. 28, 2017.
We’re also seeing wages move higher as median earnings rose 2.5% year-over-year (y/y). And that number may be understating actual wage growth according to a study released recently by the San Francisco Federal Reserve. The study points out that part of the reason wage growth has been held down is that older, more experienced, and higher paid, workers are leaving (retiring from) the work force and being replaced by younger, and naturally-lower wage workers. The study notes that wage growth for continuously-employed full-time workers “has been rising and is currently in line with rates seen at the previous economic peak in 2007.” This points to a healthy consumer and should support continued economic growth. But it also could mean inflation begins to move higher.
On a less bright note, U.S. housing data has recently been modestly disappointing. New home sales were down 9.4% month-over-month in July according to the U.S. Census Department, but that report also showed that the median home price jumped 6% year-over-year. According to John Burns Real Estate Consulting and CNBC, the price premium of new homes over existing homes is around 35-40%, which is well above the long-term average of 10-20%. Prices are a problem for existing homes as well, with the median price up 6.2% year-over-year according to the National Association of Realtors (NAR). The pricing problem is compounded by low inventory levels as they fell to a low 4.2% at the existing sales rate. NAR’s chief economist, Lawrence Yen, noted: "Buyer interest in most of the country has held up strongly this summer and homes are selling fast, but the negative effect of not enough inventory to choose from and its pressure on overall affordability put the brakes on what should've been a higher sales pace." This illustrates a continued strong housing market, but one that is dealing with the lack of skilled workers needed to add to supply. This is problem that will take some time to correct; which should be to the benefit of home sellers and homeowners, but at the expense of those looking to buy.
Congress gets to work, while the Fed enters a new stage of normalization
Members of the Federal Open Market Committee (FOMC) have been concentrating their public comments on “financial stability” as they continue to normalize rates and appear to be soon beginning to reduce the Federal Reserve’s balance sheet. They have expressed some concern about elevated asset values causing more risks to the financial system. How the Fed ultimately threads the needle and when it begins the process of unwinding its balance sheet will be closely watched and could result in times of increased market volatility. Additionally, given the tightness of both the labor and housing markets, inflation could begin to surprise on the upside, perhaps pushing the Fed to act more aggressively than the consensus anticipates.
Of a more immediate potential threat to near-term stock market performance is the need for Congress to deal with both the budget and the debt ceiling. The bluster from both sides of the partisan aisle surrounding these two issues is typically elevated—even if the actual damage ends up being limited. .We urge investors to remain focused on the longer-term as we enter a period where some choppier market action is witnessed.
Already easing some investor complacency, August came close to breaking the uninterrupted streak of monthly gains for global stocks seen in the MSCI AC World index this year. This year has seen the only time the index ever (since its inception 30 years ago) posted a gain in every one of the first eight months of the year, as you can see in the heat map of monthly returns below.
2017’s uninterrupted and unprecedented streak of monthly gains
Source: Charles Schwab, Factset data as of 8/31/2017.
The MSCI ACWI captures large and mid cap representation across 23 Developed Markets and 24 Emerging Markets countries. With 2,497 constituents, the index covers approximately 85% of the global investable equity opportunity set.
The 1% gain in the last two days of August turned the month from red to green. It’s not too surprising that August nearly gave us our first monthly pullback since last October. While June is the month that suffers losses most of the time, August has provided the worst average performance of any month. Seasonal tendencies aside, this particular August presented a few challenges to the global stock market:
- Geopolitics - The most notable daily declines of August often coincided with an escalation of tensions with North Korea.
- Politics - The U.S. debt ceiling, potential government shutdown, and budget negotiations loom in September. Election relief has faded to reality in Europe as a poll from CNews showed the approval rating of newly-elected French President Macron suffered a sharp drop and his “dissatisfaction rating” jumped to 57% in August from 43% in July. The United Kingdom and European Union still appeared to be far apart during August’s third round of Brexit negotiations.
- Natural disasters - Hurricane Harvey and Typhoon Hato reminded investors of the cost of unexpected events.
In the face of all these challenges, the stable performance in August illustrates the resiliency provided by a backdrop of rising earnings.
Nevertheless, the risk of a seasonal slump remains. Stocks have posted a decline, on average, in the month of September. However, the well-supported trends of rising earnings, improving global growth, and stronger trade should help to limit the size of potential pullbacks.
One positive of August’s relatively flat performance is that earnings continued to rise leaving the price-to-earnings ratio to end the month near the low end of the range for this year, as you can see in the chart below. This lowers world stock market valuation halfway back to the 20 year average of 15.3 according to FactSet, from over 16 in July. The improvement in valuation is a welcome development for long-term investors.
Price-to-earnings ratio ended August near lows for the year
*forward price-to-earnings ratio uses next twelve months estimates for earnings per share.
Source: Charles Schwab, Factset data as of 8/30/2017.
Action is about to heat up as summer comes to an end but investors should remain cool. Geopolitical threats, domestic politics, and Federal Reserve actions all have the potential to add to volatility and heightens the risk of a pullback or correction. But healthy economic growth and strong corporate earnings lead us to believe that the bull market has legs.