Equities have rallied off the lows but the issues contributing to the recent volatility are unlikely to dissipate in the near future. Ongoing risks keep us cautious and we continue to recommend that investors pare back risk if their equity holdings are above longer-term strategic allocations.
Economic and earnings growth rates may be peaking, while the labor market continues to tighten. This mix contributes to higher wage growth, possibly higher inflation and related uncertainty with regard to Fed policy. Midterm election uncertainty is gone, but partisan wrangling will likely persist.
U.S. midterm result may have a positive impact on international markets, but there are many other risks which keeps our outlook cautious.
“Divide each difficulty into as many parts as is feasible and necessary to resolve it”
- René Descartes
Much action, little resolution
U.S. stocks have been on a wild ride lately, with major indexes hitting correction (-10%) territory in October before bouncing sharply, albeit still below September’s highs. The internal health of the rally off the recent lows has not been impressive. While stocks were “oversold” at the late-October lows—and investor sentiment had moved from excessive optimism to pessimism—there wasn’t quite the type of panic selling and investor despair that often serves as a sign of a firm bottom. Fundamentally, the major issues which contributed to the correction—the trade dispute with China, geopolitical uncertainty, tightening financial conditions, and concern over the future of Fed policy—remain in play. We expect ongoing bouts of volatility and a wider trading range heading into 2019. The potentially-good news is that seasonality is now in the bulls’ favor. In the one year following all midterm elections in the post-WWII era, the S&P 500 was up every time (Stategas Research Partners)—albeit not without plenty of drama at times, like the Crash of ’87, which came within a year of the 1986 midterms. We continue to recommend that investors use volatility to rebalance back toward longer-term strategic allocations in order to keep excess risk at a minimum.
Another reason for optimism that the secular bull market is not dead is that stocks did not experience a blow off top before the latest correction, which is often how bull markets end. Interestingly, according to BCA Research, if bull markets were historically divided into time deciles, the first and last deciles were by far the best performers. This is yet another argument against trying to time the market with all-or-nothing moves. If you missed the first tenth or the last tenth of a bull market, historically your returns would have suffered. Past performance is no guarantee of future performance of course, but it can help to inform our decision making.
Main Street vs. Wall Street
We’ve often noted that stocks are the ultimate leading indicator, meaning that Wall Street often starts to sniff out trouble before Main Street does. While we don’t think a recession is imminent, there are signals that peak economic and earnings growth rates have been reached and for stocks better or worse matters more than good or bad. Consumer confidence hit an 18-year high recently, a potential good signal for holiday spending (for more on this see Complicated Consumer), but perhaps not a particularly great sign for the future of economic growth as peaks have historically occurred fairly close to recessions.
And while remaining quite strong, we saw the Institute of Supply Management’s Manufacturing Index fall; while its leading new orders are well off their recent highs—likely at least partly a reflection of trade/tariffs uncertainty.
Manufacturing rolling over?
There is also the sticky problem of math. Low unemployment is obviously good for Main Street. The latest jobs report from the Bureau of Labor Statistics showed 250,000 nonfarm jobs were added in October, keeping the unemployment rate at 3.7%. But in order to expand the economic growth rate, some combination of an increase in workers or an increase in productivity needs to occur. The participation rate has been rising, but remains fairly low at 62.9% given the tightness in the labor market. And nonfarm productivity ticked lower to a 2.2% annualized rate in the third quarter, down from 3.0% in the second quarter, as you can see in the first chart below. In addition, the unemployment rate has been below the “natural rate of unemployment” for 19 months; while the spread between the two is historically wide. As you can see in the second chart below, at the point the unemployment rate begins to tick higher again, it’s likely the countdown to the next recession will begin based on history.
Still mediocre productivity
And historically low unemployment could limit economic growth
Source: Charles Schwab, Department of Labor, FactSet, U.S. Congressional Budget Office, as of November 8, 2018. The natural rate of unemployment (NAIRU) is the rate of unemployment arising from all sources except fluctuations in aggregate demand. Estimates of potential GDP are based on the long-term natural rate.
Of course a surge in workers returning to the work force or sudden burst of productivity improvement due to technological innovation are possible, we just don’t see signs of either occurring in the near term.
Likewise, it’s difficult to see a resolution coming from the United States-China trade dispute in the near future. In fact, recent rhetoric indicated a further “digging in” by both sides. Earnings season saw a growing number of companies expressing concern about increasing tariffs, and if those costs are increasingly passed on to the consumer, Main Street may start to feel more of the trade pain. An easing of trade tensions could improve both the economic and earnings outlook and could sustain the recent rally, but the risk of escalation remains real; and the hit to the economy becomes larger with additional rounds of tariffs, if they’re implemented.
The Federal Reserve made no move at its most recent meeting, as expected, but also did little to change expectations of another hike in December. The Fed has shown little desire to dissuade investors from the hawkish takeaway from Fed Chairman Powell’s early October comments. If that persists, concern that the Fed may make a “monetary mistake” may continue to weigh on markets. A pause in the tightening campaign might be cheered by markets, but only if economic growth remains healthy and inflation risk has ebbed. If the Fed is forced to lift its foot off the brake due to a sharper rolling over of growth—or in the face of rising inflation—markets would not likely take that as kindly.
We did receive a resolution of sorts—and some welcome relief from campaign ads—with the passing of the midterm elections. Although that supported the classic post-election rally, little seems actually resolved. Rancor between the two parties will persist, it’s unlikely much progress on the most significant issues will be made, and House-led investigations and/or subpoenas are likely to ramp up. For now though, enjoy the respite from campaigns, because the 2020 Presidential election season will be upon us in no time.
Midterm Moves for International Markets?
We often remind investors that the economy and markets usually have more impact on politics than the other way around. Yet, there may be some takeaways from the U.S. midterm elections for investors in international stocks.
First, a look back at international stock market performance following past U.S. midterm elections reveals that losses came down to U.S. dollar moves. Over the past 25 years, midterm election years brought higher international stock markets in November. The exceptions were 1994 and 2010, when the U.S. dollar rose 5%, in moves largely unrelated to those elections, leading to 5% declines in dollar terms for the MSCI EAFE Index as you can see in the chart below.
November of midterm election years saw losses for international stocks in 1994 and 2010
Source: Charles Schwab, Bloomberg data as of 11/6/2018—total return for MSCI EAFE Index. Past performance is no guarantee of future results.
Forecasting moves in the U.S. dollar in the short-term is very challenging. One indicator that has worked well since President Trump’s inauguration has been his approval numbers, which have led the moves in the dollar by about 90 days, as you can see in the chart below. This may be because the approval number captures many things respondents attribute to the President, like the growth of the economy and inflation, which can drive the value of the dollar. If this relationship continues, the dollar may not see another 5% jump this November, allowing international stocks to rebound from a tough October.
U.S. dollar seems to follow Trump’s approval rating
Source: Charles Schwab, Bloomberg data as of 11/6/2018. Past performance is no guarantee of future results.
Beyond the U.S. dollar, there may be other factors affected by the election that could move international markets, including trade, taxes, and oil.
Trade – Global stock markets are likely to remain concerned by the trade tensions even though Democrats gained control of the House of Representatives. Congressional approval is not required for the trade tariffs and other actions Trump has implemented. However, the new trade agreement (USMCA) to replace NAFTA does require a congressional vote next year; but this isn’t likely to be a major hurdle. Winning approval for the deal would have been easier for Trump under a Republican Congress. Democrats may push for concessions on labor-related aspects of the agreement prior to ultimately approving the deal. The next trade-related event of significance is the face-to-face meeting between the leaders of the United States and China at the G20 summit in Argentina later this month.
Tax cuts – President Trump’s veto power means U.S. corporate cuts are likely to remain in place, helping further the trend toward lower corporate tax rates around the world. This year’s cut in the U.S. corporate tax rate was dramatic. Twenty years of cuts elsewhere around the world had left the United States as an outlier as you can see in the chart below. Further cuts are being discussed in Japan and there may be renewed talk of tax cuts in Germany as a leadership transition begins to emerge.
Corporate tax rates may continue their downtrend
Source: Charles Schwab, Data from KPMG as of 11/7/2018.
Oil - A further crackdown on Iran and Venezuela, as well as possible sanctions on Saudi Arabia that may have further crimped world oil supplies, may have been more likely under Republican control of both chambers of congress. Control of the House of Representatives going to the Democrats may offer some slack to oil prices, which have been sliding not only on the likely election outcome but also continued weakening in China’s economy accompanying a slowdown in oil demand. But we don’t expect much relief in the pressures that have kept oil supplies relatively tight. If China’s economic stimulus efforts in recent months soon stabilize the pace of growth, oil prices may rebound after the slide in October. Additionally, the intermediate-term impact of re-imposing sanctions on Iran may not be fully known yet.
These global impacts from the U.S. election don't change our forecast for continued elevated stock market volatility and heightened risk of a peak in the global market and economic cycle in the next 6-18 months.
Positive seasonal factors associated with putting the midterm election in the rear view mirror could result in further rallies off the recent lows. The market’s whipsaws over the past month illustrate the importance of not trying to time the market. But given the uncertainties that still exist and the potential slowdown in both earnings and economic growth, we continue to recommend a fairly cautious approach to investing, including discipline around diversification and rebalancing.