The markets are certainly making investors uncomfortable lately. However, market corrections, especially late in the cycle should be expected and can be healthy.
We have experienced five sell-offs (and recoveries!) of similar magnitude in the last five years. Unfortunately, 2018 brought the markets back to a more normal level of volatility after investors were lulled into a sense of riskless comfort in 2017. Despite the recent market instability, we still see three reasons to be optimistic.
The Good News
First, it’s an election year and history shows that the S&P 500 pulls back an average of 19 percent in mid-term election years dating back to 1962 (14 mid-term cycles) but in the year after the mid-term the S&P 500 climbs an average of 31 percent.
Second, the economy is historically strong. In aggregate, every metric still supports the notion that the domestic economy is steadily growing. GDP, employment, and inflation back the FOMC’s stance that rate increases are justified to prevent the economy from overheating. Also, rates are still very accommodative by historical standards.
Finally, corporate earnings are strong. Through November 6th, more than 80 percent of reporting companies in the S&P 500 index have released 3rd quarter 2018 earnings. Of those, approximately 86 percent grew, while the overall average earnings growth rate is 27.2 percent as seen in the chart below. Earnings are coming in four percent above analysts' expectations, with overall growth now above the second quarter rate. Sales metrics are also beating for the quarter and, forward looking, management has been guiding above the consensus for earnings outlooks.
The Other Side of the Story
Corporate America is benefitting from the 2017 fiscal package; however, this may be the high point in the earnings cycle as increased tariff costs, the tight labor market and rising debt costs start to impact revenue. The tariffs have slowed timber and grain shipments, raised the cost of textiles and heavy-equipment materials, and compressed margins for chip- and toolmakers. Overall, the negative repercussions have been universal across U.S. corporations but have had relatively modest impact so far. This may be due to a timing effect as the implementation of the second round of levies on Chinese goods only started on September 24th.
Another headwind to earnings could be the impact of higher rates on consumers. Autos, housing and credit cards will gradually get more expensive for consumers as the Fed continues to raise rates into 2019. A 4.6 percent mortgage rate seems high to a first-time buyer who has only known the accommodative policies of the last 10 years; but the wealth effect of employment and potentially higher wages could serve as an offset.
As we enter the final quarter of 2018, it is apparent that the convergence of quantitative easing in the aftermath of the financial crisis and the added fiscal stimulus of the late cycle tax reform bill last year has resulted in domestic economic growth north of almost four percent, an unemployment rate south of four percent and steadily rising (but not explosive) inflationary pressures. However, the economy runs in cycles and, ultimately, while economic cycles don’t die of old age, there may certainly be turbulence on the horizon. In this environment, we still maintain a slight bias for equities over fixed income and prefer credit over duration. We also believe that certain parts of the private markets offer attractive potential returns.