Monthly Markets Memo - October 2018
by Dan Zalipski, CFA
Fed Chairman Jerome Powell recently gave a speech in which he stated that the Fed may need to continue to increase rates, possibly aggressively, especially if inflation begins to quickly move higher. The yield on the 10-year treasury surged, with yields moving from 3.06% to 3.23% in four days, a big move for treasuries in a short amount of time. The equity markets can typically withstand rising rates but tend to get nervous when the pace is this fast. Next, the International Monetary Fund (IMF) reduced their global growth projections citing ongoing trade policy disruptions, specifically mentioning disruptions to NAFTA, Brexit and the European Union, as well as the ongoing trade dispute between the U.S. and China.
The markets wobbled, but the knock-out punch came the next day when two well known, wide-reaching industrial companies (PPG and Fastenal) pre-announced earnings warnings. These companies cited rising input costs, softening demand from overseas, and increased transportation costs (we touched on the trucker shortage back in our August Market Memo).
The S&P 500 sank over 6% within days as fears of peak earnings and a slowing economy overwhelmed the markets. International markets, already on a slide, saw their declines accelerate. The hardest hit sectors included industrials, materials, financials, and energy. Stocks were not alone in the decline; bonds also found themselves in a selloff, with investment grade indices shedding over a percent, while the lower quality bonds fared worst. The spreads between the investment grade and lower quality bonds increased from post-crisis lows but remain tight to historical averages. In fact, spreads are tighter now than they were during the market correction in February of this year, suggesting this recent action could be ‘business as usual’ for the markets rather than the onset of something more dire.
Earnings will be closely watched this quarter for signs of impairment from rising input costs or the ongoing trade disputes with China. Increasing input costs such as labor, freight, and raw commodities will put pressure on profit margins, ultimately putting downward pressure on earnings. Earnings growth is expected to decline from last quarter’s impressive numbers but are still expected to be relatively strong. However, the forward guidance these companies provide is what could ultimately be what decides the broad market’s next move.
Beyond earnings, attention will turn back toward the Fed. As we mentioned in the open, Chairman Powell’s comments played a role in the dramatic market movements this October. The Fed has a tough job ahead of itself. Should they raise rates too slowly, they risk letting inflation climb too high. Should they raise rates too quickly, they could potentially choke off economic growth and trigger a slow-down, or even a recession.
For now, the U.S. economy still looks strong. Unemployment is at a 50-year low. Both manufacturing and service sectors remain in expansion mode. Consumers are spending and their confidence in the economy remains high. The housing market appears to be cooling off compared to a year ago due to a combination of higher prices and higher rates pushing prospective buyers to the sidelines. Equities are likely to remain volatile as rising interest rates create an environment where both bonds and cash are competitive compared to stocks. We believe the market cycle is in its later stages, but still has some room to run.
"In my experience, each failure contains the seeds of your next success - if you are willing to learn from it." - The late Paul Allen, co-founder of Microsoft
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