In a Nutshell
- Volatility returns to stock markets
- Rising interest rates continue to impact bonds
- Signs of inflation?
U.S. Stocks – Markets Also Go Down
Well it finally happened. A 10% pullback in the stock market. We all knew it was coming. Well, we didn’t know exactly when, no one ever does with any consistency. We’ve been through this many times before since historically the market has averages one 10%+ pullback each year. And yet it still hasn’t felt comfortable. Maybe that’s because it had been well over a year since we’d experienced even a 5% correction. And, although the market did come back some, it wasn’t enough to prevent the first quarterly negative return since the end of 2015. (Source: S&P)
Now the question is whether this correction is done or has more to go. Although most economic indicators are positive and economic growth is the best it’s been in several years, it’s possible this market could fall further. It’s been a long time since the market has seen a 15% drop, 2011 in fact. And, at 9 years and counting, we’re in the midst of the 2nd longest bull market since 1926. (Source: JP Morgan). Could the market be in the beginning stages of ending this bull market run? Sure, but with the current solid global economy, still low interest rates, the largest corporate tax cut in history and low inflation, it would be abnormal. More likely, the stock market has returned to a more normal state where 5% – 10% pullbacks happen on a regular basis. They still won’t feel good. They never do.
Looking deeper into the performance numbers, it wasn’t all negative. Small company stocks eked out a small gain and many growth stocks such as those in the technology and consumer discretionary sectors posted solid positive performance.
An often cited reason for the volatility this past quarter was the threat of a trade war between the U.S. and China. Markets hate uncertainty and the thought of the 2 largest economies in the world curtailing their trade with each other would definitely be enough to hurt corporate profits and cause a recession. Another cause of market uncertainty right now is more seasonal. We’re in the 2nd year of a presidential administration and history shows that it’s normal for markets to stall out for several months until midterm elections are over and it’s known which parties will control the House and Senate. LPL research recently put together a nice chart showing the average market performance during each quarter of the 4 year presidential cycle.
International Stocks – A Mixed Bag
As can be seen from the chart of returns, international market performance during the quarter and over the past year has depended on whether you were invested in developed countries such as Japan and those in the European Union, or in emerging market economies. Although the EU looks like it has turned the corner economically, it has been slower to recover than either the U.S. or smaller, less developed countries that make up the emerging markets.
A reason emerging markets performed better this quarter is that commodity prices, especially oil, have been rising. Many countries in this group are commodity exporters and stock markets in Saudi Arabia and Russia, which are dominated by oil companies, helped the emerging markets index achieve a positive return.
A number of market strategists continue to think international stocks, both developed country and emerging markets are poised to outperform the domestic stock market. Their case is based on a number of reasons. A couple of the more widely cited examples are that international stocks are a better value than U.S. stocks, and their economies have been recovering more slowly and so have more room to run.
Bonds – Rising Interest Rates Taking Their Toll
As we’ve discussed in previous quarterly reviews (see here & here), rising interest rates usually have a negative effect on bond returns. The Federal Reserve raised rates again in March by a quarter point so that the Fed Funds Rate now stands at 1.75%. More importantly, it has communicated to investors that it plans to continue raising rates at a regular pace for at least the next couple of years. Although not good for bond investors, rising interest rates are a sign the economy is doing well.
If you remember back to your high school economics class…OK, nobody remembers this as we were all sleeping with our eyes open. So here’s a refresher. The Fed has 2 primary jobs, keep the country fully employed, and keep inflation under control. The fact that the Fed is slowly raising interest rates in 0.25% increments 2 – 3 times per year is positive for the economy. It means that the country overall is fully employed and inflation, while increasing, is doing so very slowly.
Low and rising interest rates are usually healthy for stocks. (Source: JP Morgan). Unfortunately, the same can’t be said for bonds, especially those with longer maturities. The result is that “safe” high quality corporate and government bonds will probably continue to have anemic annual returns for a while.
Commodities & Alternative Assets – Signs of Inflation?
While the larger commodity index was lower for the quarter some specific commodities, especially oil, rose substantially. Petroleum products are a cost for many businesses, especially in transportation and many manufacturing industries. And while it hasn’t shown up in commodity prices yet, tariffs and threats of tariffs for basic materials such as steel and aluminum may push raw material costs higher. Up to this point in the economic recovery, companies have had excess capacity and were willing to eat higher costs rather than raise prices. Now, however, the country is operating at full capacity. If oil and other basic material costs continue going up, unless companies invest in productivity improvements or are willing to lower their profit margins, they will be forced to pass their increased costs on to their customers. If this comes to pass, inflation, which has been at 2% or less for several years, will begin to climb.
Commercial real estate companies were the worst performers this quarter. This is largely because for any given real estate holding company, they are borrowing 50% – 70% of each building’s value. And these loans typically are either floating rate, where interest rates fluctuate monthly, or are shorter term loans. So, when interest rates are rising, their loan payments increase and eat into their profits until they are able to raise rents enough to compensate. For hotels and apartments, this is usually not an issue since they can change rents daily (hotels) or annually (apartments). However, for retail, office and industrial buildings, this can be a big problem they are usually on multi-year leases and take much longer to react.