The perception of the risk inherently associated with investing is ever-changing. When markets are strong and uncertainty is low, prices go up and market volatility is reduced. Of course, the opposite is true as well. Uncertain times and weak prospects can lead to an environment of low prices and high market volatility.
No doubt, you have heard about the most recent bout of market volatility. What is happening, and why now? Today we dig in a bit to understand the variety of factors at play:
Interest Rate | Impact Changes Have on Valuation
Interest rates are a key variable in the valuation of assets. When interest rates rise, two things occur:
- Future cash flows are discounted to a greater extent (lowering values). This affects any asset with implied cash flow (stocks, bonds or real estate).
- Interest-paying investments become a more attractive option as yields rise. We see this even in the market for cash, with rates on savings accounts, certificates of deposit and money market funds rising from near-zero a few years ago to around 2% today. At that level, cash is no longer ‘trash’ and offers a competitive choice for short-term capital.
This same dynamic is playing out through the entire bond market, as investors continue to dissect every Fed official speech/comment, searching for further information on when and how interest rate changes will take place. Adapting to a new regime of more ‘normal’ rates is usually not a linear process. This can result in volatility.
Interest Rate | Timing and Path of Changes
Aside from the fundamental fact that rates are on the rise, a related variable is the pace at which they are raised. Increasingly divergent market opinions about the timing of rate increases has led to uncertainty. Historically, rapid and substantial rate increases (usually to control high inflation or an overheating economy) have created more market volatility than more gradual rate movements. Occasionally, soundbites from the Fed rattle the fixed income market. We had an example of this recently when Fed Chair Jerome Powell hinted that the Fed may choose to ‘overshoot’ their target by raising rates beyond the neutral rate. Ominous soundbites aside, every decision the Fed makes remains data dependent.
As we mentioned in our blog post on interest rates a few weeks ago, the Fed controls short-term rates. Long-term rates are driven by inflation expectations and credit risk. While US treasuries are often considered to be ‘risk-free’ assets, wider budget deficits can negatively impact on the perception of the risk inherently associated with these assets.
Strong U.S. Dollar
The value of the dollar is currently experiencing a multi-year period of strength. The benefit of a strong dollar is that it’s cheaper to import goods (including selected commodities, priced in dollars). The drawback is that exports are expensive. This results in a headwind in foreign stock and bond returns for U.S. investors.
You might be surprised to learn that earnings commentary from a variety of firms (primarily, those that export more heavily) point to the dollar as a more significant headwind than tariff talk or other uncertainties. The good news is that these cycles have tended to change course after a few years.
Trade Tensions with China
This has been in the background for months, although the volume of goods is less meaningful to either side as a percentage of total production than it may first seem. There is hope that negotiations will deliver a more subdued agreement than what headlines have touted; perhaps, akin to what the U.S. has achieved with Mexico and Canada, and is working on with Europe.
US-imposed tariffs in recent years have remained near their historical lows, with taxes collected on less than 2% of imports. Global tariff rates are also quite low. A higher overall rate would bring these a bit closer to historical norms. That said, the concerns about trade tensions go far beyond tariffs, into agreements about intellectual property, the amount of latitude US firms are given to operate in China and broader theater of long-term global influence.
For nearly a century, volatility in the equity market tends to pick up after Labor Day—often dramatically. In fact, October is among the most volatile months of the year, which has shown itself to be true again in 2018. Although some seasonal tendencies defy explanation, a probable one to explain October’s market volatility may be that attention has moved from this year, to the hopes and dreams for next year. These equity market hopes and dreams have often manifested themselves as stronger-than-average market returns in November and December (the so-called ‘Santa Claus rally’), although that is never a prediction, only a historical tendency.
Economic Growth and Earnings
Markets have become more concerned about the durability of the current business cycle. It’s already one of the longest on record in the US, with continued debate as to whether we’re in the middle or further towards the end. Eventually, though, every cycle comes to a conclusion, morphs into a recession, and begins anew.
Earnings growth for companies follows this same pattern, with very strong growth over the last year (over +20%) buoyed by strong fundamental revenue gains and tax cuts (the latter of which represent about a third of earnings improvement).
This growth cannot go on at an infinite pace. Investors are looking for signs of leveling off or deterioration in earnings after conditions peak. 2019 earnings growth predictions are still strong (around +10%), but this does mark a deceleration from recent years. Profit margins too are expected to move back to a more normal, lower pace. Concerns also involve effects on growth in Europe and Japan, which has been markedly weaker and thus more sensitive to disruption and tariffs. Rates of growth in emerging markets, such as China, remain the highest in the world, but are just no longer running at the same robust pace of their infancy years.
It’s said frequently that politics and financial markets don’t necessarily correlate to each other over time, but short-term policies can affect sentiment positively (tax cuts) or negatively (imposition of tariffs and other trade policies). The market run-up to mid-term elections has historically been a volatile road (and often negative), while the aftermath has been less so (and often positive).
This is always a wildcard with financial markets. Some major events come and go, seemingly ignored, while what appears to be more minor news garners a violent reaction. Often, these events exacerbate the sentiment trends that are already in place. These include events involving negotiations between Italy and the EU involving its budget, spats with Turkey and the recent incident involving Saudi Arabia’s role in the death of a journalist. While not always directly relevant (absent military action), there can be indirect impacts on currencies, bank balance sheets and commodity prices.
In short, the list of reasons for market volatility is long. Some worries may turn out to be warranted, while others may not.
It’s important to remember how normal volatility is. We talked about this a bit on our blog two weeks ago when this most recent market volatility began. Since 1980, while the S&P 500 has earned an average annualized total return of just under +12%, half of those 38 years have featured a peak-to-trough drawdown of at least -10% during the year, and a third of those years had at least a -15% decline. Even more importantly, per research assembled by JPMorgan, over the past 20 years, the 10 best market days have occurred within two weeks of the 10 worst days—so knee-jerk reactions can be costly. We encourage our client families to keep the long term view in mind when making decisions about short term volatility.
Does the recent volatility have you wondering what impact it may be having on your long term plan? Reach out. Our team of CERTIFIED FINANCIAL PLANNERS™ is here to help.