October 2018 Market Commentary

After reaching an all-time high in late September, the S&P 500 lost over 6.8% and $1.9 trillion of value in October, its largest monthly loss since September of 2011. Despite positive news about the growth of GDP, employment, wages and third quarter earnings, investors focused instead on a number of factors, including profit margins, trade disputes and Fed policy which suggest to some that growth has peaked. Those concerns spread, leading public equities lower around the globe. And there was little safety in bonds during the month as corporate issues declined and drove the Bloomberg Barclays Aggregate to lose value over the month.

The following table contains a summary of October and year-to-date market performance:

Index October YTD Index October YTD
S&P 500 (Total Return) -6.84% +3.01% All Country World Index (Net) -7.49% -3.96%
MSCI EAFE (Net) -7.96% -9.28% Barclays Aggregate -0.79% -2.38%
MSCI Emerging Markets (Net) -8.71% -15.72% 60/40 Blend* -4.81% -3.33%

* 60% All Country World Index/40% Barclays Aggregate

The October sell-off was characterized by wild swings as investors failed to reward positive news as much as they punished bad news. The sell-off began in late September following comments by Fed Chair Powell regarding the future path of monetary policy. Powell stated that the economy no longer needs “such accommodative monetary policy”, and that he is concerned about “financial imbalances” as well as the Fed getting behind the curve when it comes to inflation. These statements led him to conclude that the Fed is “a long way” from neutral interest rates. Investors took these statements to mean the Fed would raise its policy rate to levels not originally anticipated. As the month progressed, investors’ concerns rotated from Fed policy to a rising belief that the trade dispute with China could expand in size and length, following a number of statements and policy actions from the Trump administration, leading to higher input costs. And finally, late in October a number of companies released quarterly results pointing to rising input costs due to accelerating labor costs and tariffs, leading investors to question whether earnings margins have peaked.

October was the 114th consecutive month of positive economic growth and the release of measures of growth suggests it can continue for some time. Investors, however, appear to have looked beyond the positive news and focused instead on any evidence that growth is slowing. U.S. GDP grew 3.5% (annualized), beating estimates, fueled by a 4% increase in consumer spending, but markets barely moved as investors noted that (1) housing construction fell for the third consecutive quarter and (2) export growth slowed in the face of new foreign tariffs. The ISM manufacturing index hit 59 in October, a level near its post-2008 high, but receiving as much attention was the “new orders” component falling to 57.4 from 61.8 a month earlier, due in part to weaker exports. Finally, the economy created approximately 250,000 jobs (beating expectations) helping average hourly earnings rise 3.1% year-over-year, greater than inflation and the highest growth since 2009. The increase in real income is a positive for future consumption, but is a negative to investors concerned about its impact on (1) earnings margins, and (2) inflation, and what that might mean for Fed policy and interest rates.

At the corporate level, earnings continue to be revised upward as more companies reported positive earnings and revenue surprises. As third-quarter reporting began, earnings were forecast to be 19.5% higher than a year earlier, but with nearly half of companies reporting, earnings are now expected to be 22.5% higher. While historically stocks move higher on positive earnings surprises, negative investor sentiment this quarter has led to the smallest price reaction to positive surprises since 2011.

Outside of the U.S., the European Union (EU), Japan and the emerging markets all continue to demonstrate trend- like economic growth. However, investors have punished assets from those regions over concerns that global growth is slowing, the impact of a strengthening dollar, and the negative consequences of tariffs on Chinese GDP. In the EU, 2018 GDP growth is expected to slow to 2.2% from 2.5% a year earlier, in part on slowing exports to the emerging markets. Despite the slowing of economic growth, EU corporate earnings are still expected to grow nearly 10%.

Emerging markets (EM) investors responded to the strengthening dollar by pulling $17.1 billion from emerging market equities in October, the 4th largest withdrawal since 2005, contributing to their nearly 9% sell-off over the month. EM equity returns also appear to be suffering from concerns about the effect of 25% U.S. tariffs on $250 billion of Chinese exports and the nation’s GDP growth. China’s Purchasing Managers Index (PMI) for October was 50.2, down from 50.8 in September (a value above 50 indicates a growing economy), and its lowest since July 2016. A review of the Chinese PMI components reveals new orders falling from a month ago and new export orders falling for a fifth straight month. China reported 6.5% GDP growth in the third quarter, its slowest pace since 2009.

Despite rising risks to growth, Caprock continues to observe evidence that global economic and earnings growth will extend into 2019. We also note that despite the market’s recent sell-off, U.S. equities remain fairly valued at current levels while earnings growth remains strong. The outlook for emerging market equities is unchanged from a month earlier; they remain attractively valued relative to fundamentals but subject to considerable near-term volatility as U.S. interest rates rise relative to those in the rest of the world. This underscores the importance of rebalancing and perhaps even beginning to under-weight U.S. equities for clients with more sensitivity to market risk. Based on fundamentals, equity markets are still positioned to move higher from current levels. However, the upside opportunity relative to the downside risk is becoming increasingly less attractive. As a result, our recommendations emphasize a conviction that rebalancing to target allocations remains a smart discipline at this stage of the market cycle.

This communication is not an offer or solicitation with respect to the purchase or sale of any security and is for informational purposes only. Information contained herein has been derived from sources believed to be reliable, but Caprock makes no representations as to its accuracy or completeness. Investment in securities involves the risk of loss. Past performance is no guarantee of future returns.