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Expert Perspective

News, research and market insights from our team of experts.

Investment e.Perspective

Current Issue | October 29, 2018

Chairman Powell Is Not So Accommodating

By: David Lewis, CFA, CAIA, Senior Investment Strategist & Oxford Investment Fellow


The third quarter saw strong returns for US equity markets as measured by the S&P500 Index, which was up 7.7% for the quarter, bringing year-to-date results to positive 10.5%. This result was concurrent with robust consumer and business sentiment and continued strong earnings (Q2 S&P500 operating earnings were up more than 20% year over year). A "growth over value" regime also persisted as the Russell 1000 Growth Index outperformed its value counterpart during Q3 (9.2% vs. 5.7%) and by more than 13 percentage points during 2018 (17.1% vs. 3.9%).

As we reflect back on the US market we observe that while the vast majority of S&P500 companies beat earnings estimates in the first (76%) and second (80%) quarters, we are seeing a narrowness in market support with just three stocks: Amazon, Apple and Microsoft, accounting for more than 30% of the year-to-date return.

Another continuing theme for equity investors has been the weakness outside the US. Both developed (MSCI EAFE: +1.4%) and emerging (MSCI EM: -1.1%) markets generated muted returns in the third quarter. On a year-to-date basis through September 30, developed markets declined 1% and emerging markets were down 8% from weakness in Brazil (-12%), India (-10%) and fears of contagion from Turkey which declined more than 40% due to political turmoil.

A Strong US Economy & An Active Federal Reserve
The headline strength of the domestic economy continues to be significant. Second quarter GDP (+4.2% annualized) achieved its highest result in four years, although we believe some portion of this is related to one-time events like the 2017 tax cut and cross-border activity being pulled forward amid a growing trade war. The unemployment rate in September declined to 3.7%, which is the lowest level since the late 1960s. Down from a post-recession peak of 10% in 2009, it has been aided by Baby Boomers, whose retirements since that time have reduced the percentage of adults in the work force. Over the past several years the combination of slack in the labor market and the “gig economy” (project work via mobile apps or independent contractors as opposed to full-time employment) has restrained wage inflation, but we see growing data around enhanced benefits, bonuses and raises as employers struggle to find qualified workers. This is, of course, a good thing for workers, but in time may contribute to margin compression on corporate earnings.

Amid this economic strength Chairman Powell and the Federal Reserve has continued its path of raising rates. The third rate increase during 2018 occurred in September and a fourth hike is anticipated before year-end. A second order effect on interest rates comes from the Federal Reserve’s unwinding of its multi-trillion dollar balance sheet. During the depths of the financial crisis, and at critical points in this economic recovery, the Federal Reserve has purchased mortgage-backed securities to add liquidity to those markets, and long-dated Treasuries, in an effort to hold down long-term interest rates. Over the past year, the Fed has allowed the balance sheet to shrink, which now stands at $4.1 trillion and effective October 2018, will further shrink by $50 billion per month. Though we do not anticipate significant changes to the yield curve from this policy it does affirm the Fed’s commitment to removing some of its extraordinary support.

The corporate tax cuts announced last year are supporting increased business spending but a meaningful portion has been used to expand stock buyback programs. Thus far in 2018, over $700 billion in buybacks have been announced, as compared to less than $400 billion at the same time in 2017.

More Trade Turmoil
On the geopolitical front, more of the trade rhetoric has manifested into policy. The US expanded its tariffs on Chinese goods in late September with an additional $200 billion in annual goods/products being assessed a 10% tariff, which will rise to 25% in January 2019. Unlike the tariffs on steel and aluminum, which took effect earlier in 2018 and directly impacted US producers who may or may not have raised prices, about a quarter of these new tariffs are targeted at end consumer goods. While the exact impact on the economy won’t be known for some time, this type of trade friction has the potential to slow economic growth and increase inflation.

What Lies Ahead?
Lastly, while this issue of the Investment e.Perspective speaks specifically to the third quarter, the early weeks of Q4 have seen a notable change in market sentiment as equities, fixed income and energy declined. Notwithstanding these past few weeks, the diversification within our portfolios across traditional and private markets is a key tenet of our investment approach, and maintaining a disciplined effort is critical to helping our clients weather market turbulence and achieve their objectives.

The above commentary represents the opinions of the author as of 10.31.18 and are subject to change at any time due to market or economic conditions or other factors.