During October, US and international stock prices fell sharply, although US stocks continued to outperform international for the year. These Comments will discuss mostly US stocks (we discussed international stocks last month).
Using the S&P 500 as a proxy for US stocks, the chart below shows results since Trump’s election in early November 2016, through the end of October 2018. (This chart also appeared in our recent October 24th special memo.)
|Day After Election, November 2016, Base Level:||2,163;|
|Year End 2017:||2,674; +511; +23.6%|
|February 2018 Recent Lows:||2,581; +418; +19.3%|
|Summer 2018 Recent Highs:||2,930; +767; +35.5%|
|October 31, 2018 Close:||2,712; +549; +25.4%|
These figures tell us that even after accounting for serious declines in February and October 2018, US stock prices are approximately 2% higher than year-end 2017, and a very substantial 25% higher since November 2016. Even with all the problems that the media is quick to highlight on down days, US stock prices have gained 25% in the past two years. For much of that time, the markets have known about and been dealing with most of these problems.
The more significant issues regularly cited in the media include “President Trump’s trade war with China; the Federal Reserve’s stated plans to keep raising interest rates; signs that labor and other costs could climb; slowing growth in Europe and China; and the tax cuts that increased growth in profits this year will not have the same year over year effect in 2019” (NYT, 10/31/18, page B1).
What follows are Park Piedmont’s (PPA) observations about these issues. The overriding question here is: why did dramatic stock price declines occur in October, after reaching new highs over the summer, since so much of this news has been known for many months?
- Higher Interest Rates: The US Federal Reserve has raised the short-term rates it controls by 25 basis points (bps) three times this year. In 2017, there were also three increases of 25 bps. As the chart on page 1 indicates, ten-year US Treasuries yielded 2.45% at the end of 2016. Through 2017 and 2018 year to date, there have been six quarter-point increases. The ten-year Treasury could yield 3.95% to cover all six increases, but it currently yields 3.15%, well below that rate. Taking a two-year view of interest rates, we see they haven’t risen as quickly as they could have. This is barely discussed in the popular media.
The Fed raises rates when it believes the economy is growing too quickly, with the objective of heading off inflation before it takes hold. But most people like a growing economy, which supports more employment, more wage growth, more consumer spending, more home purchases, more business investment, and more business profits. Fed rate increases are therefore not too popular. But at some point, the rate increases take hold and the economy does slow down. That in turn reduces employment, along with the rate of rising wages, consumer spending, home construction, and business investment and corporate profits, which in turn has an adverse impact on stock prices. If the stock market was predicting all this in last month’s price declines, the question is why did it take until October?
Another consequence of higher interest rates is that they make investments in bonds more attractive, because investors receive the benefits of the higher rates as existing bonds mature. When bonds become more attractive, there is some reallocation of investor money away from stocks.
Higher interest rates also create a stronger US dollar, which has adversely affected a number of emerging market countries that borrowed money in dollar-denominated loans, and now have to find a way to pay the loans back with more expensive dollars.
- Tariffs and “Trade War” with China: The Trump administration has decided that it is in America’s interests to reduce the trade deficit with China, and to get China to stop stealing technology secrets. To further these policies, the US has imposed tariffs on many goods coming from China, which effectively raises the price of those goods, reduces demand, and, presumably, overall economic activity. China has reacted with its own tariffs on US goods, but is apparently more adversely affected than the US, because its stock market has been down as much as 20% during 2018. This issue has been going on for months, and the media constantly references it as a reason for down days. But how then to account for the up days, and a 10% market gain in the US through the end of September 2018.
- Increasing Budget Deficits: The Trump administration has also been successful in pressing Congress to pass large tax cuts that primarily benefit large businesses in an effort to stimulate growth in the US economy. With lower tax collections, the US budget deficit has increased substantially, which means more borrowing is necessary by the US government. The proponents of tax cuts take the position that the economic growth will eventually add to the taxes collected, by virtue of more and higher wages for individuals, and more profits for corporations. There are many sides to this question, but why would this be a reason for October’s declines, since it too has been known for many months?
- Higher Wages Potentially Reducing Corporate Profits: This may be, but these same higher wages create more demand for businesses, and the opportunity to earn more profits. And the same question about why this factor should have been discovered in October remains.
- Other Political Issues: It is very difficult to factor these in as causation for October’s declines, as they have been ongoing since Trump took office. And as our chart on page 2 indicates, US stocks are up 25% in the two years since Trump’s election.
As we have consistently maintained in many of these Comments, causation is difficult to attribute and even more difficult to prove, with so many factors affecting stock prices. Comforting as it might be to offer explanations for difficult times like October, we at PPA have no answers as to the day-to-day (or even month-to-month) swings, particularly since the next day the markets are just as likely to reverse course as to continue in the direction they were going.
In other words, volatility is a two-way street; note that on October 29th, the S&P 500 had an intraday range from high to low of 100 points (almost 4%), which corresponded to a 900-point range on the Dow Industrials (also almost 4%). When this volatility strikes the markets, we re-emphasize our advice to think as long-term investors, with a time horizon of years. If you do need money from your portfolio, it is highly likely to be available from the sale of bond funds, which we recommend as part of most client allocations as a buffer against the inevitable times when extreme volatility affects the stock market.