At the end of October, one could almost gather that a some modest relief was returning to the financial markets as the ugly but much anticipated US midterm election drew near and uncertainty over its outcome would be no more. As it turned out, election day generally went as predicted by political pundits – that Democrats would take back the house, but Republicans could hold their majority in the Senate. The fracture of Republican control renews what is often referred to as political gridlock. Citizens will often complain about gridlock or political dysfunction, but investors see it more favorably because the probability of significant policy changes are perceived lower when political parties are at odds with each other. In this day, it also mostly removes the possibility of Democrats pursuing impeachment of Trump or a wholesale rollback of policies implemented during his first two years (which would not in any way be market friendly). On the split-power result, US equities enjoyed a strong start to the week and post-election bounce on Wednesday. That bounce, which led some to cheer that a hoped-for 4Q rally might now get underway, were cooled Thursday and Friday as the Federal reserve reiterated its intent to continue raising interest rates. Still, the strength by markets early in the week was enough to help the S&P500 conclude firmly in positive territory for the week with an advance of +2.2% on the S&P500.
Shake or bake; not! Shake and/or Break is a fitting title for the frightful market action in October. Markets may “shake” because of tariffs. But, the Fed can cause the market “break.”
Much of the blame for October is aimed at President Trump and/or Federal Reserve Chairman Powell. Investors are concerned that the Fed remains inclined to raise interest rates further – 1 more hike in December, and presently communicates 3 additional times in 2019. There are even forecasts of one more rate increase planned in 2020. Investors are also concerned about tariffs because they are like a tax to American citizens. Both issues are viewed as punitive to economic growth over the next 12 months. Some wonder if the recent economic strength is “as good as it gets.” That suggests that economic and business growth will be shifting into slow expansion again (even though this expansion will become the longest running in US history next year). The economy is probably able to handle slow rising interest rates, to a point. But the stock market will show stress earlier, as witnessed by action in October. In essence, the market tone was altered due to these two concerns. Again, markets may “shake” because of tariffs; but markets could “break” because of the Fed.
In recent days we executed several tactical adjustments in the fixed-income sleeve of client portfolios. We sold or reduced exposure to short-maturity bond funds and reinvested proceeds into position-traded money funds. These adjustments take advantage of attractive yields available on short-term money funds relative to the variable return potential on short-maturity bonds in a rising interest rate environment.
One word comes to mind when thinking of the drawdown endured in October: relentless. It was the worst month for US investors years with 16 of the 23 trading sessions during the month being negative. Worse than that, since the S&P500 made its last all-time high on September 20, 75% of all trading days were negative and the major US stock indexes flirted with technical correction – a term defined by a drawdown of -10% or more. The retreat was most severe in those areas of the stock market that to this point, performed the strongest. “FAANG” names (Facebook, Amazon, Apple, Netflix, and Google) were punished one after the next for either softer-than-hoped quarterly earnings or more sober forecasts of quarters to come. As bad as it was, perhaps the most discouraging development was that diversification provided almost no relief. Even the safest of bonds, which historically offered investors a destination of safety and could be counted on to rise during times of severe market stress, also forfeited ground during the month muting their benefit. International equities, of course more risky than bonds but experiencing troubled times throughout most of 2018 fared even worse than domestic (how much further can they fall?!). One story appearing in the Wall Street Journal went so far as to call diversification “dead”.