October 2018

bbt-perspectives-market-monthly-october-2018-feature

“You can always find a distraction if you’re looking for one.”

Tom Kite, Professional Golfer

Tom Kite probably uttered these words after a tough day on the golf course, but truer words were never spoken as it applies to this long but unloved bull market. Upcoming midterm elections, trade policy, the Fed and fears of recession are distractions that leap off the headlines. Lost in translation, however, is a U.S. economy growing above trend with continuing signs of acceleration. In this edition of Market Monthly we’ll provide context around some of these issues as we head into the perennially positive fourth quarter season. We’ll revisit and refresh our views expressed here throughout 2018 with a guided outlook into 2019. Short-term headline distractions should not derail a thoughtful long-term investment plan.

Midterm Elections:

Midterm elections will be held on Nov. 6 with higher-than-normal, midterm turnout. When the party of a first-term president also controls the House, the Senate or both, it is common for the party in power to lose control of either chamber due to an energized opposition. We’ve all learned from the 2016 U.S. election and the U.K. Brexit referendum that polls are not checks to be cashed until the final votes are counted. Recent polls reflect an expectation that Democrats will take the House while Republicans will hold the Senate. Additionally, generic party polling has maintained a range of anywhere from a 3% to 11% Democratic edge with current polls very close. Noteworthy points include:

  • 25 House Republicans up for reelection in districts that Clinton won
  • 13 House Democrats up for reelection in districts that Trump won
  • 38 House Republicans not running for reelection
  • Of the 35 Senate seats, Democrats are defending 25 and Republicans defending 10
  • Odds favor a Democratic House and a Republican Senate but neither is a lock

Our interest in the election regards investment outcomes that can be attributed to the election results. The chart below reflects historic S&P 500 performance under all six possible scenarios for various combinations of party control for the White House, House and Senate. This is always interesting but should not be mistaken as predictive. For example, the middle red bar below reflects historic performance for what current polls are showing with a divided Congress and a Republican president historically having experienced 10.8% annual returns.

bbt-perspectives-market-monthly-october-2018-partisan-control-avg

A final reference can be observed when overlaying the calendar influence of market results over midterm election years. Historically, fourth quarter market returns are the strongest. It has tended to be magnified during midterm years. But this correlation needs context as we show in the chart below which shows:

  • Best/worst/median market returns for each quarter of all Post WWII midterm election years
  • The year for each high and low
  • What was occurring during those low years

bbt-perspectives-market-monthly-october-2018-partisan-mid-term-s-p

Observations:

  • Q4 during midterm election years has been positive 16 out of 18 times since 1946
  • “Tax-cut enthusiasm” may have borrowed (pulled forward) Q4 returns
  • Possible context for each of the four “lowest” quarters was either an overly aggressive Fed or a geopolitical event (Cuban Missile Crisis in 1962 and Watergate in 1974).

Takeaway:  Market behavior around midterm elections is less investment relevant than many believe. It is doubtful the election outcome would threaten some of the legislation (tax reform) that has propped up the economy and markets. Any change in power from the elections introduces an element of uncertainty with potential for short-term market volatility. Political leanings for both sides have recently gone from polar to nuclear and could lead to increased voter turnout and election surprises.

Trade:

In our August edition we said “NAFTA remains the highest near-term probability for a trade win…” On Sept. 30 the U.S., Mexico and Canada jointly reached an agreement to replace NAFTA and now awaits a Congressional briefing by the International Trade Commission. The new agreement will be named USMCA (U.S./Mexico/Canada) and is expected to be voted on early in 2019.

On the surface this represents a major trade win for which even Ross Perot may cheer, but the details will become more evident in the weeks to come. For now, the deal represents an opportunity for the U.S. to quickly pivot and mend fences with European and Japanese allies before setting its sights on the real target, China. The chart below illustrates that while Mexico and Canada remain our largest export partners (blue), China represents our biggest source of imports (red).

bbt-perspectives-market-monthly-october-2018-u-s-trade

In the coming months, attention will turn to China to see if broad economic stimulus will be pursued to stem the slowdown to their economy in particular and emerging markets in general. The chart below seems to indicate the trade issue is a far bigger negative to China due their greater dependence on U.S. imports. Note how U.S. stock prices (blue) have outperformed Chinese stock prices (red) since trade moved to the front burner. U.S. stock prices have climbed roughly 10% while Chinese stocks have fallen roughly 15%.

bbt-perspectives-market-monthly-october-2018-shanghai

Takeaway: The intent of tariffs all along has never been as a revenue source but rather a negotiating lever for trade discussions. Having said that, Washington has shown no signs of backing down from its threat to raise the recent tariffs that went into effect on $200 billion in goods from China from 10% to 25%.

Prolonged tensions combined with a weakening Chinese economy and the near collision of U.S. and Chinese warships in the South China Sea have made conditions more intense. The consequences of this could be underappreciated by markets and represent a clear future risk. Three primary trade related risks are:

  1. Inflation: Prolonged trade disputes are becoming inflationary due to supply chain disruptions and rising import prices on final goods.
  2. Supply chain disruptions that cause manufacturing costs to rise could result in earnings downgrades and declining profit margins in coming months.
  3. Trade uncertainty could cause corporate decision makers to delay investment and expansion decisions creating an economic drag.

The Fed:

In our 2018 Outlook we made three primary observations regarding the Fed and interest rates:

  1. The Fed would hike more than markets were implying remaining on its quarterly rate hike cycle
  2. Interest rates could begin to impact financial asset prices later in 2018
  3. Falling unemployment and rising wages underpin a reflationary theme

These themes are playing out. An additional theme, which has not played out, was our expectation of continued synchronized global economic growth. Instead, growth has diverged being led by the U.S. at the expense of many other world economies courtesy of tax reform. Record low unemployment and the attainment of the Fed’s 2% inflation target should keep the Fed on its quarterly rate hike path into 2019.

The chart below tells the Fed’s story well. The Fed Funds rate now exceeds 2% for the first time since before Lehman failed. In recent days, however, interest rates have spiked across the yield curve repricing closer to Fed expectations as markets seek to redefine “neutral” rates. This is challenging since this rate hike cycle began at an unprecedented 0%.

bbt-perspectives-market-monthly-october-2018-market-expectations

Takeaway:

  • Continued quarterly rate hikes into 2019 with pauses remaining data dependent
  • Robust economic data and 3.7% September unemployment underscore continuing economic strength
  • Emerging market contagion is unlikely with financial imbalances less severe than 1998
  • Financial institutions remain well capitalized
  • Coordinated Fed and Fiscal policy could reach an inflection point in mid-2019 but recession indicators still benign

Equity Updates:

In our 2018 Outlook we made four primary observations regarding equities:

  • Transitioning from a steep return/low volatility regime to a modest return/rising volatility regime
  • 2018 earnings growth would outperform index returns
  • We expected double-digit earnings growth in 2018 with a tailwind from corporate tax cuts
  • International markets could lead the markets again in 2018

All except International market leadership have worked well so far in 2018. As international economies have de-linked, so have their markets generating negative YTD returns. Contributing modestly to international weakness is the strength of the U.S. dollar. This is one reason our asset allocation process reflects a modest U.S. home country bias to help limit currency risk and overall volatility.

The chart below illustrates our theme of tax reform aided earnings growth. Q1 and Q2 both experienced 25% earnings growth with rising estimates during earnings season. The initial thrust of tax reform is now being absorbed by expectations as we are seeing earnings estimates slowly revised downward. For Q3 we expect 19% year-over-year earnings growth and 7% revenue growth. We expect 2019 earnings to revert to a more normal 7%-9% growth rate accounting for the absorption of lower tax rates. An outright earnings contraction (recession) would be cause for concern.

bbt-perspectives-market-monthly-october-2018-s-and-p-500

Below are YTD equity returns through Sept. 30, 2018. Some observations:

  • Small caps gained early in 2018 as primary beneficiaries of lower taxes and a strong dollar
  • Large caps have recently closed the gap with small caps
  • Growth continues to outpace Value as a style but its momentum has begun to slow
  • International returns have been hampered by a strong dollar

bbt-perspectives-market-monthly-october-2018-stock-index

Takeaway:       

  • Q4 historically the best quarter especially in midterm election years
  • Third year of the presidential cycle is historically the strongest of the four-year term
  • Earnings reverting back to company fundamentals with tax reform now embedded
  • Lack of share buybacks during the blackout period could add to near-term volatility
  • Equities remain in a bull market absent any indication of recession

Bond Updates:

The recent spike in interest rates (3.24% 10-Year Treasury at this writing) continues to take its toll on bond prices. Since the recent Fed meeting, bond markets have tried to close the gap between Fed and market rate expectations resulting in higher rates and falling prices. Earlier this year we expressed a “keep your coupon” best case return scenario for bonds in 2018. This has played out in some areas and not in others. High yield bonds, municipal bonds, short-term investment grade bonds and floating rate obligations have remained the closest thing to a safe haven in 2018. U.S. Treasuries and broader bond indices have fared worse with recent record bond index durations.

Despite market chatter of an inverted yield curve, we said in our August edition: “Between now and year-end interest rates on 10-year and 2-year Treasuries may very well follow a parallel path rising equally. The greater near-term risk is not a yield curve inversion but rising long bond yields.” Since then, both 10- and 2-year obligations have risen by roughly .25%. The chart below illustrates a nearly parallel path so far in 2018 with rates across the Treasury curve rising anywhere from 75 to 95 basis points. Yield spreads between 10-year and 3-month obligations have remained largely constant while the 10-year/2-year spread has compressed from 54 to 33 basis points.

bbt-perspectives-market-monthly-october-2018-treasury-yield

The chart below reflects performance through Sept. 30 for various segments of the bond market but does not include the impact of the rate spike we’ve seen since the end of the quarter.

Takeaway:

Over the coming weeks we would not be surprised to see this recent spike in rates and widening of the 10-year/2-year spread to moderate. Elevated short bond positions of speculative traders have contributed to recent volatility. A renewed flattening of the yield curve is possible over the coming weeks once the smoke clears. We continue to think short duration high quality bond portfolios make sense both for income and as a diversifier during periods of stock market volatility.

Final Thoughts:

After revisiting some of the key themes we’ve discussed here since January, we see a slowly shifting landscape as we prepare for 2019. Fed policy is clearly tighter but not yet restrictive. Fiscal policy has supercharged U.S. growth but is expected to slowly fade as 2019 progresses. A simultaneous fade of both Fed and Fiscal policy as early as mid-2019 remains one of our primary concerns within the next 12 months. Recessions typically begin after markets correct, yield curves invert, leading indicators contract, Fed policy become restrictive and profit growth shrinks. None of these conditions are present today. Recent weakness in both stock and bond markets has more to do with mean reversion and less to do with fundamentals. Fundamentals continue to support stock prices, but the lateness of the cycle suggests a more defensive focus on high quality holdings makes sense within a fully invested portfolio.

Last Word:

To give due credit, many of our investment themes we have discussed throughout the year and reviewed here have been shaped by the forward thinking of smart and talented folks at the research partners we cite in each edition. We appreciate their insights. Thank you for reading.

October 2018

bbt-perspectives-market-monthly-october-2018-feature

“You can always find a distraction if you’re looking for one.”

Tom Kite, Professional Golfer

Tom Kite probably uttered these words after a tough day on the golf course, but truer words were never spoken as it applies to this long but unloved bull market. Upcoming midterm elections, trade policy, the Fed and fears of recession are distractions that leap off the headlines. Lost in translation, however, is a U.S. economy growing above trend with continuing signs of acceleration. In this edition of Market Monthly we’ll provide context around some of these issues as we head into the perennially positive fourth quarter season. We’ll revisit and refresh our views expressed here throughout 2018 with a guided outlook into 2019. Short-term headline distractions should not derail a thoughtful long-term investment plan.

Midterm Elections:

Midterm elections will be held on Nov. 6 with higher-than-normal, midterm turnout. When the party of a first-term president also controls the House, the Senate or both, it is common for the party in power to lose control of either chamber due to an energized opposition. We’ve all learned from the 2016 U.S. election and the U.K. Brexit referendum that polls are not checks to be cashed until the final votes are counted. Recent polls reflect an expectation that Democrats will take the House while Republicans will hold the Senate. Additionally, generic party polling has maintained a range of anywhere from a 3% to 11% Democratic edge with current polls very close. Noteworthy points include:

  • 25 House Republicans up for reelection in districts that Clinton won
  • 13 House Democrats up for reelection in districts that Trump won
  • 38 House Republicans not running for reelection
  • Of the 35 Senate seats, Democrats are defending 25 and Republicans defending 10
  • Odds favor a Democratic House and a Republican Senate but neither is a lock

Our interest in the election regards investment outcomes that can be attributed to the election results. The chart below reflects historic S&P 500 performance under all six possible scenarios for various combinations of party control for the White House, House and Senate. This is always interesting but should not be mistaken as predictive. For example, the middle red bar below reflects historic performance for what current polls are showing with a divided Congress and a Republican president historically having experienced 10.8% annual returns.

bbt-perspectives-market-monthly-october-2018-partisan-control-avg

A final reference can be observed when overlaying the calendar influence of market results over midterm election years. Historically, fourth quarter market returns are the strongest. It has tended to be magnified during midterm years. But this correlation needs context as we show in the chart below which shows:

  • Best/worst/median market returns for each quarter of all Post WWII midterm election years
  • The year for each high and low
  • What was occurring during those low years

bbt-perspectives-market-monthly-october-2018-partisan-mid-term-s-p

Observations:
  • Q4 during midterm election years has been positive 16 out of 18 times since 1946
  • “Tax-cut enthusiasm” may have borrowed (pulled forward) Q4 returns
  • Possible context for each of the four “lowest” quarters was either an overly aggressive Fed or a geopolitical event (Cuban Missile Crisis in 1962 and Watergate in 1974).

Takeaway:  Market behavior around midterm elections is less investment relevant than many believe. It is doubtful the election outcome would threaten some of the legislation (tax reform) that has propped up the economy and markets. Any change in power from the elections introduces an element of uncertainty with potential for short-term market volatility. Political leanings for both sides have recently gone from polar to nuclear and could lead to increased voter turnout and election surprises.

Trade:

In our August edition we said “NAFTA remains the highest near-term probability for a trade win…” On Sept. 30 the U.S., Mexico and Canada jointly reached an agreement to replace NAFTA and now awaits a Congressional briefing by the International Trade Commission. The new agreement will be named USMCA (U.S./Mexico/Canada) and is expected to be voted on early in 2019.

On the surface this represents a major trade win for which even Ross Perot may cheer, but the details will become more evident in the weeks to come. For now, the deal represents an opportunity for the U.S. to quickly pivot and mend fences with European and Japanese allies before setting its sights on the real target, China. The chart below illustrates that while Mexico and Canada remain our largest export partners (blue), China represents our biggest source of imports (red).

bbt-perspectives-market-monthly-october-2018-u-s-trade

In the coming months, attention will turn to China to see if broad economic stimulus will be pursued to stem the slowdown to their economy in particular and emerging markets in general. The chart below seems to indicate the trade issue is a far bigger negative to China due their greater dependence on U.S. imports. Note how U.S. stock prices (blue) have outperformed Chinese stock prices (red) since trade moved to the front burner. U.S. stock prices have climbed roughly 10% while Chinese stocks have fallen roughly 15%.

bbt-perspectives-market-monthly-october-2018-shanghai

Takeaway: The intent of tariffs all along has never been as a revenue source but rather a negotiating lever for trade discussions. Having said that, Washington has shown no signs of backing down from its threat to raise the recent tariffs that went into effect on $200 billion in goods from China from 10% to 25%.

Prolonged tensions combined with a weakening Chinese economy and the near collision of U.S. and Chinese warships in the South China Sea have made conditions more intense. The consequences of this could be underappreciated by markets and represent a clear future risk. Three primary trade related risks are:

  1. Inflation: Prolonged trade disputes are becoming inflationary due to supply chain disruptions and rising import prices on final goods.
  2. Supply chain disruptions that cause manufacturing costs to rise could result in earnings downgrades and declining profit margins in coming months.
  3. Trade uncertainty could cause corporate decision makers to delay investment and expansion decisions creating an economic drag.

The Fed:

In our 2018 Outlook we made three primary observations regarding the Fed and interest rates:

  1. The Fed would hike more than markets were implying remaining on its quarterly rate hike cycle
  2. Interest rates could begin to impact financial asset prices later in 2018
  3. Falling unemployment and rising wages underpin a reflationary theme

These themes are playing out. An additional theme, which has not played out, was our expectation of continued synchronized global economic growth. Instead, growth has diverged being led by the U.S. at the expense of many other world economies courtesy of tax reform. Record low unemployment and the attainment of the Fed’s 2% inflation target should keep the Fed on its quarterly rate hike path into 2019.

The chart below tells the Fed’s story well. The Fed Funds rate now exceeds 2% for the first time since before Lehman failed. In recent days, however, interest rates have spiked across the yield curve repricing closer to Fed expectations as markets seek to redefine “neutral” rates. This is challenging since this rate hike cycle began at an unprecedented 0%.

bbt-perspectives-market-monthly-october-2018-market-expectations

Takeaway:

  • Continued quarterly rate hikes into 2019 with pauses remaining data dependent
  • Robust economic data and 3.7% September unemployment underscore continuing economic strength
  • Emerging market contagion is unlikely with financial imbalances less severe than 1998
  • Financial institutions remain well capitalized
  • Coordinated Fed and Fiscal policy could reach an inflection point in mid-2019 but recession indicators still benign
Equity Updates:

In our 2018 Outlook we made four primary observations regarding equities:

  • Transitioning from a steep return/low volatility regime to a modest return/rising volatility regime
  • 2018 earnings growth would outperform index returns
  • We expected double-digit earnings growth in 2018 with a tailwind from corporate tax cuts
  • International markets could lead the markets again in 2018

All except International market leadership have worked well so far in 2018. As international economies have de-linked, so have their markets generating negative YTD returns. Contributing modestly to international weakness is the strength of the U.S. dollar. This is one reason our asset allocation process reflects a modest U.S. home country bias to help limit currency risk and overall volatility.

The chart below illustrates our theme of tax reform aided earnings growth. Q1 and Q2 both experienced 25% earnings growth with rising estimates during earnings season. The initial thrust of tax reform is now being absorbed by expectations as we are seeing earnings estimates slowly revised downward. For Q3 we expect 19% year-over-year earnings growth and 7% revenue growth. We expect 2019 earnings to revert to a more normal 7%-9% growth rate accounting for the absorption of lower tax rates. An outright earnings contraction (recession) would be cause for concern.

bbt-perspectives-market-monthly-october-2018-s-and-p-500

Below are YTD equity returns through Sept. 30, 2018. Some observations:

  • Small caps gained early in 2018 as primary beneficiaries of lower taxes and a strong dollar
  • Large caps have recently closed the gap with small caps
  • Growth continues to outpace Value as a style but its momentum has begun to slow
  • International returns have been hampered by a strong dollar

bbt-perspectives-market-monthly-october-2018-stock-index

Takeaway:       

  • Q4 historically the best quarter especially in midterm election years
  • Third year of the presidential cycle is historically the strongest of the four-year term
  • Earnings reverting back to company fundamentals with tax reform now embedded
  • Lack of share buybacks during the blackout period could add to near-term volatility
  • Equities remain in a bull market absent any indication of recession
Bond Updates:

The recent spike in interest rates (3.24% 10-Year Treasury at this writing) continues to take its toll on bond prices. Since the recent Fed meeting, bond markets have tried to close the gap between Fed and market rate expectations resulting in higher rates and falling prices. Earlier this year we expressed a “keep your coupon” best case return scenario for bonds in 2018. This has played out in some areas and not in others. High yield bonds, municipal bonds, short-term investment grade bonds and floating rate obligations have remained the closest thing to a safe haven in 2018. U.S. Treasuries and broader bond indices have fared worse with recent record bond index durations.

Despite market chatter of an inverted yield curve, we said in our August edition: “Between now and year-end interest rates on 10-year and 2-year Treasuries may very well follow a parallel path rising equally. The greater near-term risk is not a yield curve inversion but rising long bond yields.” Since then, both 10- and 2-year obligations have risen by roughly .25%. The chart below illustrates a nearly parallel path so far in 2018 with rates across the Treasury curve rising anywhere from 75 to 95 basis points. Yield spreads between 10-year and 3-month obligations have remained largely constant while the 10-year/2-year spread has compressed from 54 to 33 basis points.

bbt-perspectives-market-monthly-october-2018-treasury-yield

The chart below reflects performance through Sept. 30 for various segments of the bond market but does not include the impact of the rate spike we’ve seen since the end of the quarter.

Takeaway:

Over the coming weeks we would not be surprised to see this recent spike in rates and widening of the 10-year/2-year spread to moderate. Elevated short bond positions of speculative traders have contributed to recent volatility. A renewed flattening of the yield curve is possible over the coming weeks once the smoke clears. We continue to think short duration high quality bond portfolios make sense both for income and as a diversifier during periods of stock market volatility.

Final Thoughts:

After revisiting some of the key themes we’ve discussed here since January, we see a slowly shifting landscape as we prepare for 2019. Fed policy is clearly tighter but not yet restrictive. Fiscal policy has supercharged U.S. growth but is expected to slowly fade as 2019 progresses. A simultaneous fade of both Fed and Fiscal policy as early as mid-2019 remains one of our primary concerns within the next 12 months. Recessions typically begin after markets correct, yield curves invert, leading indicators contract, Fed policy become restrictive and profit growth shrinks. None of these conditions are present today. Recent weakness in both stock and bond markets has more to do with mean reversion and less to do with fundamentals. Fundamentals continue to support stock prices, but the lateness of the cycle suggests a more defensive focus on high quality holdings makes sense within a fully invested portfolio.

Last Word:

To give due credit, many of our investment themes we have discussed throughout the year and reviewed here have been shaped by the forward thinking of smart and talented folks at the research partners we cite in each edition. We appreciate their insights. Thank you for reading.

Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors

This piece is produced by BB&T’s Wealth Portfolio Management Team.

The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.