By Rebecca Anderholm, CFA, Analyst
Following the volatility in early 2018, including a February dip into correction territory by the S&P 500 Index, U.S. equity markets regained their footing throughout the summer months, with the S&P 500 reaching a new record high in late September. The month of October brought renewed market turbulence, however, as investors grew anxious over rising bond yields, the speed of interest rate hikes coming from the Federal Reserve, and the ever-present international trade narrative. While we are encouraged by the persistent economic strength and earnings growth in the U.S., we anticipate that volatility will appear more regularly across global markets during 2019, and we expect potential growth obstacles to become more pronounced as both the bull market and current economic expansion continue to age.
We are in the midst of the second-longest economic expansion since World War II.1 Despite the age of the current expansion, fundamental data continues to show strength, and, in several cases, key economic indicators remain at or near record levels. The U.S. consumer confidence index, which gauges Americans’ views of current economic conditions and their expectations for the following six months, rose to an 18-year high in September, indicating that consumers’ assessment of current economic conditions remains positive. Given that consumer spending constitutes roughly 70% of total U.S. economic production, the high levels of consumer confidence bode well for a bright economic outlook in the near term. Similarly, small business confidence surged in recent months, as the NFIB Small Business Optimism Index hovered near the highest level in its 45-year history following tailwinds from tax reforms that encourage small businesses to expand facilities and grow their workforces (Exhibit 1).
As the U.S. economy’s growth has persisted, the Fed has proceeded with its plan for gradual interest rate increases. The latest interest rate increase in December marked the ninth rate bump since 2015, with two additional rate increases projected through 2019.2 As interest rates have steadily climbed over the past few quarters, rising yields on fixed income investments have increased the attractiveness of bonds compared to riskier assets like stocks. Much of the volatility in the first half of October was attributed to this, as the yield on the 2-year U.S. Treasury note rose to its highest level since the financial crisis—and also surpassed the S&P 500 dividend yield for the first time since 2008 (Exhibit 2).
U.S. equity markets continued to show signs of strength in the second and third quarters of 2018. The S&P 500 reported returns of 10.6% through the third quarter, before turbulence returned in October. From an earnings perspective, the S&P 500 reported year-over-year earnings growth of around 25% in each of the first two quarters of the year, with estimates for third-quarter earnings above 20%. Looking ahead, earnings growth for the S&P 500 is estimated to remain in double-digit territory for 2019.
Globally, market performance was less synchronized in 2018 than it was in 2017, when performance was consistently positive. In fact, both international developed and emerging market regions outperformed the U.S. in 2017, with the MSCI Emerging Markets Index reporting a 37.3% return for the year and the MSCI EAFE Index reporting a 25.0% return for the year. In 2018, U.S. equity markets showed resilience over the first three quarters, while international developed and emerging equity markets struggled to find their footing. Both the MSCI EAFE Index and the MSCI Emerging Markets Index reported negative returns for the year through the end of September.
Several factors contributed to uncertainty and influenced this shift, such as general political turmoil across the Eurozone, lingering Brexit concerns, and new political regimes coming to power in various countries—despite positive economic growth across the European region. Trade was also a factor, as the Trump administration’s focus on renegotiating trade agreements fueled anxieties and volatility across global markets. Following discussions at the G20 summit in early December, the U.S. and China agreed to a trade “truce,” halting the implementation of additional tariffs through March 1 while the countries negotiate and address grievances that have fueled the tit-for-tat exchanges this year. The U.S. made some other encouraging progress earlier in the year by successfully renegotiating trade agreements with Mexico, Canada, and South Korea.
Additionally, the continued rise in the U.S. dollar relative to other currencies plagued international returns this year. As economic growth in the U.S. has outpaced other regions and as the Fed has raised interest rates faster than other central banks, the U.S. dollar has strengthened (Exhibit 3). This is a concern for emerging markets in particular, as dollar-denominated debt held by other countries becomes more difficult to service when the dollar rises. Historically, the U.S. dollar has proven to be volatile and tends to cycle through periods of consistent rises and declines. As central banks across the world begin to wind down the practice of quantitative easing and start to implement their own interest rate increases, it may provide some relief from the surging U.S. dollar values last year.
As the current bull market approaches its 10th birthday in March, we aim to balance an appreciation for the continued strength exhibited by economic indicators and earnings growth here in the U.S. with an understanding of the various risks that have become more distinct as the bull market has aged. At RMB, we’re confident that our asset management team’s expertise and capabilities, coupled with the investments we’ve made in technology and other resources, will help us properly position our clients for the year ahead.
Toward the end of 2018, volatility continued to rear its head across global markets. The weeks following October’s sell-off proved to be turbulent ones for the markets, with major indices at times falling to the lows seen in October and at other times rallying over 2% in single trading sessions. The international trade narrative continued to be a major contributor to volatility, as did investor concerns over the Federal Reserve’s expected schedule of interest rate increases. With interest rates approaching the “neutral” rate as defined by the Fed, investors are questioning whether the Fed will employ a “wait and see” approach with future interest rate increases. For investors, anticipating the speed of future interest rate hikes adds yet another layer of uncertainty to a market landscape where the downside risks are becoming increasingly visible.