“If it’s not one thing it’s another…” Rosanne Rosanna Danna SNL circa 1970 something
In view of current economic growth in the U.S. and overseas, what stands to be the largest potential areas of impact over the next 12-24 months?
The month of October has a reputation for being the cruelest of months for markets. And this reputation is well earned. During October of 1929, 1987, 1989, 1997 and 2008, U.S. stock markets experienced elevated levels of volatility, often in response to political and economic events that had been building throughout the year. On average, the S&P 500 has over 60 days each year in which it rises or declines over 1%. In 2017 there were only 8 of these days. So far, as of October 26, 2018, there have been over 40 of these days.
This increased, yet historically normal, level of market volatility has been impacted by political and economic events such as the U.S. government’s fiscal deficit, mid-term elections in the U.S., concerns about fiscal and bank solvency in countries such as Argentina and Italy, and assorted other political events in the U.S. and abroad. While tax reform and a less burdensome regulatory regime have provided meaningful economic stimulus in the U.S., the challenges mentioned above are threatening to undo this positive momentum. Additional challenges facing financial markets include the most recent announcement that the US government’s fiscal deficit was higher than some analysts expected, a heightened degree of uncertainty and unrest politically, the threat and uncertainty around rising interest rates and the potential impacts of trade conflicts and/or tariffs that may inhibit cross border exchange and dampen global economic growth.
Of all of the challenges mentioned above, those that most directly affect the global economy are most likely to have a direct impact on financial markets. Recently International Monetary Fund economists have estimated world economic growth is slowing to 2-3% annually. In addition, short-term interest rates, which have been near zero since the great recession of 2008-09 in many countries, are starting to rise, increasing the cost of capital and potentially dimming investors’ enthusiasm for risk-taking. This decreased risk appetite may impact a wide range of investments, including equities, high-yield bonds, private equity, real estate and other assets classes with higher risk and return profiles relative to cash. The lower cost of borrowing has allowed federal and state governments, companies, municipalities and individuals to access financing at attractive rates. All of this has, in turn, increased economic activity, capital spending, hiring plans and helped drive economic growth rates higher. In the U.S., stronger GDP growth (over 3% annually in the most recent quarterly reports), low unemployment (under 4%) and low inflation (under 3% annually) are partly responsible for strong corporate earnings growth in the last several years.
This equity bull market has had a long run with few interim declines, so what can investors expect?
Since the beginning of this most recent bull-market almost ten years ago in the spring of 2009, passive investment strategies such as index funds have attracted an increasing share of investor dollars. These inflows to passive funds have begun to slow in 2018 compared to 2017. In the event of a significant market correction this could present a few challenges to investment markets. Passive funds provide daily liquidity even though no cash is retained in the mutual fund portfolio. Redemptions are met through stock sales, and in order to maintain the passive nature of the fund, securities are sold on a pro rata basis, regardless of their individual investment merit. Just like many of these strategies have seen large net inflows, if outflows begin, it could pressure stocks across the entire market causing potential price declines from selling to meet these redemptions.
Monetary policy may provide another source of market volatility. The Federal Reserve is decreasing their balance sheet, thus lessening demand for the securities for which they have been buyers over the last decade. The direct impact of this policy is that bond prices fall, and interest rates rise. The low-rate environment of recent years has allowed public companies to finance the repurchase of their own stock. These corporate buybacks have helped fuel the bull market. However, rising rates may make this a less attractive strategy. When coupled with slowing economic growth and the tough earnings comps that many companies will face in 2019, it is certainly fair to be wary of the challenges facing stocks in 2019. These may be some of the drivers that have led to increased October volatility in 2018.
Through Friday, October 26, 2018 the major U.S. stock market averages such as the S&P 500 have declined 10% from recent highs as have other stock indicators. While these types of market declines have been less frequent in recent years, more normal annual volatility often includes at least one of these 10% corrections. Whether it becomes more than 10% domestically, as we have experienced in international equity markets, remains to be seen.
Diversification provides the opportunity for a smoother ride, but is the destination clear?
Among the advantages of diversified portfolio construction is one which involves reasonable straight forward math. Through allocation to strategies which will outperform at various, but usually different, times, well diversified portfolios will, in the aggregate, not go up or down as much as the most volatile individual asset class. Diversification can not only make the investment “ride” smoother, it can also increase the ultimate value of the investment portfolio.
As a simple example, assume an investor starts with $100,000 and invests it in a strategy that produces annual returns of +10%, -5%, +10%, -5%, and repeating in this pattern for ten years. After ten years, the investor has slightly less than $125,000, ignoring any income tax effect. However, if the portfolio is invested 50% in the original strategy and 50% in another strategy which earns +5% during the down years and 0% during the up years, the portfolio will be worth over $126,000 at the end of 10 years. While the increase in return is very small, the risk-adjusted rate of return is much higher, due to significantly lower volatility. The result is more money for retirement, education or other purposes. The less extreme declines hopefully lead investors to better decision making along the way. While real life investing is more complex than this simple example, over time diversified portfolios tend to provide superior risk-adjusted returns as we have outlined here. See the 2018 RGT Investment Perspectives available from our office for more information on investor behaviors.
While some years like 2018 produce a wide disparity between the best and worst performing asset classes, we believe proper diversification is still the approach that is most likely to help investors reach their financial goals.
Please contact someone from RGT Wealth Advisors to discuss these topics further.