Round and round we go, where we stop…only the Fed may know… As expected the Federal Reserve (Fed) held short-term interest rates steady in September at 1.00-1.25%; and announced the long anticipated reduction of its $4.5 trillion balance sheet beginning in October 2017. The Fed has indicated for some time that it would begin reducing the bonds it purchased and held following the 2008 financial crisis, as a way to keep interest rates low following the 2008 financial crisis. They further indicated they are on track for another quarter-point increase in December, and the Fed’s so-called “dot plot” reflects three more hikes in 2018. Fed-funds futures however, which have been more successful than the Fed itself at predicting interest-rate changes, is pricing in far fewer rate increases in 2018. As we have opined before, the net impact of aggressive monetary policy (low interest rates and non-traditional Fed balance sheet initiatives) has provided much of the tail winds leading to current elevated asset prices.
That said, the resilience of the capital markets with all its uncertainty has been impressive, with 2017 recording the lowest level of volatility (daily moves of greater than 0.5%) in the equity market since 1965. The bull market is now the second longest on record, as investors have seen their stocks more than triple since the depths of the financial crisis. All of which creates concerns about the imminent end of this great bull market run. High valuations, along with the interest-rate backdrop, certainly suggest higher risk of a pull-back or correction. However, it should be pointed out that a correction is quite different than a pro-longed market decline referred to as a “bear market.” Market corrections happen frequently, then have a way of bouncing back as long as the economy continues to grow. In fact, it’s worth reminding ourselves that during the past several years the S&P 500 suffered a number of pull-backs: a decline of -7% in 2014, a sell-off of -12% in August 2015 and a decline of -11% in early 2016. The key distinction between a short-term correction and a pro-longed bear market is tied to the sustainability of economic growth. Market corrections can also present great opportunities to buy good quality investments at reasonable “on sale” prices.
That said, stocks and risk assets continued their march higher during the third-quarter as equity indices set new highs. The S&P 500® gained +4.5%, the Russell Midcap® rose +3.5% and the MSCI EAFE® advanced +5.4% (+2.7% excluding currency effect) during the three month period. Longer-term interest rates fell modestly driving bond prices higher and coupled with interest income, delivered strong returns. The Bloomberg Barclays Intermediate U.S. Government/Credit® Index advanced + 0.6% and the Bloomberg Barclays U.S. Aggregate® Index gained +0.8% for the quarter. Year-to-date equity market returns have been very impressive as the S&P 500 Index returned +14.2% and the Russell Midcap Index advanced +11.7%, while the Bloomberg Barclays Intermediate U.S. Government/Credit Index gained +2.3% and the Bloomberg Barclays U.S. Aggregate Index advanced +3.1% for the nine-month-period.
Supporting some of these market moves higher, economic data improved in the third-quarter as manufacturing strengthened, employment continued to improve and housing stabilized. Gains in employment showed an average of 185,000 jobs added each of the last three months (through August) driving the unemployment rate down to 4.4%. While hourly wages were only up a modest 2.5% from a year ago, consumer confidence increased to its highest level since 2000. Second-quarter gross domestic product (GDP) growth was also revised upward to 3.1% (previously reported at 2.6%) partially driven by increased consumer spending. While hurricanes Harvey and Irma may have pruned third-quarter growth, it is likely that the rebuilding effort and replacement of waterlogged autos may boost consumption over the next several quarters. Importantly, earnings growth has been impressive with earnings per share growing approximately 10% in the latest quarter compared to a year ago. This also marks the second consecutive quarter of double digit earnings growth following a two-year stall, and may be supportive of increased business spending in 2018.
Despite all this fun however, there is an increasing awareness that a healthy pause in parental (the Fed and other global Central Bankers) pushing of the merry-go-round is looming large, and for many long overdue, in allowing the markets to begin to normalize, self-regulate, and return to reasonable risk premium levels. When the merry-go-round of overly accommodative monetary policy will stop, particularly given current stronger global economic conditions, is ultimately up to the central bankers. We expect however, that as interest rates increase, whether by deliberate baby-step increases in Fed Funds, or by more pronounced market driven risk premium requirements, so will volatility in the capital markets. Elevated stock valuations, soaring investor optimism, rising geopolitical tensions and uncertain policy from Washington create a recipe for higher volatility in the future. Although lofty valuations may continue longer than justified, we believe investors should prepare for more modest returns and focus on proper positioning to insulate their portfolio from the effects of these likely headwinds. We continue to believe stocks of lower-risk, higher-quality companies, along with shorter-duration, higher-quality bonds will allow investors to participate in the market, while providing shelter when volatility returns and markets begin their return to more “normalized,” non-intervention levels.
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Past performance is not a guarantee of future results. Madison Scottsdale is the insurance asset management division of Madison Investment Advisors, LLC. © October 20, 2017.