The third quarter brought much less volatility than we saw in the first two quarters of the year, but that is likely to change as we enter the final month before the US election. Nearly all asset classes outside of commodities posted gains for the quarter. The S&P 500 rose 3.9% for the quarter and is now up 7.8% for 2016. Bond yields remained relatively unchanged during the quarter as the Federal Reserve ended up making no changes at their July and September meetings. So far this year, the Barclays Aggregate Bond Index is up a whopping 5.8%.
Election season has taken much of the focus away from the Fed, the economy and corporate earnings. At this point, many polls show Hillary Clinton with an edge in the race for the White House but as fast as things are changing, and after so many surprises this election cycle, it is way too early to declare a victor. Due to the still-tight contest, we suspect that events such as last week’s debate are moving markets as investors try to predict the outcome.
We may see more volatility in coming weeks now that the election is less than a month away but that is nothing new. Recent research from Vanguard found that volatility around an election is typically short-term in nature and that volatility typically fades once the election has passed.
While the platforms of both presidential candidates promise significant changes in the areas of tax policy, trade agreements, foreign policy, entitlement spending and more, it is important to note that there is usually a wide gap between the winning candidate’s promised proposals and the enactment of those proposals. Most policy changes such as tax reform need to be approved by Congress. The president does have the power to affect trade agreements such as NAFTA but modifications wouldn’t be easy or quick as existing treaties are written into US law and would likely bring counter-measures from affected nations. It is worth noting that the US hasn’t withdrawn from a trade agreement since 1866.
While most economic data over the past few years have been consistently positive, this election has brought to light the angst felt by many Americans who haven’t enjoyed the full effects of the economic recovery. While the unemployment rate has fallen to a relatively low 5%, much of the improvement has happened at the extremes. As you can see in the chart put together by Russell Investments, most of the employment growth has occurred in either high-paying jobs or low-paying jobs. Employment growth in mid-level jobs has lagged in comparison. This may be one reason the Fed has continued to delay rate hikes while the economy has shown slow but consistent growth.
In a July speech at Jackson Hole, Fed Chairwoman Janet Yellen said, “The case for tightening has strengthened,” and by early August, it appeared a September rate hike was all inevitable. The Fed, however, is “data dependent” and after a handful of lukewarm economic reports the committee voted in September to leave rates unchanged. On the Fed’s willingness to wait longer, Yellen said, “We can more effectively respond to surprisingly strong inflation pressures in the future by raising rates than to a weakening labor market and falling inflation by cutting rates.” In our view, the trajectory indicates that rates are likely to rise only gradually. Of note, while US monetary policy has been dovish, it remains in stark contrast to that of central banks and policy makers in the UK, the EU and Japan, who are aggressively pursuing monetary easing and fiscal stimulus to prop up their slow-growing economies.
As we always say, company fundamentals drive returns (and not elections). On this front, earnings have been a disappointment over the past year and a half but there is reason for optimism on the horizon. The current estimate for third quarter earnings for S&P 500 companies is a decline of 2.1% according to FactSet, reflecting a significant drop from early-year estimates. The main culprit continues to be the energy sector which is expected to post a year-over-year decline of 67%.
Excluding energy, however, earnings are projected to grow 1.2% for the rest of the S&P 500 and in the fourth quarter, overall earnings are expected to grow. Also, revenue is expected to grow 2.6% in the third quarter and at least that much in the fourth quarter–the first quarterly growth since the fourth quarter of 2014.
Looking deeper, it is hard to argue that US consumers overall aren’t doing better even though there are very clear pockets of economic struggles. The unemployment rate has fallen to 5%, weekly unemployment claims are at their lowest point since the financial crisis of eight years ago and there were over 1.6 million new jobs created in the first 9 months of the year. Also, consumer confidence, as measured by the Conference Board, is at its highest level since the financial crisis. Confident consumers with jobs tend to spend more and this spending drives GDP.
Following the surprising Brexit vote in June, the Bank of England quickly moved to support the economy by cutting interest rates and stepping up purchases of government and corporate bonds. Stock markets across Europe, including the UK’s FTSE 100, moved higher during the third quarter as the shock from Brexit wore off. It will still take some time to see the effects of Brexit as the UK Parliament has yet to formally file to leave the European Union. Valuations in Europe look less expensive than in the US as market returns have been tempered by fears of political risk as growing anti-globalization movements threaten to impact elections over the next year. Also weighing on the European financial system is a potential fine of $14 billion that the US government is considering imposing on Deutsche Bank, Germany’s largest bank.
Most central bankers would admit we are seeing diminishing returns after eight years of monetary policy measures. Something else is needed to kick-start growth and the presidential election is unlikely to be the catalyst. Two important things to watch for are productivity and fiscal policy.
At nearly 70%, the largest component of GDP is personal consumption. On that front, the numbers look fairly good given that job creation has brought the unemployment rate down to the point that we’re starting to see wage gains. Productivity, on the other hand, has not rebounded as it typically does in economic recoveries. Some predict that automation or increased connectivity of everyday objects (i.e. the “Internet of Things”) will begin to move the needle but productivity growth has historically been difficult to forecast.
Over the past eight years, central banks have provided unprecedented stimulus through monetary policy as lawmakers of developed nations have been reticent to use fiscal policy (government spending) in the face of strong support for austerity. This may change in the in the US in the near future as both Donald Trump and Hillary Clinton have talked about upgrading our infrastructure. If Congress approves new spending on highways, the power grid and other essentials, it could have long-term effects. We think this is something to watch.
It would appear that we are nearing a major inflection point with the election looming. Just a few months ago, it seemed the same way in the UK with the Brexit vote and yet British citizens continued to get up each morning, go to work and spend money and the UK stock market calmed down and even moved higher. In our opinion, regardless of the election results, our experience in the US isn’t likely to be much different. We’ll continue to see the usual gyrations but that shouldn’t change long-term investment plans. As always, our advice is to stay the course with the knowledge that companies will adapt to a changing world and find ways to prosper.