Markets changed gears in the third quarter, as more risk produced more reward. Examples include foreign and emerging market stocks outperforming their U.S. counterparts, small cap stocks beating out large cap stocks, and low quality “junk” bonds outpacing investment grade bonds. In contrast, perceived safe-haven assets such as treasury bonds and gold, among the best performers in the first half of the year, had overall flat performance for the quarter.
The key drivers of the rally in risk-based securities were continued accommodative monetary policy from the Federal Reserve and other central banks, an improving growth picture in the U.S., and greater stability post-Brexit in foreign and emerging market economies. Oil prices remained volatile during the quarter, but the stock market, unlike earlier this year, was indifferent. Bond returns were mostly flat for the quarter, as a slight increase in yields caused modest price declines. The benchmark 10-year U.S Treasury ended the quarter at 1.60%, 30% below its 2015 year end level, reflecting current subdued expectations for both growth and inflation.
Looking forward, the key events between now and year-end include third quarter earnings season, two more Federal Reserve meetings, and the U.S. Presidential election. Third quarter earnings growth for the S&P 500 is expected to improve versus the first half of the year, with a positive growth trend continuing through 2017. Given valuations that are generally above most long term averages, we think an improving earnings picture will be a necessary factor for stocks to move meaningfully higher from current levels.
The Fed meets in early November and again in mid-December. The market currently expects no action in November, but a greater likelihood of a rate increase for December. In its September statement, the Fed noted that the case was building for higher rates, citing continued strong employment gains, strength in consumer spending, and a pickup in overall economic activity. If the Fed raises its overnight rate by .25% in December we don’t expect extreme market disruption, as we believe the market will have already factored this event into stock prices.
Finally, the U.S. Presidential election will take place on November 8. The latest aggregate poll data shows Clinton slightly ahead of Trump in the popular vote, but by a spread that generally falls within standard margins of error. Looking at the more important Electoral College vote, the current map favors Clinton with a lead of 205 to 165, but with 168 votes deemed to be a toss-up. Wins in key swing states such as FL (29), PA (20), and OH (18) will likely decide the outcome, with the first candidate to 270 declared the winner.
Also important in this election cycle is the composition of Congress going forward. The Senate race is tight and could go either way. However, a super-majority win for either party is unlikely, limiting any significant legislative advantage. In the House of Representatives, Republicans may give up a few seats, but are largely expected to maintain their majority.
What are the investment implications of the election?
The stock market is currently priced with a greater probability of a Clinton victory. A Clinton presidency would generally be regarded as a continuation of the status quo and fairly neutral to the markets. In contrast, the market considers Trump to be more of a “wild card” and less predictable. Should a Trump presidency become more likely, the markets may react negatively in the short term.
Thinking longer term, the historical data shows that markets are indifferent to the President’s political party. Looking at the returns of the Dow Jones Industrial average since its inception in 1897 shows relatively equal periods of market strength and market weakness under presidents from both parties. Thus, the common belief that markets perform better under a pro-business Republican president and worse under a Democratic president who favors higher taxes and greater regulation is unfounded. Ultimately, consumers and businesses, which make up over 80% of GDP, have a much greater impact on the economy and the stock market than the government. This is true regardless of who controls the White House or who controls Congress. Finally, history shows that any election impact on the market is transient; factors such as corporate earnings, monetary policy, and global growth should be much more influential to the markets over the coming year.
Going forward, we continue to expect positive but below-average economic growth in the U.S. and global markets driven by a slowdown in labor force expansion and productivity gains. Given this picture, we expect interest rates to stay lower for longer with the potential to rise gradually over time as conditions warrant. This outlook continues to favor stocks, hedged investments, and bond substitutes. We remain underweight traditional bonds given the current rate environment and the potential for price declines with rising rates.
* Information provided should not be construed as investment advice and is not meant to be taken as a recommendation to buy or sell. The financial situation and investment objectives of each individual must be considered for suitability prior to any recommendations being made.