Third Quarter 2018: Changing Market “Seasons” and Weathering the Occasional Storm

October 3, 2018

Just as the season changes from summer to fall, it is important to remember that economies and markets also have “seasons,” which are sometimes referred to as cycles. While it has been almost 10 years since the U.S. economy experienced a recession and the U.S. stock market experienced a true bear market (decline of 20% from peak to trough), there are still signs of acceleration, despite conventional wisdom indicating that we are late in the cycle. Second quarter GDP growth came in above 4%, and third quarter GDP growth is expected to be solid, as well. Market returns were strong in 2016 and 2017 and have rallied again in July and August after a sideways trend for the first half of 2018. This market and economic behavior does not seem indicative of a season that is about to experience bad weather; however, we believe that investors need to be prepared for some occasional thunderstorms.

The transition to higher inflation, higher interest rates and higher volatility is not necessarily a bad thing. Job growth is steady, corporate profits are robust and business and consumer confidence are reaching multi-decade highs. On the other hand, the potential for dark clouds caused by trade wars and the imposition of additional tariffs may put some downward pressure on global stocks. For long-term investors, there may be near-term challenges that create some tension and anxious moments, but successful investing is achieved by staying focused on goals in the face of day-to-day noise.

In other words, there is reason for both optimism and pessimism in the current environment. Corporate America continues to deliver impressive profitability, and while tax cuts have caused 2018 to be stellar so far, analysts are expecting a return to a more normal level of earnings growth in future years. Markets have not shown levels of overvaluation or excessive euphoria that typically lead to the end of a bull market. The Federal Reserve, under the direction of Jerome Powell, is being very transparent about the future path of interest rates as it attempts to keep inflation in the moderate range and potentially avoid the dreaded yield curve inversion, whereby short-term interest rates exceed long-term rates.

In terms of market performance, the third-quarter results led to investor excitement, with domestic stocks rising significantly and international stocks recovering from earlier declines. U.S. large company stocks (S&P 500) delivered the best results, up 7.7%, while the Russell Mid-Cap index rose 5.0%, and the Russell Small Cap index returned 3.6%. International stocks in the developed markets of Europe and Japan, as measured by the MSCI EAFE index, stayed positive by coming in at 1.4%. Meanwhile, the MSCI Emerging Markets benchmark was most impacted by trade war discussions and declined by -1.1%. Stable interest rates caused the bond market to finish close to flat, producing a return of 0.02%, based on the Barclay’s Aggregate index. For the year-to-date period through September 30th, the broad U.S. stock market (Russell 3000 Index) outperformed the non-U.S. stocks (MSCI ACWI Ex U.S. Index) with the former generating a 10.6% return, while the latter returned -3.1%. Bonds continue to be in the red with a -1.6% return.

The fall season brings with it shorter days, changing leaves, college football and pumpkin-spice drinks. No one can accurately predict what this time of year might mean for the markets; however, what we do know is that investors must weather some storms in order to ultimately receive the benefits that stocks and bonds can deliver in the long run. Our advice to investors is to enjoy the transition from warm weather to milder weather while watching some good games.

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