What is causing the current market volatility?
As we approach the end of October, most of us are aware that the stock markets have been in decline. The S&P 500 is off 10%, depending on the time of day, from its recent all time high reached during the end of September, erasing the gains for the year. While unnerving, these market “corrections”, defined as a 10% drop from a recent high, are not all that uncommon, and should not, in and of itself, cause a change in investment strategy.
We wanted to update you on what’s going on in the financial markets, what we see as the drivers behind the recent pick up in volatility, and to provide some objective perspective on our outlook for recovery.
First, the US Economy has been in a bull market uptrend since March 9, 2009 – close to 10 years now. While bull markets don’t necessarily die of old age, we need to be mindful of the normal dynamics of economic expansion and contraction. Simply put, financial markets go through period of productivity, or growth, and also periods of contraction, or decline. It is a normal component of the stock market – it goes up, it goes down, but over time, the stock market has continued to move higher.
So what’s causing this current decline? First of all, financial markets do not like uncertainty. The financial markets are a discounting mechanism that forecasts the future and re-prices the value of corporations (stocks) based on the perceived future economic environment which in turn “justifies” the price an investor is willing buy a stock based on its future earnings expectations. When the future becomes cloudy, uncertainty sets in and the market attempts to reprice based on the future outlook. Uncertainly breeds volatility, and there is a decent amount of uncertainty for the future.
There are a few main drivers causing this market correction. First, is the Fed normalizing interest rates. Interest rates have been historically low since they were reduced to near zero to get the US economy out of the great recession in 2008. Rates have been kept low over the past 9 years to allow consumers and business owners to repair their respective balance sheets – helping them lower their borrowing costs, and making borrowing “cheaper”. The Fed uses its interest rate policy to keep inflation in check, as well as a means to provide liquidity for financially distressed environments like we had in 2008. However, rates cannot (and should not) stay low forever, as the ability to lower rates during future economic distress is imperative, and raising rates can “cool” down a “hot” economy that may likely cause inflation to get out of control. The Fed is on a clear and gradual path to “normalize” interest rates, thereby raising the short term fed funds rate by around .25% a few times a year. Rising rates make it more expensive to “borrow” money, cause the value of bonds (issued at a lower interest rate) to decline in principal value, as well as reduce future revenue and corporate profits. While the pace of the rate rise is quite moderate, the market is attempting to determine to what extent continued increases in the interest rate policy will begin to slow down, and perhaps negatively impact corporate earnings.
The second item is the Trade Wars between the US and China. As the US imposes tariffs on goods imported from China, China has retaliated with Tariffs of their own on US goods imported to China. This back and forth, tit for tat cycle is adding to the uncertainty of future corporate growth, and thereby profits. Quite simply, those US companies that have significant sales overseas may see a reduction in revenue (and likely profits) due to the tariffs making the overall costs of goods more expensive to make and sell. This second potential source of slowdown is causing the market to re-price the risk in the markets driven by increased costs of the sale of goods and services.
The third driver, which ties in to the first two drivers, is whether the record profits of Corporate America can continue to grow in the face of higher future interest rates and the potential adverse impact of ongoing trade wars with China, the second largest economy in the world. Investors are willing to take risk in owning a stock in order to share in the profits on the underlying company. What one investor is willing to pay depends on a lot of factors, but typically the earnings (profit) relative to the stock price has to make good economic sense for the investor to risk their money owning a given company. Corporate earnings have been very solid, steadily increasing profits over the past year. The concept of “peak profit” would imply that profits will not be expanding in the future, and that profits may begin to decline, thus making the cost to own a given stock more expensive given their future expected earnings. The uncertainly surrounding higher future rates, the duration of the current bull market possibly being it its “later” stages, the unknown impact from ongoing trade wars, and the potential for “peak profit” whereby companies may earn less profit moving forward are all putting pressure on the stock market while the market is trying to settle in to what it should be priced at based on the prospects of slower future growth. This “discounting” of current stock prices to more accurately reflect future profits is what is causing the market volatility, as participants are attempting to settle into a new market value to reflect the future profit outlook during a period of uncertainly.
Simply put, the market may have gotten ahead of itself over the past several years of above average returns, and perhaps need to be repriced given the future uncertainly and perceived increased risk and a potentially slowing economy. We do not see the current market environment as the beginning of a longer term bear market, and do not see a recessionary environment in the near horizon. The fundamentals of the US economy are frankly too strong to suggest that a recession is imminent.
It is important to put the recent volatility into perspective, and the fact that 10% corrections are a normal, and frankly healthy component of the markets ability to move higher from here. More importantly is the fact that for those of you who do not need to generate income from your investment accounts in the near term, what happens in the market today, next week and next month will not negatively impact the ability for your assets to provide FUTURE income. For those of you requiring current income from your accounts, we have an appropriate quantity of lower risk investments that will be used as your immediate source of income, precluding a need to sell riskier assets while they are at levels depressed from just a month ago. Markets should ultimately recover, and again, over a longer time horizon we expect the value of stocks to be higher in the future. We want you to be comfortable staying the course – we’ll get through this current market malaise – and knowing your accounts are risk appropriate and structured accordingly so that we are not forced to sell assets today at a lower price.
Should you have any questions or want to have a more detailed conversation about the markets and its impact on achieving your financial goals and objectives, please contact our office to schedule time to talk.