My F&M

3rd Quarter Market Commentary

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2018 through the third quarter has been marked by a strong economic backdrop in the US and by mixed financial markets globally.

Mixed markets?!  What about the new stock market highs?  Yes, after setting a slight new high in January and then backing off around 10%, large US stocks recovered to a new high in late August and have moved higher since, with US stocks (the Russell 3000 index) up 10.6% this year through the 3rd quarter (7.1% of that coming in the 3rd quarter alone).  But no other asset group has fared nearly as well.  This year to date international stocks are down 3.1% with emerging markets being especially weak (-7.7%).  The US Aggregate bond index is down 1.6% year to date.  Real estate (as measured by the REIT Index) is only up 1.8%. 

Even within US stocks, the gains have been relatively narrow with growth stocks up 17% (propelled by some “high flying” darlings in a manner that looks unsustainable) while the value index is only up 4.2% - lagging the overall market by an unusually wide 6.4% (recall that in the long run, value stocks have tended to outperform the higher priced growth stocks).

Markets have been mixed, but the economy has been unambiguously strong.

Economic growth has been the strongest in several years and unemployment is now the lowest in nearly 50 years – the last time unemployment was lower was in 1969!  Corporate earnings growth has been quite strong.  Per the latest report (as of August), average hourly earnings growth was 2.8% (up from 2.1% a year ago).

So far, so good on the economic front, but if growth is too strong, it can actually harm markets as wage pressures could make their way into inflation.  The Federal Reserve has recently been raising rates from unnaturally low levels that had persisted for many years. Those interest rate increases have occurred in a measured, careful way which has been absorbed well by markets mostly because inflation has remained tame, at least until now.  But if inflation picks up much from here, that could force the Fed’s hand, causing rates to raise faster and higher than anticipated which could increase the odds for market setbacks, and perhaps even a stumble in economic growth.

Moreover, when central banks depress interest rates for many years, both lenders and borrowers tend to get too aggressive, setting the stage for credit problems to come.  Compounding that, an easy money environment having caused too much money to chase too few opportunities for several years, the inevitable result is that most assets are now overvalued, embodying more risk than average.  For some time, we have spoken regularly about expensive stocks and bonds, but some “diversifying assets” have also had their own yields depressed for the same reasons, and we must continue to evaluate their attractiveness as well.

In a dynamic world, opportunities and risks change.  In the current environment, risk looms larger than headlines might suggest, and we are proceeding accordingly.