As the decorations my wife puts up around our house read: “Happy Fall, Y’all!” The third quarter of 2017 had its fair share of global headlines, starting with a queue of hurricanes ravaging Haiti, Puerto Rico, and a giant portion of the southern U.S. The headlines didn’t stop there, though. President Trump continues to trade barbs with North Korean dictator Kim Jong Un every few hours, Equifax had 44% of Americans’ personal information stolen, and to top it off we’re still uncovering more and more evidence of Russian meddling in our presidential election last year.
So has any of that spooked U.S. equity markets? Absolutely not! Thus far in 2017 we’ve had historically low volatility. Only 5% of 2017’s trading days thus far have seen the S&P 500 move by more than 1% in either direction. This is by far the lowest number ever (since intra-day trading began being recorded in 1982, at least).
While any number of the aforementioned headlines could yet derail our smooth cruise to this year’s finish line, we should remember that we’re entering a historically bumpy time of the year, too. September has been the worst performing month of the year, October the second worst, and November and December the 3rd and 2nd best.
And in case you have difficulty remembering those facts, this October will mark 30th anniversary of the stock market crash of 1987. On top of all this, the fourth quarter is typically a very busy period. We have budget battles in governments (and boardrooms) across the country, the holiday shopping season, and investment managers across the world positioning & trying to manage taxes for year-end.
The most common question I get when highlighting these and other current events is: “OK, great. So if we think there’s a big risk the market could sell off soon, shouldn’t I sell my stocks and wait to reenter after the next crash?”
Let me be clear here. I have absolutely no idea when the market will sell off. Nor does anyone else. I can only tell you that it will from time to time. Will it be President Trump hitting the launch button at the wrong time? Will it be the Federal Reserve tightening monetary policy faster than expected? I really have no idea.
What I can tell you is what the research shows: that you’ll achieve the best investment outcome staying fully invested consistently, through thick and thin, no matter what we think the market will do next.
Because remember, if you’re going to sell, not only must you be correct in timing the next crash. You must also know the right time to re-enter the market. According to a study performed by Dimensional Fund Advisors, the annual return of the S&P 500 was 9.38% between October of 1989 and December of 2016. But if you miss the one best performing trading day each year, your return falls to 8.94%. Miss the five best, and it falls to 7.75%. Miss the top fifteen, you’re down to 5.67%. And miss the twenty-five best trading days? 3.98%. In other words, by missing the top 10% of trading days each year, annual equity returns each year fall from 9.38% to 3.98%. Ouch.
What does this mean for us? It means that if you want to sell stocks now and wait for a correction, you’ll need to be clairvoyant not once, but twice! And if your crystal ball is even the slightest bit cloudy, causing you to miss some of the best days in the trading year, the missed opportunities will probably crush your net returns. The moral here is that even though the markets look pretty spendy, if we have a long-term outlook we’re far better off riding out the next correction and awaiting the subsequent, inevitable rebound.
As the third quarter economic data comes out over the next weeks and months, it’s important to remember that everything will be skewed downward as a result of the hurricane damage across the south. But then, as the rebuilding and replacing takes place in the coming months, we should expect a corresponding rebound.
Prior to hurricane season the economy had shown strong growth, with second quarter GDP being revised upward to 3.1% on an annual basis. But unlike prior quarters, inflation has ticked up as well. In the first half of the year, the consumer price index (by and large the most common inflation benchmark) rose a total of 0.5%. This is quite low, and below the Fed’s target of 2.0% per year. While the September numbers aren’t out yet, the CPI jumped during July and August, rising another 0.5% between the two.
Meanwhile, the Federal Reserve has announced that it is beginning to reduce the size of its massive balance sheet. This is a topic I’ve written about extensively in prior editions of Investment Insights. If you recall, during the financial crisis the Federal Reserve purchased huge amounts of U.S. Government securities in order to inject more money into the banking system and support the economy. We still don’t know what the ultimate result of this tactic will be, but so far the strategy seems to have worked pretty well.
The tricky part will be unwinding these purchases. The Federal Reserve currently owns about $4.5 trillion in U.S. Government debt. To get rid of them there are two basic options: sell them on the open market or allow them to mature. The Fed has communicated that starting next month it will opt for the latter. As some of the securities mature each month, the Fed will take the cash received (the principal returned) and retire it from circulation, rather than reinvesting in another debt security.
This maneuver is a tighter monetary policy. By decreasing the money supply circulating throughout the banking system, cash becomes scarcer and interest rates will ease upward accordingly. The challenge is that the Fed is already raising short-term interest rates. This additional mode of tightening will need to be handled delicately. Unwinding too fast could apply too much downward pressure and stamp out potential growth. On the flip side, not unwinding enough could cause the economy to overheat and inflation to spike.
The Fed has said it will begin by allowing $6 billion in Treasury securities and $4 billion in mortgage-backed securities to mature every month. As long as all goes smoothly the bank will pick up the pace over time, not to exceed $30 billion per month in Treasuries and $20 billion in mortgage backed securities. Ideally this “great unwind” will occur in a gradual, boring fashion. But with the CPI gaining speed in July and August, the bank will have certainly its finger on the pulse of inflation.
The steady climb and low volatility in equities isn’t unique to the U.S., either. September marks the 11th consecutive month global stocks have posted gains. This ties the all-time record set during the post dot com bust rebound back in April of 2003.
From an economic standpoint, the global producer’s manufacturing index (PMI) has been in expansion territory for 17 straight months. This index is what’s considered a “leading indicator” of global economic health, meaning that strong numbers normally indicate good things to come. PMI measures the health of the global manufacturing sector, and is based on new orders, inventories, production, supplier deliveries, and the employment environment. Not only has global PMI been on a consistent run, in August the index rose to its highest level since May of 2011.
One international trend that’s on my radar is the growing protectionist sentiment both in the U.S. and abroad. I wouldn’t say the British started the movement, but they certainly played a big hand by deciding to leave the European Union in the summer of 2016. Since then rumors of other potential EU exits have skyrocketed, including whispers that France, the Netherlands, and/or Hungary may also depart.
Adding fuel to the fire, President Trump continues to lean toward a protectionist, “America first” viewpoint. While I’m all for an agenda focusing on American wellbeing, framing the discussion in terms of “winners” and “losers” in trade is short sighted. Free flowing global trade is in everyone’s best interests. It gives global consumers the best opportunity to improve their standard of living, promotes innovation, and can reduce the opportunity for corruption. There are complications, of course (trade is very political). But the takeaway here is the more that countries veer toward this nationalist, isolationist mentality, the farther we stray from integrated, free flowing trade we should be striving for.
Fortunately, the economic numbers don’t reflect the rhetoric (at least not yet). Global export orders (a decent benchmark for global trade) in August grew at their fastest pace since March of 2011. The economic data was matched by strong equity market performance around the globe as well. The MSCI Emerging Markets Index rose 7.89%, and the MSCI World ex-USA Index rose 5.62% in the third quarter.
Looking ahead, the central banks of China and the European Union will be a focus. China has finally cut off banking relationships with North Korea. This will be crippling for the North Koreans, as China amounts to 90% of their foreign trade. It won’t make a dent in China’s output though, with North Korea making up a little less than 0.2% of theirs.
In the EU, most analysts believe the European Central Bank (ECB) will begin tapering their asset purchases sometime in the fall. This means the ECB will begin walking a similar tightrope as the Federal Reserve here in the U.S., where the bank will attempt to tap on the breaks without slamming to a sudden halt.
U.S. Fixed Income
Interest rates increased across the U.S. bond market for the quarter. The yields on 5, 10, and 30-year Treasury notes all rose slightly, to 1.92%, 2.33%, 2.86%, respectively.
In terms of total returns, corporate bonds gained 0.59% on the quarter, while intermediate-term corporates gained 1.05%. One sector of the bond market that’s been particularly strong this year is preferred stocks. Despite their name, preferred stocks are actually long term fixed income instruments. They’re senior to equity holders in a company’s capital structure, but junior to other traditional bondholders. That means that if a company is going bankrupt, traditional bond holders will get their money back before preferred stock holders do. Common stock holders are last in line.
Some types of preferred stocks are convertible into traditional equity shares, as well. For that reason preferreds often exhibit the characteristics of both a debt and equity investment – a “hybrid”, if you will.
Just like bonds, preferred stocks have fixed par values and make coupon payments based on either a fixed or variable basis. Maturity dates of preferred stocks tend to be very long term, too. It’s common to see maturity dates on preferred shares at 30 or more years into the future, or have no maturity date at all. For issues without maturity dates, a company agrees to pay preferred shareholders coupon payments in perpetuity.
With the long maturity dates, preferred stocks tend to be very sensitive to interest rate changes. And since the securities have characteristics of both debt and equities, they tend to be influenced both by moves in long term bond yields and movements in the stock market.
As a sector, preferred stocks finished off the third quarter very close to their all time highs. With long-term Treasury yields still quite low, preferred stock issuers have successfully retired high coupon issues, replacing them with lower coupon offerings. This has led to a steadily decreasing average coupon rate, pushing up prices on the preferred stocks remaining in the market.
When considering preferred stocks for your portfolio, remember that they’re securities better suited for the long-term investor. You may be able to garner more yield out of a preferred share than your typical corporate bond, but there’s an inherent level of interest rate risk you should be aware of. If your strategy is to remain invested regardless of the market climate (which is the strategy we urge our clients to employ), preferred shares will still offer an adequate long-term return and act as a diversifier. But for the short-term investor, be sure to weigh the interest rate risk against their attractive yield.