Concerns Over Global Growth, Earnings, Trade Woes Contribute to October’s Market Turmoil
Tightening financial conditions beginning to weigh on borrowing costs and bottom lines
Last month was a rough ride for global financial markets as stocks sold off and bond yields rose, reflecting concerns over the pace of global economic growth, whether corporate earnings have peaked, and trade woes.
The Dow Jones Industrial Average fell 5.07% in October, while the Standard & Poor’s 500 index declined by 6.94%. The tech-heavy Nasdaq lost 9.20%. For the broader S&P 500, it was the index’s worst monthly performance since September of 2011 when it fell by more than 7.0%, according to S&P Dow Jones Indices.1
Investors didn’t fare much better in global terms. The MSCI All Country World Index (ACWI) declined by 7.57% last month, its worst monthly price performance since May 2012. The MSCI Emerging Markets Index posted a price decline of 8.78%, that index’s worst month since August 2015, according to this Reuters report.2
Rising U.S. Treasury yields and a stronger U.S. dollar have also led to a significant tightening of financial conditions in recent months. Since the end of August, the yield on the benchmark 10-year U.S. Treasury note has risen by nearly 31 basis points to 3.16% through October.
It’s continued its march higher during the first few trading days of November, settling at 3.21% as of November 6. Higher yields raise borrowing costs for companies and consumers (fixed-rate mortgages and other consumer credit is largely pegged to Treasury yields).
For its part, the dollar has appreciated by nearly 6.0% this year through October as tracked by The Wall Street Journal Dollar Index – a measure of the U.S. currency relative to 16 other currencies. A strengthening dollar adds to the costs that foreign governments and overseas companies have to repay on their dollar-denominated debt.
Other measures of funding costs are also on the rise. After hovering near 2.30% in recent months, dollar funding, as measured by the three-month London interbank offered rate, or Libor, closed out October at around 2.56%.
The three-month Libor rate reflects expectations of where the federal funds rate set by the Federal Reserve will be in a few months’ time and the risk premium lenders such as financial institutions charge for lending out to other banks. The rate, though, is also tied to floating-rate debt issued by corporations, securitized transactions and other dollar-denominated debt.
A transition process to a new dollar reference rate for borrowing known as the Secured Overnight Financing Rate is currently underway following the scandal regarding Libor’s manipulation which emerged in the wake of the financial crisis and great recession.
Global Economy: U.S. Growth Continues; Signs of Slowdown Emerging Overseas
As the U.S. economy enters the fourth quarter, the past six months have been among the best in the past decade. The Commerce Department reported in late October that the nation’s gross domestic product (GDP) rose at an annualized rate of 3.5% in the third quarter.3 Though not as strong as the 4.2% annualized pace of growth in the second quarter, the Commerce Department’s “advance” estimate of third quarter growth still reflected strong consumer spending, which helped offset a decline in business and residential investment.
Consumer spending rose 4.0%, even stronger than the 3.8% rate of growth in the second quarter. The report also showed signs that inflationary pressures remained below the Federal Reserve’s target of 2.0%. The personal consumption expenditures (PCE) price index, excluding food and energy, increased by 1.6%, compared to an increase of 2.1% in the previous quarter.
Other measures of spending within the report showed a mixed picture underneath the headline 3.5% growth figure, however. Business investment grew by 0.8% after a gain of 8.7% in the previous three months. Spending on new structures declined 7.9% after rising by 14.5% in the second quarter. The trade deficit also subtracted 1.8 percentage points from overall growth.
While the headline growth figure is still among the fastest in recent quarters, expectations are that the U.S. economy may begin to slow over the next several quarters. The Federal Reserve projects that the U.S. economy will grow by 2.5% in 2019. Economists also expect that tighter Fed policy will weigh on growth in the upcoming quarters, as the central bank has forecast up to another one percentage point rise in interest rates through 2019 in its projections released in late September.4
“A confluence of fiscal stimulus measures and elevated business and consumer confidence have helped the US economy enjoy an extended period of well-above trend growth,” Brian Schaitkin, senior economist with The Conference Board, said in a statement on the third quarter GDP data. “In 2019 however, headwinds from Federal Reserve policy, the fading influence of stimulus measures, and a weaker external environment will drag growth back towards its longer-term trend.”5
A strong employment market has been one of the key factors helping to lift consumer spending, and the most recent payrolls report demonstrated that the U.S. employment market remains strong. Employers added 250,000 workers to their payrolls in October, and the unemployment rate remained at 3.7%, the lowest since December 1969.
The strong hiring trends and low unemployment rate helped lift wages, something that has been in check for much of the economic recovery. Average hourly earnings rose by 5 cents to $27.30. Over the year, average hourly earnings increased by 83 cents or 3.1%, according to the Bureau of Labor Statistics.6 That was the biggest year-over-year gain for average hourly earnings since 2009.
The nation’s manufacturing sector continues to show signs of expansion, however a gauge of new orders fell to its lowest level since April 2017. The overall reading of the Institute for Supply Management’s (ISM) manufacturing index fell to 57.7 in October, down from 59.8. As recently as August, the ISM manufacturing index was at its highest level since May 2004.7
The most recent reading is at its lowest level in six months. Purchasing managers cited rising prices, tariffs and falling demand. The new orders index, meanwhile, declined by 4.4 percentage points from the previous month to 57.4 – the second consecutive month of softening customer demand.
For the U.S. housing market, slowing trends are also notable despite the strength of the nation’s job market and economy. Sales of existing homes in September fell to their lowest level since November 2015, according to the National Association of Realtors (NAR). The seasonally-adjusted rate of 5.15 million existing-home sales in September represented a 3.4% decline from the previous month and a 4.1% slide from the same period a year ago.8
Higher interest rates have led to rising mortgage borrowing costs this year. That plus home price appreciation upwards of 50% since the market bottomed in 2012 have been among the factors contributing to the housing market’s recent stumbles. These trends are particularly impacting first-time buyers – which made up about 32% of existing home sales in September, compared to an annual share of 34% in 2017, according to NAR.
“Despite small month over month increases, the share of first-time buyers in the market continues to underwhelm because there are simply not enough listings in their price range,” NAR President Elizabeth Mendenhall, said in the press release accompanying the most recent existing-home sales figures.9
Growth Slowing Overseas
Signs elsewhere of a slowdown in economic growth were evident in Europe where annualized GDP growth fell to its lowest level since 2014. The economy of the eurozone rose by 0.2% for the third quarter, after rising by 0.4% in the previous quarter. On a year-over-year basis, eurozone GDP increased at an annualized pace of 1.7%, according to Eurostat, the statistical office of the European Union.10
Also in the eurozone, a key gauge of business growth for October came in at the lowest level since September 2016. The final reading of the IHS Markit Eurozone Composite Purchasing Managers’ Index fell to 53.1 in October from a reading of 54.1 in September.11
Chris Williamson, IHS Markit’s chief business economist, noted the disappointing start to the fourth quarter for companies in the eurozone, adding that business activity is growing at its slowest rate for over two years and expectations have slumped to the bleakest since the end of 2014.
“An export-led slowdown, linked to growing trade tensions and tariffs, has been exacerbated by rising political uncertainty, growing risk aversion and tightening financial conditions,” Williamson said, in the news release announcing the results. “The slowdown has consequently become more broad-based to increasingly envelop the services economy.”
In China, economic growth moderated in the third quarter to 6.5% compared to the same period a year ago, according to the National Bureau of Statistics of China.12 It was the weakest pace of growth since the first quarter of 2009.
The Chinese government has put in place a strategy to rebalance economic growth away from investment and export-led growth to a consumer and service-based economy. The government has also attempted to foster measures that support financial deleveraging.
Trade tensions with the U.S. have also impacted financial markets. Since mid-April, the renminbi, the nation’s currency, has depreciated against the dollar by more than 9.0%. China’s main stock index, the Shanghai Composite Index, is down by 21.3% this year through October.
Stocks: For U.S. Markets, Earnings Haven’t Been the Tonic to Soothe Volatility
There was no room to run for cover from the selloff in stocks during October. While the Dow, S&P 500 and Nasdaq fell by more than 5.0%, nearly 7.0%, and more than 9.0% respectively, the three major benchmark indexes remained in positive territory through the first 10 months of the year.
Corporate earnings, a key driver of market performance prior to last month’s selloff, remained strong, though a significant portion of the year-over-year operating earnings gain “appears to have come from lower taxes,” said Howard Silverblatt, S&P’s senior industry analyst, in its monthly market recap.
While that trend is similar to what companies reported in the first and second quarter, “underlying organic growth has slowed” with companies mentioning gains from cost controls, but also offset by higher operating costs and even the strong U.S. dollar. “The takeaway is that the Street expected a lot from Q3, and since it is all about expectations, even a record-setting quarter can be a disappointment,” Silverblatt said.13
Data from FactSet shows that the market is rewarding positive earnings surprises less than average and punishing negative earnings surprises more than average. For example, the stock prices for companies reporting positive earnings surprises for the third quarter experienced an average price increase of 0.2% in the two days before the earnings release through the two days after the earnings ─ below the five-year average price increase of 1.0%.
In contrast, the stock prices for companies reporting negative earnings surprises had an average price decrease of 3.8% two days before earnings through two days after earnings were released – well above the five-year average price decrease of 2.5%.
Overall, earnings for companies in the S&P 500 are still on track to post double-digit earnings growth for the fourth quarter, with analysts forecasting a 15.0% year-over year increase. The pace of growth, however, is expected to decline to 9.4% for calendar-year 2019, according to FactSet.14
October’s selloff also extended to small capitalization shares, which had been somewhat of a haven from trade woes earlier in the year. The thinking had been that smaller companies have less international revenue exposure than large cap shares which have more exposure to global trade. But as October’s selloff accelerated amid concerns over higher interest rates and bond yields, small cap shares declined.
The S&P SmallCap 600 fell 10.54% in October. Amidst concerns over economic growth and rising operating costs, all 11 sectors of the index ended the month in the red. For the year through October, however, the overall index is still up by 1.46%, according to S&P Dow Jones Indices. The Russell 2000 declined 10.9% in October and is down by 1.6% for the year through October.
A diversification strategy also didn’t work for investors during October. According to Bank of America Merrill Lynch, a conventional portfolio of 60% stocks and 40% U.S. Treasury securities fell 5.3%, the worst monthly return since February 2009, as noted in this Reuters report.15
Of note to watch will be how much the idea that fixed income offers a safe haven from equity market volatility holds up. In general, the two asset classes tend to be negatively correlated – when stocks go up, bonds go down and vice versa.
That relationship broke down earlier this year in February but somewhat reverted to what had been the general norm for nearly two decades, when stocks continued their swoon in March and U.S. Treasurys rallied. Since 2000, research from Morgan Stanley Capital International (MSCI) published in its blog in June found that “significant downdraughts” in equities (2% or greater) were consistently (about 84% of the time) accompanied by positive returns in the U.S. Treasury market.16
Over shorter timeframes, however, the correlation does tend to shift and weaken. This occurred during the “taper tantrum” in 2013, for example. Short-term estimates are more responsive and “may serve as early warning signs for a regime change shift,” MSCI wrote in a follow up blog post published in November on the correlation of stocks and bonds.
Analysis of historical data is needed when managing the risk of a structural change in the bond-equity correlation, but so too is judgment, Michael Hayes and Thomas Verbraken, two MSCI executive directors, say in the blog post. And there are reasons for concern, given that the rise of “populist, protectionist governments” bring the threat of de-globalization, slowing growth, and increasing budget deficits.
This, in turn, could lead to an inflation shock, which could have a negative impact on bonds and (real) equity prices, driving the correlation positive. A positive correlation along with increased interest-rate volatility could harm long-term investors with traditional 60-40 portfolio allocations.
“While one or two sell-offs do not constitute a trend, interconnected risks – increased rate uncertainty and the potential disappearance of the bond-equity hedge – may be an important medium-term scenario to manage against,” Hayes and Verbraken say in the blog post. “In such a scenario, long-term investors would likely be under significant pressure to find alternative sources of diversification.”17
Commodities: Oil Prices Test Bear Market Territory
Expectations that the energy market would continue its strong run this year gave way to a shift in October as production from major oil exporters collided with concerns over global economic growth and volatility in financial markets.
After settling above $76.40 a barrel – a four-year high – in early October, West Texas Intermediate crude prices have since fallen by more than 19.0% through November 7, and have traded at intraday levels below 20%, or bear market territory. A bear market is generally defined as a 20% decline from a recent peak in prices.
Brent Crude, the global benchmark for oil, has experienced similar price declines, though not as severe. It was down by nearly 16.50% October 3 through November 7, settling at $72.07 a barrel.
The oil market had been clouded in some uncertainty in previous months, awaiting the impact from the implementation of U.S. sanctions on Iran and whether supply disruptions would be replaced by countries within the Organization of the Petroleum Exporting Countries (OPEC) and other producers.
U.S. sanctions on Iran went into effect in November, though fears of a supply shortage were eased by President Donald Trump’s granting of waivers to eight governments that purchase Iranian oil. Prior to the sanctions, producers, including Saudi Arabia and Russia, added supply to the market. A committee within OPEC plans to meet in November, before a broader meeting in December, with production levels potentially to be discussed.
In the U.S., oil production continues at, or near record levels amid rising inventories. Weekly data from the Energy Information Administration released November 7 showed that production rose to 11.6 million barrels a day, up by 400,000 barrels from the prior week, according to this CNBC report.18 Total production represented a weekly record, while inventories rose for the seventh straight week and were at their highest level since June.
For consumers, the significant drop in crude prices is translating to lower prices at the pump. AAA, the motor and leisure travel organization, reported in early November that the nation’s $2.76 average price for gas was the cheapest since April. The national average was 15 cents lower than the previous month, yet still 24 cents higher than a year ago, just as motorists get ready to hit the road later this month for the Thanksgiving holiday period.
The price decline is occurring when analysts had thought the re-imposition of sanctions on Iran would lead to higher oil prices and filter through to what consumers pay for gas. “With the market anticipating and reacting to the pending Iran sanctions throughout the summer, motorists likely have seen the worst in terms of retail prices for the year,” Jeanette Casselano, AAA spokesperson, said in a press release. “If the crude oil market remains steady, gas prices are likely to continue to fall as much as ten cents in the near-term.”19
1 Silverblatt, H. (2018, November 5). U.S. Equities Market Attributes October 2018. S&P Dow Jones Indices. Retrieved from: https://us.spindices.com/documents/commentary/market-attributes-us-equities-201810.pdf?force_download=true
2 McGeever, J. (2018, November 5). COLUMN-Red October a historic month for shell-shocked investors: McGeever. Reuters. Retrieved from: https://www.reuters.com/article/global-markets-positioning/column-red-october-a-historic-month-for-shell-shocked-investors-mcgeever-idUSL8N1XG3MA
3 U.S. Department of Commerce. (2018, October 26). Gross Domestic Product, Third Quarter 2018 (Advance Estimate) [Press Release]. Retrieved from: https://www.bea.gov/system/files/2018-10/gdp3q18_adv_2_0.pdf
4 Federal Reserve. (2018, September 26). Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under their individual assessments of projected appropriate monetary policy, September 2018 [Projection Materials]. Retrieved from: https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20180926.pdf
5 Schaitkin, B. (2018, October 26). US Economy Maintains Rapid Pace of Growth, but Future Headwinds Are Strengthening [Press Release]. Retrieved from: https://www.conference-board.org/pdf_free/economics/2018_10_26.pdf
6 Bureau of Labor Statistics (2018, November 2). The Employment Situation—October 2018 [Press Release]. Retrieved from: https://www.bls.gov/news.release/pdf/empsit.pdf
7 Institute for Supply Management (2018, November 1, 2018). October 2018 Manufacturing ISM Report On Business [Press Release]. Retrieved from: https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm?navItemNumber=31078
8,9 National Association of Realtors (2018, October 19). Existing-Home Sales Decline Across the Country in September [Press Release]. Retrieved from: https://www.nar.realtor/newsroom/existing-home-sales-decline-across-the-country-in-september
10 Eurostat (2018, October 30). GDP up by 0.2% in the euro area and by 0.3% the EU28 [Press Release]. Retrieved from: https://ec.europa.eu/eurostat/documents/2995521/9350040/2-30102018-AP-EN.pdf/1420dd25-a69f-4489-a684-76fab0bdba6f
11 IHS Markit (2018, November 6). IHS Markit Eurozone Composite PMI – final data [Press Release]. Retrieved from: https://www.markiteconomics.com/Survey/PressRelease.mvc/086f9e6f394e47e7bbd53a460ea2b9b6
12 National Bureau of Statistics of China (2018, October 19). National Economy Stayed Generally Stable with Further Economic Restructuring and Upgrade in the First Three Quarters of 2018 [Press Release]. Retrieved from: http://www.stats.gov.cn/english/PressRelease/201810/t20181019_1628678.html
13 Silverblatt, H. (2018, November 5). U.S. Equities Market Attributes October 2018. S&P Dow Jones Indices. Retrieved from: https://us.spindices.com/documents/commentary/market-attributes-us-equities-201810.pdf?force_download=true
14 Butters, J. (2018, November 2). Earnings Insight. FactSet Research Systems Inc. Retrieved from: https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_110218.pdf?hsCtaTracking=31d0f488-5c02-4193-b93b-f1708067f4fa%7Cb994622e-6b82-4c98-ad34-76c848088314
15 McGeever, J. (2018, November 5). COLUMN-Red October a historic month for shell-shocked investors: McGeever. Reuters. Retrieved from: https://www.reuters.com/article/global-markets-positioning/column-red-october-a-historic-month-for-shell-shocked-investors-mcgeever-idUSL8N1XG3MA
16 Sparks, A. (2018, June 25). Bonds and Equities: Still Happy Together? The MSCI Blog. Retrieved from: https://www.msci.com/www/blog-posts/bonds-and-equities-still-happy/01028696727
17 Hayes, M. and Verbraken, T. Is The Bond-Equity Hedge Slipping Away? The MSCI Blog. Retrieved from: https://www.msci.com/www/blog-posts/is-the-bond-equity-hedge/01148009486
18 Domm, P. (2018, November 8). US now pumping more oil than Russia and Saudi Arabia; OPEC could strike back. CNBC Market Insider with Patti Domm. Retrieved from: https://www.cnbc.com/2018/11/07/us-pumps-more-oil-than-russia-and-saudi-arabia-opec-could-strike-back.html
19 AAA. (2018, November 5). National Gas Price Average Drops To Cheapest Levels Since April [Press Release]. Retrieved from: https://gasprices.aaa.com/national-gas-price-average-drops-to-cheapest-levels-since-april/
Sources for Financial Data
Dow Jones Industrial Average:
10-Year Treasury Note:
WSJ Dollar Index:
Shanghai Composite Index:
S&P SmallCap 600:
West Texas Intermediate crude:
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