October 11, 2018— Hurricane Michael is not the only thing leaving a wake of destruction in its path. The stock market has also experienced a swift correction that has spared few stocks, sectors, or regions—with weakness extending into European and Asian markets. The S&P 500 had its worst day since March, and the Dow Jones Industrial Average (DJIA) fell over 800 points on Wednesday.
The market seems to be a jumble of nerves over a number of concerns that, while not new, seem to have escalated to a temporary breaking point.
1) Interest rates. A string of very positive data—along with some pointed words from Federal Reserve Chair Powell last week regarding the Fed having a ways to go before it may pause its rate-hike cycle—have pushed interest rates higher across the board. With cash yielding a respectable 2% and the 10-year Treasury yield testing 3.25%, stocks are no longer the only viable investment option.
2) Fed independence. Related to rates, President Trump has taken the opportunity to break with convention (again) and comment on Fed policy. Referring to the Fed’s rate hikes as “crazy” has called into question the Fed’s independence under the president.
3) Tech security issues. Technology stocks have been the darling of the stock market this year, but a string of reports about security breaches have left investors questioning how much investment will be needed to rectify the issues. Tech stocks have been hit particularly hard, experiencing their worst day in seven years.
4) Trade war. After Secretary of State Pompeo’s very brief visit in China, more analysts are pricing in a protracted trade war with China, including an escalation of tariffs to 25% as scheduled on January 1. We are also getting more anecdotal evidence of higher input costs and supply disruptions for businesses. It does not help that there were reports this week of a crackdown on luxury items at China’s border.
We do not dismiss any of the above, but we think the current market activity is a necessary consolidation before markets move higher. It is also likely exacerbated by algorithmic traders, who rely on rules of when to sell and buy based on, among other things, markets breaching particular levels. We do not expect interest rates to climb in a straight-up trajectory, and we do not believe there is any real threat to Fed independence. Tech stocks arguably needed to take a breather, but security innovation is core to their businesses and we think they will manage through the challenges. A protracted trade war is probably the most concerning issue, namely because a compromise seems elusive at this point and slowing global growth is already evident.
S&P 500 Daily Price Level
Data as of October 10, 2018
Source: Moody’s Analytics
We have taken steps this year to reduce risk modestly and raise cash levels slightly. Robust economic data and reasonable valuations (particularly outside of the U.S.) give us conviction that the current selloff in equity markets, though uncomfortable, is normal. Higher volatility is painful but should be expected and does not prevent markets from climbing higher over the next 6–12 months. Even so, keep an eye out in the days ahead for further communications from us, depending on how events unfold. To read more about the risks we believe are currently at play, along with a discussion of deploying new cash into markets at this time, see the latest issue of Capital Perspectives.
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