Market Commentary: October 24, 2018


Paradigm Financial Advisors

Market Update

October 24, 2018

 

Global stock markets have experienced increased volatility over the past few weeks as a number of issues have combined to rattle investors.  Investors are concerned about corporate earnings and profit margins, a potential full-blown trade war with China, interest rate hikes by the Federal Reserve, European tensions regarding Brexit and the Italian budget negotiations, the implication of Saudi Arabia in the brutal murder of Jamal Khashoggi, and uncertainty surrounding the upcoming Mid-term elections.

 

A few market commentators have been stirring up fear by predicting that corporate earnings have peaked and that we could fall back into a recession in the U.S. as early as 2019.   Ratings go up when fear rises but the doom and gloom commentators are likely to be wrong again because the economic and earnings data do not indicate any risk of a recession any time soon.  The third quarter earnings reports are forecast to show double digit earnings growth and the most recent economic data indicate that the U.S. economy is the strongest it has been in many decades.  The tax cuts and decreased business regulations will help U.S. companies continue to produce strong earnings going forward.   We believe the recent sell-off has produced an excellent opportunity for investors to rebalance their portfolios to take advantage of very attractive prices.

 

While It is impossible to figure out the exact cause of these short-term market pullbacks, the following “fear factors” likely have contributed to the recent increase in volatility:

 

1) Will the Federal Reserve Raise Rates Too Quickly?

The Federal Reserve, under the new leadership of Jerome Powell, has been very hawkish in their recent outlook for future rate hikes.   They have implied that they will raise rates one more time this December, followed by 3 more rate hikes in 2019.   The problem with this guidance is how they have framed the statements as “tightening” monetary policy and they should change the terminology to “normalizing” monetary policy.  They need to explain that interest rates are still very low compared to historical standards and that if the robust economic conditions continue, they will continue to move rates higher to a more “normalized” level.

Home & Auto Sales:  Home and Auto sales have fallen over the past few months due to higher interest rates.  The Federal Reserve may have to walk back their most recent statements indicating more aggressive tightening after seeing the most recent Housing and Automobile sales data.  Rising interest rates may be hurting home and auto sales more than anyone expected.  If the threat of increased rate hikes continues to hurt the housing and automotive markets, we may see the Federal Reserve move to a more dovish stance on future rate hikes.

Inflation Concerns:   The Federal Reserve is also causing some fears in the market due to their 2% inflation target.  As the U.S. economy strengthens the Fed may face pressure to change its inflation target to a range of 2% to 3%, rather than boxing itself in with the 2% target.  Inflation is not currently an issue in the U.S. or across the globe and we have seen over the past two decades that the globalized economy and technological advances has helped keep inflation in check and we expect this trend to continue going forward.

 

2) Trade War with China:

We believe that the fears of a full-scale trade war with China are overblown and that these fears have created a fantastic opportunity for long term investors.  Most of the Chinese stock market is now trading in bear territory (down over 20%) and is very attractive from a valuation perspective.  We do not believe that our administration or their administration wants this to turn into a full-scale trade war, in that scenario, neither country wins.   We think a breakthrough could happen in the next few weeks which will hopefully set the stage for a meeting between President Trump and Chinese leader Xi Jinping at the multilateral summits which will be held in November.

 

3) Peak Earnings Fears

Many pundits continue to predict that U.S. companies’ profits and margins have peaked and its all downhill from here.  They have been saying this for several years and they continue to be wrong.   This is the second full week of this earnings season and approximately 20% of S&P 500 companies have reported earnings thus far, and we are still expecting total earnings growth of 20% for the quarter (year over year), which will mark the 3rd consecutive quarter of over 20% earnings growth.   The economic data has clearly indicated that the U.S. economy is still growing at a very solid pace at approximately 3%.  The third quarter GDP report will be released this Friday and we believe it may show higher growth than economists have forecasted.

 

4) Will the Tax Cuts Benefit Companies in 2019 and Beyond:

The benefits of the tax cuts have already surpassed what nearly all of the economic forecasters predicted.  However, there is still fear that the Tax Cuts will only benefit the earnings of U.S. companies in 2018.  We believe the tax cuts will continue to help U.S. companies be much more competitive globally and will save U.S. companies millions of dollars EVERY year.  The big surprise that commentators should be talking about is that the tax cuts and reduced business regulations could lead to stronger than expected economic growth in the years to come.

 

5)  European and other Geopolitical Fears:

European political uncertainty continues to weigh on European stocks.  The never-ending Brexit debate continues and the European Union is demanding that Italy change their budget to reduce entitlement spending further and a decision is supposed to be reached in Italy today.  If Italy refuses to change their budget the European Union may take the unprecedented step of demanding Italy take back, revise and resubmit its fiscal plan.

 

6) Midterm Elections: 

President Donald Trump is intensifying his campaign ahead of the midterm elections and is making promises in a bid to ward off Democratic control of Congress. He doubled down on his promise for further tax cuts, saying there would be an additional 10 percent reduction for middle-income families.   President Trump is also promising that the U.S. would outspend any other nation in building up its military defense to answer any challenge presented by Russia and China.  President Trump is also taking a hard line on immigration, saying the U.S. may close the border temporarily and the U.S. may cut off foreign aid to Guatemala, Honduras and El Salvador as thousands of people march north from the region in search of a better life in America.

 

7) Saudi Arabia’s Involvement with the Murder of Jamal Khashoggi:

The Saudi Government has denied involvement but Investors are concerned because their explanation does not seem credible.  The timing of this incident is terrible for Saudi Arabia because they are hosting the Saudi Arabia Future Investment Initiative conference which begins today.  Many countries have pulled out of the conference due to the murder of Khashoggi.  Turkey’s President Recep Tayyip Erdogan is laying the blame for the death squarely at the door of Saudi authorities, dubbing it a planned operation. The markets are concerned that the U.S. and other allies of Saudi Arabia may impose sanctions or take more serious action against them which could have a destabilizing impact on the middle east.  There is very little risk of a major conflict between the U.S. and Saudi Arabia over this but it is still weighing on the global markets because it creates uncertainty.

 

Conclusion:

This is a bump in the road and it has created some excellent buying opportunities.

The media has, and will likely, continue to question whether this is the end of the bull market.  It’s an easy story to push, as we are now in the longest economic recovery in history and the market is near all-time highs.  The odds of a recession are still very low over the next few years, so it is hard to buy into this thinking that we are due for a recession simply because we have not had one in a long time.  A recession is defined as two consecutive quarters of negative GDP growth.  U.S. GDP growth is accelerating not declining and it is forecast to be over 3% during the remainder of 2018.  We believe that many economists are underestimating the impact of the tax cuts and decreased business regulations and that we could see GDP growth in the U.S reach 4% in 2019.

Keep in mind that no bull market has ever died simply of old age. We believe that the recent sell-off has been irrational and it provides us with an opportunity to rebalance our portfolios to take advantage of mispricing in many asset classes.

 

PFA’s Investment Committee:

Jim Reding                        Bob Spindel

Ryan Powers                     Brad Combs

Matt Schaller                    Matt Kellerman