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Wall Street to Your Street
What's Driving Stock Volatility And What To Expect Next
December 12, 2018 | Mark Simenstad, CFA, Chief Investment Strategist
In the past year, the S&P 500® has gone through two corrections of 10% or more from peak to trough. This roller coaster market has left the S&P 500 with a modest loss of approximately 1.3% for 2018 through December 10. (The S&P 500 Index is a market-cap-weighted index that represents the average performance of a group of 500 large-capitalization stocks.)
And, like a roller coaster, it has left many investors with a great sense of unease, if not outright nausea.
Although there are many reasons for broad stock market moves, the following factors are the most important issues that we believe have been driving this volatile market. We also lay out our current views on the prospects of the market:
The Federal Reserve (Fed) has been systematically raising short term interest rates and has discontinued its large bond buying program after a period of increasing money supply and low rates following the financial crisis.
The result has been reduced liquidity throughout the capital markets. It has also led to meaningfully higher short-term bond yields, which now provides a more competitive return alternative to stocks. Our view is that this policy has been prudent thus far, and that the Fed may now be close to a level that they believe should be appropriate for an economic and inflationary environment that is approaching more normal levels.
Closely tied to Fed policy has been the relentless narrowing of the spread between long and shorter maturity bonds. This "flattening" of the yield curve, as short-term rates and long-terms rates begin to converge, has led to widespread concerns of outright "inversion"—a historical precursor to recession.
Our view is that although the yield curve has, in fact, flattened at the very short end of the curve, we don't believe this is a classic inversion, where short-term rates are higher than long-term rates. In addition, although it is true that inversions often precede serious market and economic weakness, the length of time from the flattening/inversion of the yield curve and a bear market can vary greatly from one instance to another.
There are a multitude of disconcerting geopolitical events, particularly U.S.-China trade frictions and Brexit, which have injected a high degree of uncertainty and anxiety into the markets. Our view is that the outcome and ultimate impact of these developments are very hard to determine. Consequently, this uncertainty will continue to manifest itself in higher levels of volatility and more subdued market valuation (lower price-earnings ratios globally). (Price-earnings ratio refers to a stock valuation method in which the stock price of a company is divided by its annual earnings.)
Corporate earnings have been exceptionally strong due to solid economic fundamentals and the recent corporate tax cuts. However, the market has been concerned that we have seen the peak in earnings, with revenue growth poised to decline as the economy moderates, as well as profit margins that may decline as employment and logistics costs escalate, and as the positive impact from lower tax rates fades.
Our view is that although the positive impact from lower tax rates will fade, earnings will still be quite healthy by historical standards if operating margins prove resilient. Also, we see little evidence that the economy will downshift materially such that corporate revenues will stop growing.
The high and growing level of global debt and other liabilities, including pension and health benefit obligations, are beginning to weigh on longer term investor perceptions. Historically low interest rates have significantly mitigated the near-term cost of servicing these liabilities.
Our view is that high debt levels are indeed an issue of concern, particularly if interest rates were to rise further. Partially offsetting this concern is the fact that consumer debt has not increased to excessive levels since the last recession, and thus should not be a contributing catalyst for potential problems. However, elevated corporate and government debt will weigh on global economies and markets as interest rates increase.
As discussed above, there are many risks that will continue to weigh on market returns, with high and rising debt levels being the most problematic risk from a longer-term standpoint. Given the diminished level of liquidity in the market, volatility will remain high, and further equity market declines are certainly possible.
However, we believe a healthy domestic economy, sustained relatively strong corporate earnings, low interest rates, and relatively moderate valuations may counteract the rising tide of late cycle risks. We continue to believe that long term returns will be muted as compared to the very strong returns over the past number of years.Finally, in periods such as this, it is important for investors to again assess their real risk temperament relative to the time frame of their investment objectives and to ensure that their overall portfolios remain properly balanced and diversified across asset classes.
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Media contact: Samantha Mehrotra, 612-844-4197, firstname.lastname@example.org
All information and representations herein are as of December 10, 2018, unless otherwise noted.
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Thrivent Asset Management associates. Actual investment decisions made by Thrivent Asset Management will not necessarily reflect the views expressed. This information should not be considered investment advice or a recommendation of any particular security, strategy or product.
Past performance is not necessarily indicative of future results.