U.S. stocks rose to record highs in the third quarter. International markets also gained, but only modestly as tariff concerns remained a headwind. Bond returns were flat for the quarter as interest income was offset by a decline in bond prices as rates drifted higher.
1. What factors caused stocks to reach record highs?
After experiencing lackluster results in the first half of the year, U.S. stocks rose to record levels in the third quarter. The U.S. market gained 7.7 percent during the period, outpacing most other asset classes.
Several factors led to the surge in prices, including:
- Improving economic growth – The U.S. economy grew by 4.2 percent in the second quarter, the best in three years.1
- Strong corporate revenue and profit growth – S&P 500 sales increased by 10 percent in the second quarter, and earnings rose nearly 25 percent.2
- Share buybacks – Companies are buying back their own stock at a record pace in 2018. Buybacks increase earnings per share, all else equal.
- Reduced regulation – The administration is reducing the amount of business regulation, which lowers costs.
Despite tariffs, fears of trade war and Federal Reserve rate increases, stocks climbed higher. Recent price gains have been supported by improving fundamentals, keeping valuation in check.
2. How will midterm elections affect the market?
On November 6, voters will determine who will control the House and Senate for the next two years. Uncertainty regarding potential election outcomes has increased market volatility in recent weeks.
Despite the short run “noise” that midterm elections cause, investors should focus on improving economic and market fundamentals. Those trends are more important to future returns than politics. According to Goldman Sachs,3 volatility usually declines and stocks rise as clarity develops in the days leading up to the election. Once elections are over the stock market tends to move higher, regardless of the outcome.
3. What are expectations for interest rates in 2019?
Federal Reserve policy has become an important factor for the markets. Over the past few years, the Fed has raised rates eight times, with another 0.25 percent hike expected in December. These hikes have resulted in negative returns for the bond market this year. 2018 could become only the fourth year since 1980 that bonds have posted a loss.
If the Fed continues to raise rates in 2019, what will that mean for investors? Most forecasts call for two to four 0.25 percent increases in 2019. The market currently has priced in two hikes. A larger rise in short rates would have a negative effect on bonds. But inflation has been moderate, with prices rising at a slow and steady pace. We expect that trend to continue, causing rates to move gradually higher in 2019.
Despite the near-term headwinds, bonds still make sense for investment portfolios. They are the first line of defense against stock market risk. Current yields are more than 1 percent higher than last year, which increases future return potential. While the recent environment has been bumpy, bonds still play a key role in diversified portfolios.
4. When is a recession coming and how can you tell?
Bear markets for stocks almost always occur in tandem with economic downturns, so monitoring the chance of recession is helpful in managing portfolio risk. As the current expansion approaches the longest in U.S. history, attention has turned toward its eventual end—but forecasting the specific recession timing is difficult.
Recessions normally occur when the Federal Reserve raises interest rates to a level that stalls economic growth. Only after the fact does the Fed realize it raised rates too far. Wage inflation has been modest in this cycle, despite low unemployment. This has allowed the Fed to raise rates more slowly than in prior periods, which may extend the expansion.
We do expect further Fed rate increases in 2019. The economy is growing today, but additional rate hikes could raise the chance of recession in 2020. The key will be to monitor economic data for signs that activity is weakening in response to future rate rises.
5. With U.S. stocks performing so well, does it really make sense to diversify?
U.S. stocks have handily outperformed most other asset classes over the past five years. Average annual returns have been well above normal, at 13.46 percent per year.4 Diversifying into international stocks, bonds and alternative investments resulted in a lower return than owning U.S. stocks alone. Over the same time frame, the other asset classes produced returns below their long-run averages.
One of the reasons for strong U.S. market performance is that our economy is doing well. Consumers and business owners are optimistic. There are few indications that a recession is near, nor are we predicting one any time soon. Stock prices are at all-time highs.
The years leading up to 2008 also were good for U.S. stocks. Volatility was low, and five-year average returns through December 31, 2007, were strong at 13.63 percent. Then in September 2008, Lehman Brothers collapsed under the weight of subprime mortgages. The bankruptcy of this 158-year-old firm triggered a 57 percent decline in U.S. stock prices, the worst bear market since the Great Depression. Ten years later, this period is a distant memory and one that most investors would like to forget! Such extreme market declines are rare, but offer a reminder of the importance of diversification in mitigating losses and speeding the recovery of value.
Diversification offers a consistent risk benefit, and asset class returns tend to revert to long-run averages over time. During periods like this, the fear of missing out may tempt investors to chase returns. But we believe that maintaining discipline and diversification will prove beneficial once again, as it has across market cycles throughout time.
Thank you for the confidence you have placed in the BKD Wealth Advisors team!
1 Capital Economics, August 29, 2018.
2 Thomson Reuters, Bloomberg, September 12, 2018
3 Goldman Sachs Asset Management, August 3, 2018
4 Tamarac Advisor View, Russell 3000 Index through 9/30/18
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.