Market Commentary & Investment Perspective October 2018
Market Update
(all values as of 03.29.2024)

Stock Indices:

Dow Jones 39,807
S&P 500 5,254
Nasdaq 16,379

Bond Sector Yields:

2 Yr Treasury 4.59%
10 Yr Treasury 4.20%
10 Yr Municipal 2.52%
High Yield 7.44%

YTD Market Returns:

Dow Jones 5.62%
S&P 500 10.16%
Nasdaq 9.11%
MSCI-Europe 4.60%
MSCI-Pacific 5.82%
MSCI-Emg Mkt 1.90%
US Agg Bond -0.78%
US Corp Bond -0.40%
US Gov’t Bond -0.72%

Commodity Prices:

Gold 2,254
Silver 25.10
Oil (WTI) 83.12


Dollar / Euro 1.08
Dollar / Pound 1.26
Yen / Dollar 151.35
Canadian /Dollar 0.73

Macro Overview

The Fed raised rates for the third time this year, signaling it was on track for further hikes over the next few months. Rates moved higher across the fixed income spectrum, with the 10-year Treasury bond piercing the 3% mark, a level last reached in May of this year. The Federal Reserve also revised its estimates for GDP growth from 2.8% to 3.1% for 2018, with an eventual slowing to1.8% by 2021.

Newly imposed tariffs by the Department of Commerce on Chinese imports became effective in late September. The $200 billion worth of tariffs will begin at a 10% rate and increase to 25% by year end should the two countries not come to an agreement.

The Department of Commerce is incentivizing U.S. companies to shift production of goods in China to the U.S. by allowing companies to redirect production prior to year end before tariffs are scheduled to reach 25% on Chinese made products.

Equity markets brushed aside ongoing concerns over escalating international trade tensions and instead focused on economic expansion in the United States. Analysts are seeing the benefits of the recent tax cuts and deregulation translate into expanding earnings for U.S. companies. Economists are also citing the tax cuts as a monumental factor in economic expansion.

Preliminary damage estimates following the destruction caused by hurricane Florence are expected to reach between $38 billion and $50 billion.The cost of Florence is not expected to be anywhere near the cost of hurricanes Harvey, Maria, or Irma, yet will impose additional strain on an all ready straddled insurance industry. Damage estimates are compiled by Moody’s which tracks the claims paying ability of insurance companies, especially during periods of significant payment of claims. The Federal Emergency Management Agency (FEMA) has thus far received over 8,000 claims for flood damage which allows for a $5,000 payment without an adjuster visit.

Oil prices headed higher in September topping levels not reached since 2014. Global energy markets reacted to limited production from OPEC, Saudi Arabia, Russia and the United States. The price for a barrel of Brent oil, which is priced internationally, reached $80 while the price of domestic oil priced as WTI surpassed $72. Adding to the supply strain were recently imposed sanctions on Iranian oil exports along with production constraints in the U.S.

Consumer sentiment reached its second highest level since 2004, as tracked by the University of Michigan’s Consumer Sentiment Index. Sentiment among consumers improved across all income categories with the expectation of higher wages and continued job growth. Modest levels of inflation also propelled confidence among consumers.

The White House Council of Economic Advisers reported that 623 companies this past month announced bonuses, pay increases, and better benefits as a result of the recent tax cuts. The council also estimates that over 6 million American workers have so far directly benefited from the tax law changes. (Sources: Fed, Dept. of Commerce, Moody’s, EIA, White House Council of Economic Advisers)

The OECD estimates U.S. economic growth at 2.9% for 2018, up from 2.2% in 2017

Economic Data Influences Stocks – U.S. Equity Update

Major equity indices all posted gains for the third quarter, with the S&P 500 advancing 7.2%, the Dow Jones Index gaining 9%, and the Nasdaq rising 7.1%. It was the single best quarter for stocks since 2013, buoyed by recent corporate tax cuts, improving earnings, and stable economic growth.

A notable shift occurred in the third quarter as equities surpassed real estate as the largest portion of household wealth. Real estate has out-valued equities as a percentage of household wealth for nearly 20 years.

Investments by companies in the S&P 500 Index increased to $341 billion in the first half of 2018, exceeding the same period last year by 19 percent. The increase in investments is on pace to be the most significant in nearly 25 years.

Several analysts are forecasting that the positive effects of the recent tax cuts will begin to fade as higher interest rates begin to inflate capital borrowing costs.

Growth estimates from the Organization for Economic Cooperation and Development (OECD) place U.S. economic growth at 2.9% for 2018, up from 2.2% in 2017, making it the fastest pace of growth since 2005. (Sources: S&P, Bloomberg, OECD, Dow Jones, NASDAQ)

Larger Increase in Benefits Than Income – Labor Market Review

As companies struggle to keep existing qualified workers as well as attract and hire new workers, the task of keeping labor costs minimized becomes an increasing challenge. Rather than paying higher wages, some employers are compensating their employees with enriched benefits.

The Department of Labor monitors not only how much companies pay their employees, but the breakdown of how companies are compensating their employees. The most recent data released shows that companies are spending more on health insurance, retirement savings, bonuses, vacation time, and other group benefits rather than increasing wages. The recent gain in benefits grew by nearly 12% for bonuses and benefits.

With unemployment near 18-year lows, the 3.9% unemployment rate has led to numerous job openings that exceed the number of jobless seeking work. This tightening has led to employers using bonuses and benefits to maintain and recruit skilled employees.

This past month, the White House Council of Economic Advisers reported that 623 U.S. companies announced bonuses, pay increases, and better benefits as a result of the tax law changes. (Source: Labor Department; September 18, 2018 Release,USDL-18-1499, White House Council of Economic Advisers)










(Source: Labor Department; September 18, 2018 Release,USDL-18-1499, White House Council of Economic Advisers)

90% of ibuprofen consumed in the U.S. is imported from China

Rates On The Rise – Fixed Income Update

The Fed announced its third rate hike for the year, indicating another rate increase anticipated in December and three more to follow in 2019. The Fed’s key policy rate, the Federal Funds Rate, now stands at a range of 2% – 2.25%, the highest in ten years. Borrowing rates are gradually increasing in various consumer sectors including autos, appliances, and home mortgages. Many analysts believe that the current Fed Chairman, Jerome Powell, may have the ability to orchestrate a soft landing, meaning raising interest rates gradually without triggering a recession or economic slowdown.

Of the various fixed income sectors, U.S. corporate high-yield bonds had the least amount of price declines in September, outperforming both government and investment grade debt. Some analysts view this as a validation of improving financial conditions for U.S. companies and their ability to repay debt. (Sources: Treasury Dept., Federal Reserve, Bloomberg)

Household Equity Rising as Mortgage Debt Falling – Housing Market Overview

Following the debacle of the housing crisis from ten years ago, homeowners have become less ambitious and more conservative. Equity levels in homes across the country have respectfully increased past mortgage debt levels over the past few months. The latest data from the Fed shows that household equity is now approaching $16 trillion, exceeding the level of mortgage debt standing at $15.1 trillion.

Contributing to the rise in home equity includes rising real estate values, a sustained low rate environment, limited housing supply, and an improving economic environment.

The amount of mortgage debt held by homeowners has not yet returned to the levels seen since before the housing crisis. Homeowners have become more conservative and less ambitious as they were during the crisis. Americans are also staying in their homes longer which helps build equity faster as opposed to moving and taking out a new loan laden with fees and interest payments. The Fed report notes that homeowners are taking much less equity out of their homes relative to the crisis period. The Fed data has also identified that more cash buys are prevailing throughout the market, helping to somewhat reduce the reliance on mortgage loans.

Sources: FRED; Federal Reserve Bank of St. Louis


The Three Big Things

There are three signs that we look at when determining the probability of a bear market. The first is Central banks withdrawing liquidity the second is profits recession and the third is overly bullish sentiment.

Dwindling corporate profits would be an indication of a pending recession.
In a recent interview with Consuelo Mack WealthTrack, Richard Bernstein discussed the difference between Real or Nominal Growth, explaining that with Nominal economic growth, Corporate profits can expand through raising prices.  To economists, this is not “real” growth, but to investors and the stock market, profit per share is going up. This may be the likely scenario, at least until 2019.  KCG favors sectors that benefit from rising inflation, especially materials, energy and industrials.  Industrials and global commodities markets, however, have also been negatively affected by tariffs/trade talks.  We are riding out the volatility of the Asia Pacific region by continuing to hold the Matthews Pacific Tiger Fund, but have replaced some individual stocks to conserve their gains.  Once the uncertainty caused by trade talks is removed, we believe the current pro-inflationary public policies will be passed through to the investor.

High levels of debt have resulted in slower, secular, real growth over much of the same period that we’ve enjoyed a very long, bull stock market. The extended late-cycle of the market continues to be exacerbated by pro-inflationary policies and fiscal stimulus including tax cuts, tariffs, immigration, and government spending.  In the last week, we’ve seen 10-year bond rates rise significantly and suddenly, drawing investors away from stocks.  But the bond market is the only US major asset class with a negative total return since June 2016.  Bond funds will need to re-allocate their holdings out of their current, disinflationary positions and we may be seeing some stabilizing in the equity market as investors review their options.  Should the yield curve actually invert, it has historically taken 6-12 months for a bear market to develop after an inversion. Central banks continue to moderate their activities and we don’t believe the economy is at risk of overheating at this time.  As Hoover Institute Fellow, Edward Lazear, rightly pointed out in a recent Wall Street Journal editorial, “Job growth is too high, wage growth is too low and the unemployment rate is still below the level consistent with full employment.

While we do not hesitate to point out market and economic implications of public policy, our attention is strictly centered on the potential investment effects of policy.  We, as investors, must remain unbiased and objective when evaluating investment choices.  KCG remains committed to target-weighted, well-diversified  allocations.  Our portfolios also include small allotments to zero and low correlated alternative strategies with the potential of additional return but intended to conserve the value of our portfolios in the long run.

That said, this market is certainly not overly bullish.  It is rational to see a response to global, geopolitical events including the trade war and Saudi crisis.  Pending  non-catastrophic resolutions over time, KCG believes that we may see a correction, followed by more modest gains, but the U.S. economy is still providing good reason for positive sentiment.