Thursday, 11 October 2018

Global equity markets have trended down over the past week and sold off sharply yesterday with ongoing volatility again today.

In fact, the S&P 500 is down today approximately 0.63% at the time of this writing. As such, we thought you would appreciate our latest thoughts on the markets.

The current selloff actually began immediately after Fed Chairman Powell’s comments on October 3rd during a Q&A session. His said that the Fed Funds Rate is nowhere near neutral yet, implying that more tightening of interest rates is on the way and that tightening could exceed current market expectations. As a result of these comments, interest rates moved higher, with the magnitude of increase in long-term rates exceeding the rise in short-term rates. The selloff in equities promptly followed as investors grew concerned that Fed policy aggressiveness could begin to squelch economic growth and eventually earnings growth. Indeed, perhaps the biggest problem the equity market now faces is that good news (e.g. falling unemployment, strong wage growth, record small business sentiment, etc.) has become bad news to the extent that it compels the Fed to become overly concerned about would-be inflation to the point of causing slower economic growth through restrictive monetary policy.

Despite the Fed’s new found hawkishness and the move higher in rates, inflation growth remains quite tame and well within expectations. September CPI, reported this morning, was up only 0.1%, less than the 0.2% gain expected. In fact, because inflation has remained within a tight band, the rise in interest rates of late is actually a function of rising real interest rates (nominal rates less inflation). Rising real interest rates are typically a sign of strong economic growth.

Fear of a Fed mistake is not the only factor creating equity market angst. The technology sector, which is the largest economic sector of the market and the one leading the selloff, had gotten quite pricey and was perhaps in need of some correction to take the froth off of prices, especially in light of the trade skirmish with China where debate over technology is front and center. Note that the technology sector is still up approximately 12% year-to-date at the time of this writing.

When the financial markets encounter downside volatility, it is always helpful to step back and ask, “What has really changed?” We remain mostly sanguine on the equity market because the answer to that question appears to be “not much”. That is, actual inflation, which the Fed seems committed to short-circuiting, is well contained, at least for now. Economic growth, earnings growth, sentiment, and the under-appreciated leading economic indicators index are all still very strong indicating that recession looks to be at least two years or more in the future.

Rest assured we will remain vigilant in determining if the current equity market selloff is the typical pause that refreshes or a deeper move underpinned by deteriorating fundamentals. As of today, we expect it is the former. However, if credit spreads start to widen significantly from current tight levels, 3Q earnings disappoint, or corporate stock repurchases diminish, it may indicate a more significant issue. Ideally, the Fed will walk-back some of Fed Chairman Powell’s hawkish comments, the trade skirmish with China will at least not escalate, and the equity market will enjoy its typical seasonal strength in November and December, the two strongest months of the year for equity performance.

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