by Donald Gould

The US stock market set a torrid pace in the third quarter, with the S&P 500 turning in a 7.7% return, its best quarter in four years. The quarter puts an exclamation point on a remarkable 9-year stretch for US equities. In contrast, foreign markets have lagged substantially this year under the weight of escalating trade tensions and political strains. At this point, international stocks—especially emerging markets—are a lot cheaper than the US when measured by how much one pays for a dollar of corporate earnings, i.e., the price-to-earnings ratio. The debate, of course, is whether foreign stocks deserve the discount. The answer depends largely on which economies one expects will grow fastest. Of late, it’s the US economy that’s outpacing others, and its stock market’s 2018 performance reflects that. Given the interdependencies of today’s global economy, however, one might posit that the divergence in performance between US and foreign markets will resolve in either a cooling US market or some catch-up abroad.

Lost in the excitement over the US stock market’s gains is the less cheery reality that nearly every other major asset class is down in 2018. Through September 30, foreign developed stocks are down 1.0%, emerging market stocks have shed 7.4%, and US bonds—the main risk dampener in almost every balanced portfolio—have lost 1.6% due to rising interest rates.[1] Consequently, well diversified portfolios have significantly underperformed those concentrated only in US stocks in 2018. We note that just a year ago, it was international stocks that set the pace. And those with longer memories will recall that bonds were about the only safe haven in the 2007-2009 worldwide stock market rout. Diversification remains as important as ever.

The third quarter also saw the 10th anniversary of that frightful September of 2008, when fabled investment bank Lehman Brothers failed, Wall Street brokerage behemoth Merrill Lynch required a rescue, and the US government provided insurer AIG with an $85 billion bailout and took over failing mortgage giants Freddie Mac and Fannie Mae. In some ways it is hard to believe that was ten years ago. Not surprisingly, the media marked the anniversary with a barrage of stories, many focused on today’s risks to financial stability. Again, debt is an issue, with high levels of corporate and student debt worrying many. Nonetheless, both the timing and nature of the next crisis are unknown, and the risk of periodic financial crises comes with the territory known as investing. Our experience suggests that discipline and calm are the key elements for riding out the storms, whenever they come.

If one is inclined to worry about the end of this very long economic expansion, there’s no shortage of items to focus on. As mentioned, debt is one. A whole variety of workers are in short supply, which usually means wage inflation pressures.[2] Crude oil prices, now in the $80/barrel vicinity, have climbed about 45% in the past year. And we are now less than six months away from the date of Britain’s exit from the EU, aka Brexit, with no divorce agreement in sight.[3] Finally, we’re just weeks from Election Day, in the midst of a highly volatile political environment.

Rising interest rates are another concern, with the Fed continuing to steadily ramp up short-term interest rates and the 10-year US Treasury’s yield jumping over 40 basis points (from 2.82% to 3.23%) in the past seven weeks. As this letter is finalized in mid-October, we note that that S&P 500 is down about 4% this month, with most analysts citing the continued rise in interest rates as the leading culprit. Viewed in a vacuum, higher bond yields depress stock prices by providing more competition for the investor’s dollar. However, the cause of the rise is quite important in determining whether higher rates are really bad news.

In this instance, about three-quarters of the rise was due to higher real interest rates[4], while the balance reflected modestly higher inflation expectations. From the stock market’s perspective, higher real interest rates can be good news if they mostly reflect a strengthening economy and the expectation of higher corporate earnings. Consequently, we don’t wholly subscribe to the interest rate theory of falling stocks right now, but of course there may be other factors at play.

It’s often said that markets climb a “wall of worry,” so perhaps this market will resume that climb once the current downdraft is digested. We don’t yet see the euphoria commonly associated with market tops, except perhaps in the cannabis stocks, where highs are expected. We will continue to watch carefully.

[1] Recall that the price of existing bonds falls when the interest rate on new bonds goes up.

[2] Amazon’s recent decision to pay workers a $15/hour minimum wage underscores this point.

[3] The potential consequences of the so-called Brexit “crash out” scenario are fairly terrifying. Food and medicine shortages; cessation of direct flights between the UK and the EU or US; major economic and financial dislocation, etc. The counter we hear is that, well, that’s just too awful to contemplate, so it probably won’t come to that. We don’t find that viewpoint reassuring.

[4] We can divine this by comparing the change in the yield of regular (so-called “nominal”) Treasurys with the change in the yield of inflation-indexed Treasurys (“TIPS”) over the same time period. TIPS were introduced 21 years ago, in part to enable policymakers with a market-based source for doing precisely this calculation.