Stocks declined in October as sovereign bond yields resumed their march higher and investors grew cautious ahead of the U.S. election. A historic month for M&A activity and decent earnings were not enough to boost sentiment. With market valuations somewhat elevated despite high levels of political and economic uncertainty, we continue to believe that a cautious stance is best suited for the current environment.
Sovereign bonds were again in focus during October, as yields in many countries reached multi-month highs. We believe there are several reasons behind these moves. First, central bankers across much of the world appear to be inching away from the extreme dovishness which has dominated policy in recent years. Examples include the Federal Reserve in the U.S., which appears poised to raise rates at its December meeting, and the Japanese central bank which recently shifted away from a set amount of asset purchases and instead is targeting yield levels as well as a steeper yield curve. Other factors that we believe are impacting bond yields include rising inflation as well as expectations for increased fiscal stimulus in various parts of the world. Equity investors are concerned with rising yields, as all else being equal rising yields tend to depress valuation multiples. Despite this recent uptick, yields remain low by historical standards and therefore likely have the scope to continue to move higher. That being said, in our view stocks should be able to handle a slow and steady escalation in yields; it’s a rapid move higher that could be disruptive.
Third quarter earnings season is well underway, and by and large the results have been positive. As of this writing, approximately 75% of S&P 500 companies that have reported have met or exceeded profit expectations, on average by an impressive 5.8%. Should the current trend continue, the third quarter will likely mark the end of five consecutive quarters of year-over-year earnings declines. Drilling down a bit further, the financial sector, and banks in particular, enjoyed a strong quarter. However, we believe that this was at least in part due to factors that may be one-time in nature. For example, the volatility which ensued in the aftermath of the ‘Brexit’ vote led to a surge in fixed income trading, which benefitted banks. Elsewhere, the health care sector was a laggard, declining 6.5% in October. We believe that political rhetoric regarding drug pricing, and in some cases the inability to raise prices, are likely responsible for the sector’s woes. We had been concerned about these issues earlier in the year and took steps to reduce our portfolio exposure to these risk factors. While we continue to hold pharmaceutical companies, we have focused on those which we see as more dependent on volume gains than price increases to drive growth.
October was a record month for merger and acquisition activity. In our view, after years of below-trend growth, companies are anxious to find new sources of revenue and profit. Moreover, with yields moving higher there is a belief that interest rates may have bottomed, and therefore certain companies may be looking to take advantage of low-cost financing conditions while they last. Overall, we see this surge in M&A as a positive indicator, and take it as a measure of confidence on the part of the acquiring companies.
Turning to the U.S. election, we see signs that investors are becoming more cautious as the presidential race looks to have tightened. Both gold and the VIX volatility index have moved higher over the last several days, while stocks have pulled back (although they are rallying today). In our view, market expectations appear to be for the status quo, with a Democratic president, Republicans controlling the House, and a closely divided Senate. While a gridlocked outlook may not appear ideal, companies have been navigating just such an environment for the last several years, and we view this as the best outcome for stocks.
Overall, our outlook for stocks is guarded. In the near-term, we are optimistic that the consumer can drive a healthy holiday shopping season, which should help support economic growth during the current quarter. With a firm labor market and wages moving higher, we believe that consumption can improve upon the 2.1% growth rate realized during the third quarter. Looking out a bit further, there are reasons to believe that the U.S. economy may be close to overcoming the structural barriers to growth that have held back the recovery since the great recession. Considering the analysis by Reinhart and Rogoff which looked at 100 systematic banking crises over 150 years and concluded that economic recovery takes approximately eight years on average, this may bode well for future economic activity if history is any guide.
Key risks to the market which give us pause include the rising dollar, which recently notched a seven month high on a trade-weighted basis. A stronger dollar typically weighs on both exports and corporate earnings. We are also keeping a watch on the budget, as the government is only funded through December 9, 2016. Whether Congress extends funding and under what conditions are key issues which can significantly impact stocks, in our view. Last but certainly not least is the U.S. presidential election. As noted, polls have tightened recently and investors appear anxious. We think that a surprise result could have the potential to jolt capital markets worldwide. As always, we remain cognizant of the risks while seeking to preserve and grow capital over the long term.
This information is intended solely to report on investment strategies and opportunities identified by Roosevelt. Opinions and estimates offered constitute our judgment and are subject to change without notice, as are statements of financial market trends, which are based on current market conditions. This material is not intended as an offer or solicitation to buy, hold or sell any financial instrument. References to specific securities and their issuers are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations to purchase or sell such securities. Please contact us at 646-452-6700 if there is any change in your financial situation, needs, goals or objectives, or if you wish to initiate any restrictions on the management of the account or modify existing restrictions, or if you would like to request a copy of our Code of Ethics. Our current disclosure statement is set forth on our Form ADV Part II, available for your review upon request, and on our website, www.rooseveltinvestments.com.