Once in a while, a single week seems to perfectly illustrate the main forces in markets.
Last week did just that for stocks, highlighting two sets of competing influences that are unlikely to dissipate any time soon and have important investment implications.
The day after the US midterm elections, November 7, was the most notable of last week’s swings.
The Dow Jones Industrial Average was up more than 500 points, or 2.1 per cent, the Nasdaq Composite rose 2.6 per cent, and the S&P 500 Index gained 2.2 per cent.
The immediate cause of the rallies was the split Congress that emerged as Democrats gained control of the House of Representatives and Republicans increased their majority in the Senate.
Conventional wisdom holds that such a divided outcome tends to be good for markets as gridlock keeps the government on the sidelines, allowing businesses to do what they do best: pursue profitable opportunities without undue interference from new legislation and regulation.
There were also powerful economic forces at play in the markets. The US economy continues to move forward, powered by three simultaneous and self-reinforcing engines:
- Consumption (driven by strong labour markets, tax cuts and the positive sentiment).
- Business investment (reflecting favourable corporate sentiment, high cash balances and deregulation).
- Fiscal stimulus (especially as government spending increases and a spilt US Congress is unlikely to scale back outlays or roll back the recent tax cuts).
President Donald Trump’s comments the day after the election that he would “like to see bipartisanship” opened the possibility that this growth spurt could be reinforced by progress in Congress on an infrastructure modernisation initiative.
This favourable economic outlook for the US was offset in markets by two factors that caused the Dow to decline 0.8 per cent on November 9, the S&P to fall 0.9 per cent, and the Nasdaq to lose 1.7 per cent.
The first downward force is that economic activity outside the US continues to slow, making some large debts even more burdensome. This was illustrated by more data out of Europe last week and by a stark warning from China’s central bank about the “profound changes” facing its economy.
Second, the markets and the Federal Reserve haven’t yet fully resolved their differences of view on the path of future interest rate hikes. The Fed reiterated on November 8 its more hawkish intentions, supported by the higher-than-expected producer price inflation data.
This came on top of the European Central Bank’s resolve to end quantitative easing this year despite growing economic and financial risks to the Eurozone.
Tug of war
This tug of war is likely to escalate in the months ahead, leading to more market volatility that will test not only investors’ resolve, but also some rather asymmetrical investor positioning that was not shaken out by the sudden market drops in October.
Last week should serve as a reminder to investors that there is no easy return — or perhaps no return at all — to the wonderful simultaneous trio of 2017: surging stock prices, remunerative bond markets, and virtually no daily volatility.
Instead, the ups and downs highlight again that markets are in a process of important transitions in key growth, liquidity and technical influences.
Along with the big longer-term question of which of the competing divergent influences will ultimately prevail, investors must also look at the immediate implications for portfolio strategies. Specifically, as they embrace the realities illustrated by last week’s market movements, various investors may see the need to:
- Reassess some (now-excessive) examples of abandoning active investment management in favour of passive approaches.
- Supplement strategic and secular portfolio positioning with small tactical overlays.
- Appreciate more the role of explicit cash allocations in portfolios as a means of enhancing optionality to respond quickly to pockets of market overshoots.
- Better price liquidity risk.
- And, for risk mitigation, supplement the benefits of portfolio diversification with more explicit strategies to also manage more extreme tail risks.