Equity markets continued to grind higher through the summer, with the S&P 500 notching a quarterly return of 4.5% and posting eleven straight months of gain (as of September). The index has gained 14.2% over the first three quarters and is at record high levels. Even an escalation of the situation in the Korean peninsula caused only the briefest volatility spike. Volatility, as measured by the VIX index, rose from below 10 to close above 16 on August 10th, as markets responded to President Trump’s warnings against North Korean aggression. However, the index plunged back below the 10 handle in September, falling to its lowest close since December 1993.
Equity markets outside the U.S. also saw significant momentum, reflecting a global economy that is powering ahead. The MSCI EAFE Index (net) gained 5.4% over the third quarter (Q3), powering the index to a year-to-date gain of 20.0%. The MSCI Emerging Markets Index (net) rose 7.9% in Q3 and is up 27.8% year-to-date, keeping it on track for its best year since 2009.
Fixed income gained over the first two months of the quarter as falling inflation numbers raised doubts as to whether the Federal Reserve would raise rates for a third time before the end of the year. However, they reiterated their commitment to raising rates at their September meeting, sending yields higher. U.S. ten-year yields ended the quarter at 2.33, just 2 basis points higher than where it started Q3. Unlike the previous quarter, we did not see significant yield curve flattening either.
The global equity market rally shows no sign of let-up as the fourth quarter gets underway, but we do have a few questions as the year draws to a close.
1. Will tax reform, or tax cuts, get done before the end of the year?
The failure to pass health care reform has put pressure on the Trump administration and Congressional Republicans to make progress on tax reform, giving them at least one large legislative victory this year. The administration recently released a broad outline of what they would like to see in a tax bill, but Congress is yet to begin converting this into actual legislative text. As we discussed in our piece on tax reform , they will have to navigate a complex set of trade-offs as the bill gets written, let alone passed.
Republicans would like to incentivize business by slashing the corporate tax rate from 35% to 20%, while also delivering tax cuts to individuals. Both of these objectives will have to be squared with several members’ desire to not raise the federal deficit and debt. However, base broadening measures such as eliminating several business deductions and provisions on the individual side, like deductions for state and local taxes, are already facing intense opposition. This reduces the likelihood that tax reform will actually happen this year, if at all. At best, Congress is likely to pass a politically palatable package of temporary deficit-raising tax cuts.
2. How will trade partners retaliate against new tariffs imposed by the administration?
Tariffs imposed by the Trump administration – such as the recent 220% tariff on Canada’s Bombardier jets that were ordered by Delta airlines – is likely to raise tensions with trade partners and uncertainty. The Commerce department is also looking into imposing steel tariffs based on national security grounds, which would be the most significant act of protectionism for the U.S. steel industry in 15 years. In an ironic twist, steel imports have spiked as domestic consumers look to front-run higher tariffs and higher prices.
The administration has also put forward a set of controversial proposals ahead of the fourth round of NAFTA renegotiations. These include higher domestic content for autos, restricted access for Canada and Mexico to the U.S. government procurement market, changing the dispute settlement mechanism (companies use this to take legal action against foreign governments that undermine their investments) and auto-termination of the agreement after five years unless all three countries renew the pact (a sunset clause) – all of which are opposed by Congress as well as the business and agricultural community. There is a serious chance of negotiations breaking down since Canada and Mexico also oppose these provisions.
3. Will inflation pick up in the fourth quarter?
The Federal Reserve (Fed) has raised rates twice already this year and is expected to do so for the third time in December despite inflation going in the opposite direction from their target. Fed officials have attributed this to transitory factors such as cellular phone plan prices, which have fallen steeply due to increased competition. However, our own research indicates that the decline is more broad-based than just cheaper wireless service. The question is whether this falling inflation trend will reverse, and if not, whether that causes the Fed to pause.
On a positive note, wage growth appeared to have turned a corner in Q3, with annual wage growth surging to a pace of 2.9% in September, up from a low 2.5% in June. Though it remains to be seen whether this is a temporary bump due to low-income workers, especially in the restaurant industry, not showing up for work amid hurricanes in the South.
4. Will the euro’s surge make Eurozone exports more expensive and crimp economic growth?
Rising global demand has boosted the European export sector, which in turn has bolstered Europe’s recovery. At the same time, the euro has appreciated significantly this year, especially in Q3 amid wide anticipation that the ECB will unwind its stimulus program sooner rather later. The big near-term question is whether a strengthening euro will reduce demand for the regions exports, slamming the brakes on Europe’s recovery. While a good chunk of Europe’s exports are within the Eurozone, more than 50% flows to regions outside it.
So far exports appear to be shrugging off a stronger euro – for example, German exports surged in August to the highest level in twelve months. It remains to be seen whether this will continue, and if not, whether the ECB will slow the pace of tapering.
5. Will the rhetorical back-and-forth between President Trump and North Korea subside, or erupt into something worse?
The rhetoric between President Trump and the North Koreans has escalated over the past two months, with both sides calling for total destruction. The President has continued to threaten military action and leaned on China to implement a stricter sanctions regime on its neighbor even as North Korea frantically races to further develop its nuclear missile capability. While all-out war on the Korean peninsula appears to be highly unlikely, the heated back-and-forth and apparent lack of even back-channel communication does raise a tail risk possibility of a miscalculation by either side.
Another interesting question, albeit one that amounts to an inside parlor game, is who will replace Janet Yellen as the next chair of the Federal Reserve (assuming she will be replaced). Chair Yellen is apparently in the final running along with four other candidates, including Kevin Warsh (a former Fed board member), John Taylor (a Stanford University economist), Jerome Powell (a current member of the Fed board) and the President’s own National Economic Council director Gary Cohn. In any case, it is unlikely that we will see dramatically different policy from the Fed if Janet Yellen is replaced. The Fed likes to be seen as data-driven and the chair tries to build consensus, as opposed to making unilateral decisions. The committee also keeps a close eye on markets and will look to keep monetary policy expectations on track, without getting too far ahead or behind the curve.