Market Update for the Month Ending October 31, 2016

Posted November 3, 2016


October held tricks and treats for financial markets
Equity markets around the world had a tricky October. The Dow Jones Industrial Average posted a loss of 0.79 percent for the month while the Nasdaq and S&P 500 indices were down 2.27 percent and 1.82 percent, respectively. All three spent most of the month in the red, as concerns about weak economic news and the upcoming presidential election weighed on returns.

Despite the trick in returns, a treat came in the form of better corporate earnings, where both expectations and results for the third quarter of 2016 have improved substantially. As of the end of October, with 58 percent of S&P 500 companies having reported earnings, the blended third-quarter earnings growth rate was 1.6 percent, up from the 1.7-percent decline expected at the start of the period.

If we do see earnings growth for the quarter, it will be the first year-over-year growth in earnings since the first quarter of 2015. Because the growth reported thus far has been widespread─with all 11 S&P 500 sectors reporting higher growth rates than expected─it seems quite possible that we will end up with earnings growth. This would help support U.S. equity markets going forward.

October's market declines notwithstanding, technical trends remained positive for the major U.S. indices. All three were comfortably above their respective 200-day moving averages, signaling healthy technical support.

Developed international markets also had a tricky October. The MSCI EAFE Index was down 2.05 percent on concerns about the rocky path leading to a recently ratified trade deal between Canada and the European Union. But, again, technical trends stayed positive, as the index spent the entire month above its 200-day moving average, suggesting that the longer-term outlook continues to be positive.

Emerging markets, as represented by the MSCI Emerging Markets Index, ended October up 0.25 percent. Technicals were strong, as the index was above its 200-day moving average for the month.

The U.S. fixed income sector had a difficult October, with the Barclays Capital Aggregate Bond Index posting a 0.76-percent loss. Much of the weakness can be attributed to an increase in interest rates, as the 10-year Treasury yield rose from 1.60 percent at the end of September to 1.84 percent at the end of October, matching highs last seen in May. The increase was due to rising expectations of an interest rate hike by the Federal Reserve (Fed) at its December FOMC meeting.

U.S. corporate high-yield bonds─less correlated to interest rate changes than fixed income offerings─performed better in October. The Barclays Capital U.S. Corporate High Yield Index finished the month with a gain of 0.39 percent. Performance was again driven by spreads on high-yield bonds, which tightened to their lowest levels in more than a year as confidence in corporate credit remained high.

Economic data recovers from slowdown
The economic data released in October held more treats than tricks, as the economy continued to reverse the slowdown of earlier months. Employment growth was strong, with a healthy 167,000 jobs added in September, and both hours worked and wages increased. Average hourly earnings growth continued an uptrend, as illustrated in Figure 1, moving toward a post-recession high.

Figure 1. Average Hourly Earnings, 2008−2016

Despite the positive employment and income news, consumer confidence dropped somewhat, although it remained at reasonably healthy levels. Interestingly, the decline was due in large part to a downturn in how consumers felt about present conditions, which may have been associated with the election campaign, as longer-term expectations continued steady. This metric will be worth watching next month.

Although consumer confidence moderated, business confidence increased. Both the ISM Manufacturing and Non-Manufacturing indices rebounded in October, with the manufacturing index returning to expansionary territory and the non-manufacturing index hitting an annual high. These results indicate that the previous declines may have been temporary blips rather than signals of a sustained slowdown.  

Even though much of the economic data reported in October was good, there were a few tricks. Durable goods orders declined slightly, indicating that businesses may be postponing large purchases, possibly due to the uncertainty around the U.S. presidential election. Housing also retreated a bit, with a slowdown in starts and new home sales; however, confidence remained strong, as existing home sales increased. Here, again, the end of election season could provide more clarity and lead to faster investment and construction growth.

Gross domestic product (GDP) growth exceeded expectations
The first estimate of third-quarter GDP growth was a treat, at 2.9 percent, well above expectations and more than double the growth seen in the second quarter. This solid number shows that the economic recovery is continuing despite the slowdown earlier in the year.    

The report's details, however, did include some tricks, as a large portion of GDP growth was driven by increases in exports and inventories. The export growth shows that the headwinds caused by the strong U.S. dollar may be passing, and the inventory uptick may help offset the five straight quarters of declines that had dragged growth down. That's good news. But the trick may be that these are exceptional events and not guaranteed to continue. Nevertheless, at minimum, these trends should no longer slow growth.

Most risks are now political
With international risks still restrained during October, the U.S. election took center stage. Although many polls and betting markets favor a Clinton presidency, changes to that expectation have the potential to increase political and economic uncertainty, perhaps creating volatility in the financial markets. For example, the recent announcement that the FBI is investigating e-mails related to a high-level Clinton staffer caused a major swing in global equity and foreign exchange markets toward month-end, and we may see more swings like that.

Apart from the election, the Fed has created uncertainty around whether it will raise interest rates in December. Although the market expects it to do so, the FOMC has cautioned that any rate hike would depend on economic conditions; a failure to hike rates when expected could rattle markets.
     
Short-term volatility likely, but fundamentals look good
Heading into year-end, with investors uncertain about the election and the Fed, market volatility is possible. That said, positive economic news combined with the return of earnings growth should help bolster markets. As always, even though short-term swings can be worrying, a well-diversified portfolio matched with a long-term perspective continues to offer the best path to reaching financial goals, despite any setbacks along the way.

Authored by Brad McMillan, senior vice president, chief investment officer, and Sam Millette, investment research associate, at Commonwealth Financial Network®.

All information according to Bloomberg, unless stated otherwise.

Disclosure: Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Barclays Capital Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Barclays Capital government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Barclays Capital U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.