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Market View

In our view, a market sell-off in a fundamentally strong economic environment should not by itself be seen as a reason to abandon sound long-term strategies that offer investment opportunity.

 

In Brief:

  • We believe the recent drop in U.S. stock market prices is more like a normal correction after a strong rally than the beginning of a bear market.
  • Investor expectations for U.S. economic growth, interest rates, and risk have not changed much from a year ago, and are already priced into the market. We think the United States remains in a strong position relative to the rest of the world.
  • In our view, a sell-off in a fundamentally strong economic environment should not be seen as a reason to abandon sound long-term strategies that offer investment opportunity.

 

As unnerving as a sharp sell-off in the market can be, such corrections historically tended to be short-lived in periods of strong economic growth. In such an environment, history has shown that markets typically got back on their feet rather quickly and continued to rise again. 

Although there can be no guarantee that the market will follow historical patterns, that’s exactly what happened earlier this year. The U.S. stock market (as represented by the S&P 500® Index) peaked on January 26, 2018, sold off by 10% between late January and early February, retested its February 8 low on April 2, and then climbed steadily, hovering near record highs until the sell-off on October 10-11.

In any market sell-off, there is a scramble to understand why it occurred, and the tendency after a long winning streak is to suggest that a bear market is nigh. In this recent decline, there was a lot of discussion in the financial media about investor uncertainty, particularly with regard to interest rates, and falling investor expectations. 

A Correction, Not a Bear Market
There is little doubt among most market observers that the sell-off in early January was provoked by investors’ concerns that the U.S. Federal Reserve (Fed) would raise interest rates by more than had been expected. Although the financial media has attributed this most recent sell-off to the same concerns, we do not share that conviction. 

In fact, we believe that the Fed has been unusually clear about what investors can expect. It is adjusting policy on the basis of a longer-term set of considerations that have to do with whether inflation pressure is building, and how quickly, and whether the broader U.S. economy really needs higher rates. In its remarks following its Federal Open Market Committee meetings, the Fed has signaled that it is going to keep trying to tighten a few more times, at least until it reaches a fed funds rate target of 2¾–3¼%. Then it will probably pause and assess the likely impact on the U.S. economy of all of the rate hikes (since 2015) as well as its balance sheet changes as it unwinds a decade-long quantitative easing policy.

We know that investors are already expecting interest-rate increases. Based on fed funds futures data from Bloomberg, investors’ expectations for Fed rate hikes have not changed much recently from early 2018 when the market first started pricing in sustained tightening by the Fed at a faster-than-expected rate.  Inflation expectations have also been quite stable, despite recent hints that wage growth is accelerating. And notwithstanding the Fed’s tightening to date, investors’ expectations regarding the durability of U.S. economic growth have been improving, as evidenced by a modestly steeper Treasury yield curve (see Chart 1).

 

Chart 1. Modestly Steepening Yield Curve Signals Improving Expectations for U.S. Growth
U.S. generic Treasury yield curve (spread between 10-year and three-month yields), November 30, 2015–October 10, 2018

Source: Bloomberg and Lord Abbett.

 

Together, these expectations amount to an essentially unchanged outlook from a year ago. In our opinion, expectations of continued U.S. economic growth despite rising rates will ultimately stabilize markets and provide the potential for even higher stock market prices going forward. That is why we are calling this a stock market correction, and not a bear market.   

Less Optimism Overseas
But there also has been a sell-off outside the United States, where the economic fundamentals are quite different, and we need to be clear about that. Non-U.S. economies are much more dependent on trade than is the United States, and, after a sustained recovery from early 2016, global trade has entered into a cyclical slowdown that has not been fully priced into non-U.S. markets. The moderation in trade has been hurting the emerging markets (EM) and the eurozone the most. Tariff uncertainty is also playing a role as is a stronger U.S. dollar, which is a negative for EM economies. Earnings revision trends also have become less positive outside the United States, or in the case of EM economies, negative.    

In comparison, the U. S. economy, due to its lower exposure to global trade and ongoing positive fiscal stimulus through tax reform, is in a much stronger position to sustain growth than the rest of the world.  And there is, accordingly, more support for potentially higher stock prices in the United States.

Why the Sudden Sell-Off?
Why did the market plunge so sharply? Sometimes it’s just a confluence of factors—too much information for investors to be able to factor in during a reasonable period of time. There may be specific companies that are causing concern, or geopolitical hot spots, or threats of economic slowdown as a result of trade tariffs.

 As we’ve discussed elsewhere, President Trump’s agenda has positive elements (including tax reform and regulatory relief) which have helped corporate earnings growth, as well as potentially negative aspects (such as a slowdown in immigration, which could tighten the labor market, and tariff/trade wars).  Perhaps we are now in the period where the positive parts of the agenda have already been factored in and the negative parts are part of the background noise that the market is just starting to reflect.

Investment Strategies
In any event, Investors may be getting a little nervous, which is understandable. So here are a few investment perspectives which we think are timely for this kind of environment.

  • A market downturn in a period of strong U.S. economic fundamentals is an opportunity to buy, not a signal to sell, in our opinion.
  • We believe growth strategies always have a place in a portfolio, particularly in a time of strong economic fundamentals. As we pointed out in a previous Market View, there is more to growth stocks than large-cap telecom, and we believe there are many potential investment opportunities going forward.  And because of the recent market downdraft, now those opportunities are more attractively priced.
  • For investors who want to reduce their allocation to stocks, floating-rate loans offer the potential for yield as well as historically low correlation to the stock market.
  • Other less risk-averse investors may want to consider high-yield bonds, where yield spreads have widened out a bit after reaching the narrowest recorded levels for this cycle.
  • Finally and most fundamentally, we strongly believe that a diversified portfolio is a prudent long-term investment strategy that can help weather the market downturns.

Summing Up
In our view, a sell-off in a fundamentally strong economic environment should not be seen as a reason to abandon sound long-term strategies that offer investment opportunity. 

 

Glossary of Terms

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Portfolio diversification does not guarantee a profit or protect against loss in declining markets.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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