Market corrections a reaction to rising interest rates

October 12, 2018

Rising interest rates have caused some investors concern. This dip in market sentiment was reflected in market changes in early October 2018.

Market corrections in the month of October are largely a result of concerns with rising interest rates, fear of future inflation, the possible risk associated with extended trade war with China, and political uncertainties this coming November (Exhibit 1).

None of these risks are new. Market pundits, including Schenck, have been calling for rising short-term and longer-term interest rates. The last time our country had unemployment this low was in 1969, establishing a 49-year record low. We expect employers will need to raise wages in order to compete for the limited number of eligible job candidates, which in turn will put upward pressure on inflation.

The evolving economic trade tensions with China represent a new risk in 2018, but the U.S. has established trade deals with Mexico and Canada, decreasing trade risk when compared to earlier in the year.

The upcoming November elections represent a possible shift in power with the Democratic Party predicted to win a majority of the House of Representative seats, but historically the incumbent party typically concedes seats during the midterm elections.

Exhibit 1:

Index Asset class Month-to-date ending October 11, 2018 Year-to-date ending October 11, 2018
S&P 500 Index U.S. Large Cap Equity -6.31% 3.58%
Russell Mid Cap Index U.S. Mid Cap Equity -7.58% -0.68%
Russell 2000 Index U.S. Small Cap Equity -8.89% 1.60%
*MSCI ACWI Ex – U.S. Index International Equity -6.79% -9.29%
Bloomberg Barclays Aggregate Bond Index U.S. Investment Grade Bonds -0.46% -2.05%

*Morgan Stanley Composite Index – All Country World Index Excluding the United States

What is likely affecting the market?

So, with no material changes in risk, what is causing the market to correct sharply in such a short period of time? The U.S. 10 Year Treasury hit a 3.23% yield earlier this week, increasing the yield by 0.43% in a mere six weeks. In May, we observed the U.S. 10 Year Treasury yield over 3%, but did not experience any type of market correction.

The reason for the market correction is simply anxiety, also known as a decline in market sentiment. We have had phenomenal corporate profit growth and consumer and small business confidence levels are near historic record highs. At times when the markets move up quickly, that creates more opportunity for quick adjustments.

Think of market sentiment this way

The market is similar to a student who has properly prepared for an upcoming test. He has reviewed the notes, conducted the pretest exercise from the teacher and has been quizzed by his parents…he is prepared and ready for the test. Then his best friend says he heard a rumor there might be test questions on topics that were not covered in the pretest exercise and notes. The student’s anxiety spikes as he starts to worry if he is truly prepared for the upcoming test.

The pretest exercise, notes and quiz represents the economic and valuation framework that has been in place for most of this year. The rumor and associated anxiety is represented by the market correction in response to rising interest rates. We believe there will be moderate growth in inflation and we will have modestly rising interest rates across short- and longer-term interest rates. However, we do not buy into the notion that we will see significant spikes concerning inflation or interest rates.

Market corrections from a historical perspective

Equity valuations are slightly above their respective 25-year levels, but certainly not overly expensive given the strong economic and corporate profit growth in the U.S.

Since 1980, over the course of two consecutive trading days there has been 88 times when the market (S&P 500 Index) has corrected by 4% or greater. During the six months that followed those corrections, historically the market has been positive 76% of the time.

Our thoughts

We do not believe this is the start of an extended correction and we do not believe one should be selling equities. This is the first week of earnings for third-quarter results and we anticipate continued record profits across equity sectors. Like with most anxiety, it is usually a short-term in nature and we believe this will be the case for the current market correction.

Dave Isaacson is the Chief Investment Officer of Schenck Investment Solutions, LLC, a Registered Investment Adviser. Registration with the Securities and Exchange Commission does not imply any level of training or expertise. Schenck Investment Solutions, LLC is wholly owned by Schenck SC. Material presented herein is for informational and educational use only. The views, forecasts and opinions presented herein may change based on market conditions and other factors. Nothing herein should be considered to be legal, accounting or tax advice. Consult your lawyer, accountant or other advisor before making any financial, legal or investment decision. This information may not be duplicated or redistributed without prior consent of Schenck Investment Solutions, LLC and distribution or publication of this material does not represent a solicitation to complete a financial transaction with the Schenck Investment Solutions, LLC. In developing the forecasts and opinions contained herein, we have relied on data from third-party sources. Though information was prepared from sources believed reliable, Schenck Investment Solutions, LLC does not guarantee its accuracy or completeness.

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