Into Midterms We Go!
A Historical Look at Midterm Elections and Fed Tightening Cycles
US stocks, as measured by the S&P 500, are on pace for their 10th consecutive year of annual gains following the financial crisis market low in March 2009. The US economy appears strong with final second quarter 2018 GDP growth reading 4.2% on an annualized basis and third quarter estimates well above 3%. While economic, employment, and housing metrics indicate an optimistic outlook, there are several questions regarding the sustainability of the current US economic and market strength. A potential global trade war, protectionist rhetoric, and US dollar strength have led to a divergence in US stock performance compared to international markets in 2018. It is unlikely the US can continue outsized economic growth and market returns while the global economy struggles. Add the divisive political environment in Washington leading up to midterm elections in November and there are plenty of potential headlines and events to derail the longest bull market in modern history.
Midterm elections create uncertainty for the market as campaigning heats up in advance of the November election date. Markets do not like uncertainty, and volatility is common with an average correction of 19% in midterm election years since 1962. Interestingly, however, October and November represent the strongest performance months for the market in midterm election years during this period. Presumably, come October, the potential election result becomes more clear and the level of political hostility moderates. The 12 month period following the midterm election since 1950 provided positive returns in every period with average returns of 15.3%. Also, within a 4-year presidential cycle, Q4 of year 2, Q1 of year 3, and Q2 of year 3 are the strongest market return quarters of a Presidential cycle in that order1. We are in the first days of Q4 of year 2 of this presidential cycle. This positive historical data surrounding the next 6-12 months combined with the strength of the US economy suggest an optimistic environment for stock returns. Uncertainty regarding global trade, political vitriol, and the Fed’s tightening cycle keep us cautiously optimistic and advocating balanced portfolios.
We remain focused on monitoring several key indicators to help frame our view of financial markets. These include Fed policy (tightening), interest rates (rising), inflation levels (low/moderate), credit spreads (historically tight), and corporate earnings (significant annual growth) among many others.
Right now, interest rates and Fed policy are top of mind. On December 16, 2015 the Fed increased its target interest rate for the first time since 2006. Since then, the Fed has increased its target rate several times, which combined with economic strength, has caused a substantial increase in US short-term interest rates. Medium-term and long-term interest rates have remained relatively flat as price and wage inflation have remained relatively subdued. This combination has caused short-term and long-term rates to converge at very similar levels – a flattening of the yield curve.
The relationship between different maturity US Treasury rates has historically provided context regarding economic cycles and subsequent market returns. The spread between 10 year and 2 year US Treasury interest rates is one of the most discussed among investment professionals with smaller interest rate spreads often signaling reduced optimism for future economic growth. Figure 1 provides a view of 2 year, 10 year, and 30 year US Treasury interest rates since 1999. The dark line denotes the spread between 10 year and 2 year rates (10-2 spread).
Figure 1: US Treasury Interest Rates
Source: Thomson ONE
As highlighted by the light blue circles, this is not the first time the Fed has increased their target interest rate following a period of strong market returns. Historically, when the interest rate spread enters into negative territory indicating that short-term rates are higher than long-term rates, known as an inverted yield curve, a recession typically follows in the not too distant future.
At first glance, this chart appears concerning as we drift toward negative territory. However, in our view, a flattening of the yield curve, the reduction of the spread between short and long-term interest rates, and nearing a negative spread has produced very different results from entering negative territory and experiencing a substantially inverted curve. For example, in the mid-90s, the 10-2 spread moved very close to negative but remained positive until later in the decade. During the period from 11/1994 – 6/1998, stocks returned around 150%. Betting against the market is a risky business as discussed in last quarter’s commentary. In addition to the curve not yet being inverted, a recession has often resulted in the years following the inversion, not immediately. Nonetheless, we believe this is a very important relationship to continuing monitoring.
If the yield curve inverts will we recommend a drastically different approach? Likely not as we have recommended an asset allocation approach, and because predicting short-term market movements doesn’t historically work. However, we will continue to advocate holding a core bond position to provide ballast to portfolios during times of market stress and volatility.It is also worth noting that there is considerable discussion that the yield curve inverting this time should not cause immediate concern because this Fed cycle has been so different. The San Francisco Fed even wrote an entire paper on this – but as the saying goes – this time is different!
1Strategas: “Washington & The Investment Landscape” 9/10/18