Tuesday was another tough day for stocks, with major US indices declining by more than 3%. This swoon came on the heels of a pretty good week for stocks. So what caused the recent battering?
Well, as we have been warning for some time, investors should be prepared for increased volatility. Last year volatility, as measured by the CBOE’s VIX Index, was the lowest on record. This low level revealed just how complacent the market really is. Unfortunately, this complacency increases the chance of sudden shocks to investor confidence.
For quite some time, investors have relied on the Fed to prop up the markets when things got dicey. The “Fed Put” started all the way back in the 1990s with former Fed Chairman Alan Greenspan lowering interest rates when the markets experienced any downdraft. Quite frankly, some of these cuts came before any slide just to prevent a downdraft. This protection gave investors confidence which helped push the market to all-time highs. Recently, however, the Fed has been trying to extricate itself and go back to a more normal stance. Over the last three years the Fed has raised interest rates eight times, for a total of 2%. They plan to hike rates another ¼ point in December and possibly three more similar hikes next year. Beyond rate hikes, the Fed has lowered its capital market exposure by letting its portfolio shrink by not reinvesting maturing bonds. Currently, that reduces the Fed balance sheet by $50 billion a month.
These interest rate increases, along with the shrinking of the balance sheet, have awakened investors to the risks inherent in investing. And these risks have increased. When the Fed raises interest rates, it reduces the money supply and lowers economic activity with the hope of restraining inflation. The problem is that there is a lag between the time the Fed raises rates and its effect on the economy. History is replete with examples of the Fed raising rates too high and pushing the economy into recession. While rates are still well below historic averages, the percentage increase in rates has been substantial, and this has already been felt in the housing market with home sales down 12%.
On the bright side, economic growth is good, fiscal stimulus is still in the pipeline, corporate earnings are strong, inflation is low, unemployment is low, and stock prices are cheaper now than they have been for a while. All these things are bullish for the market. The concern, of course, is how can things get better from here. If they can’t, then we’re looking at a less rosy future, speaking of the near-term only, and the markets need to adjust. Investor sentiment can change quickly, especially with the communication style of the President. And this is the direct cause for the market’s gyrations on Monday and Tuesday. We saw a quick run-up on Monday based on hopes of avoiding a trade war with China, only to be dashed on Tuesday by a Presidential tweet.
Given our current climate, I think investors should be prepared for a more volatile market going forward.
Washington Trust Bank believes that the information used in this study was obtained from reliable sources, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation for business or a recommendation of the purchase or sale of securities or commodities.
Washington Trust Bank.