ETON Advisors Newsletter - October 2018

Markets Shift Focus

Returns on financial assets were scattered in the Third Quarter of 2018, with U.S. equities posting robust returns (up +7.7%), while global stocks, investment-grade bonds, and public real estate were relatively flat for the quarter. Commodities and precious metals suffered losses in Q3, but crude oil and Master Limited Partnerships (MLPs) were up nicely.

U.S. equity returns were propelled by strong corporate earnings, positive sentiment, and fiscal stimulus. The strong U.S. economy, rising inflation already at or slightly above targets, and fiscal stimulus from the recent tax cut all give the Federal Reserve cover to continue to raise interest rates and decrease its balance sheet toward more typical historical levels. The Fed has raised rates eight times now—in quarter-point increments starting in December 2016—and expects to raise rates four additional times over the next year.

Again, we find ourselves in the tug-of-war that we described in our last quarterly outlook, wherein stronger corporate earnings, rental yields, and other cashflows are being discounted at progressively higher interest rates. So far this year, the positive forces have outweighed the negative forces with respect to U.S. equities, as both the Dow and the S&P 500 hit multiple record highs in the late summer and early fall.

Looking toward 2019, we reiterate our tug-of-war thesis and add our view that the contest may shift in the coming quarters more decidedly in the direction of the negative forces. Potentially twelve quarter-point rate hikes from December 2016 to late 2019 would likely dampen economic activity, make it difficult for corporate earnings to continue growing at their recent torrid pace, and weigh on stock and bond valuations.