August 2018 Market Recap: Do Midterm Elections Matter?

Since the global financial crisis, August has regularly proved difficult for financial markets. This summer was no exception. Investors had to digest the reintroduction of US sanctions against Iran, new tensions between Turkey and the US, a deterioration of trade talks between the US and China, and volatility in the Italian government bond market. Most equity markets and risk assets sold off, with the notable exception of the S&P 500, where extraordinarily strong macro data, and a general absence of any inflation concerns, once again pushed the index higher. Amid the geopolitical turmoil, the search for a safe haven helped push government bond prices up, with the 10-year US Treasury yield falling by 10 basis points (bps) to 2.86%. The labor market goes from strength to strength. The U6 unemployment rate – a broader measure of unemployment than the headline rate – dropped to 7.5% in July, its lowest level since 2001. This is considered to be one of the best measures of unemployment since it accounts for underemployment, such as those working part time that wish to work more, and those currently discouraged but considering re-entering the labor market.

With no shortage of political noise and the midterm elections quickly approaching, many investors have been asking what this means for markets. Putting political issues aside, we maintain the view that investors should work to separate the signal from the noise, and only make portfolio changes when the facts have changed. Midterm election years have historically seen worse than average returns, and these negative excess returns have typically come with a price of higher volatility. Since 1970, midterm election years have seen average annual returns of 6.1%, versus average returns of 11.9% during the full period. Furthermore, volatility has historically increased as the midterm elections approach, with S&P 500 realized volatility an average of 1.8%pts higher on average in the three months leading up to November. That said, the equity market has typically enjoyed a relief rally from September through the end of the year, rising 7.1% versus an average return of 3.7% during the full period, as uncertainty recedes and investors refocus on the fundamentals. As such, the historical data suggests that investors should not necessarily seek cover as midterm elections approach, but rather understand the market dynamics that will be at play and position portfolios accordingly.

After a solid 2017, emerging markets (EM) currencies have had a tough 2018, with the JPM EM trade-weighted currency index falling 14% year-to-date. EM economies have been stuck in a tug of war between still solid fundamentals, with economic growth continuing to improve relative to developed markets and earnings growing by 20% in the second quarter, and sentiment, which has turned much more negative. This deteriorating sentiment reflects rising trade tensions, some disappointment in Chinese data and concerns of second round effects of dollar strength, all of which have been clouding the outlook for EM investors. However, as we highlight in this week’s chart, there has been a wide difference in performance within EM, with certain currencies punished much more than others. In particular, countries with significant external vulnerabilities, such as Turkey and Argentina, and countries with limited visibility on growth, such as Brazil and South Africa, have been hit hardest. The takeaway for investors is not to view EM economies as one homogenous group but to separate those economies with vulnerable dynamics from those with stronger fundamentals in order to uncover the still present long-term investment opportunities.

Leave a Reply

Your email address will not be published. Required fields are marked*

Join my List and get you 10 Day CashFit Guide

Get Access to the 10-Day CashFit Challenge. This 10-Day money detox and money affirmations will help you answer the question "How am I doing?" and get you on your way to financial success.