The Calm After the Storms

Third Quarter 2017 Market Commentary

We have stated many times over the past decade how well the stock market does overlooking the prominent headlines of the day and remaining focused on the underlying economy and its outlook. The third quarter of 2017 was no exception. Despite three devastating hurricanes that wreaked physical and economic havoc on Texas, Florida, Puerto Rico and the majority of the Caribbean, political divisiveness in Washington, and nuclear saber rattling from North Korea, the US stock market rose an impressive 4.5%. If anything, despite repeated setbacks to repeal and replace the Affordable Care Act, optimism is building towards possible tax reform and the prospect that Congress will now successfully address the issue.

The absence of an interest rate increase from the Federal Reserve also helped equities this quarter. Chairman Yellen’s desire to lift short-term rates and rearm the Fed’s monetary arsenal are well known. The unknown has always been the speed and severity of the rate normalization. After raising interest rates in both Q1 and Q2 of 2017, the Federal Reserve left the Fed Funds rate at 1.25%. Stocks, in general, like a low interest rate, low-inflation environment. Minor inflationary pressures have been appearing, but the backdrop for stocks remains friendly.

The three devastating hurricanes this season will have a lasting effect on the economic numbers going forward. Natural disasters skew economic activity and destroy capital investment. Consumers in Houston and Florida will certainly replace damaged items, particularly vehicles and home furnishings. While initially stimulative, in reality, consumer spending shifts as purchasing is brought forward and future consumption is often suppressed as a result. The destruction of existing capital and investment assets will slow long-term economic growth as these assets, such as factories, inventories, or strategic initiatives, are not easily replaced, financed, or feasible anymore. Competition for rebuilding-related trades and materials will also rise, both regionally and nationally, as assets are redeployed to satisfy demand. However, given the strength of the domestic economy and the sound financial environment, the economic effects of hurricanes Harvey, Irma and Maria are manageable. Monetary policy is still very relaxed, and while the Fed may be eager for higher short-term rates, it has shown a deference to keeping conditions accommodative should extenuating circumstances warrant.

In addition to the meteorological issues in the quarter, aggressive rhetoric with North Korea did increase volatility in mid-August temporarily. The VIX Index, a measure of uncertainty using option prices inputs, spiked twice in the third quarter, reflecting the insecurity over geopolitical issues under President Trump. These spikes were short-lived however, and the VIX Index returned to a historically low level below 10 in September. Undoubtedly a rising stock market helped alleviate investors’ uncertainty. By the end of the quarter, the VIX was sitting near a year-to-date low.