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Junior: The markets are up sharply since the November elections. Why?
Charles: Stocks rallied following the elections due primarily to rising expectations for a business-friendly administration and pro-growth policies. Obviously, the catalyst for the rally was Donald Trump’s unexpected victory on election night, but the Republican sweep of both houses of Congress was equally important. Recall that the markets initially dropped in after-market trading immediately following the election results. The rally began to unfold only when the results, with Republicans controlling the Senate, the House of Representatives, and the White House, became clear. In turn, investors are expressing hope for the incoming administration’s legislative priorities. The most important of these include comprehensive tax reform, reduced regulations, and an infrastructure spending program. Each of these, on its own, could generate meaningful growth; but, taken together, they represent an agenda that has elevated expectations for the economy and stocks.
Investor sentiment soared in the fourth quarter with the unexpected results of the U.S. elections. Markets had not only assumed that Hillary Clinton would be the next President of the U.S. but that she might also deliver a Democratic majority in the U.S. Senate. In hindsight, Donald Trump’s election and Republican control of the Congress turned out to be the U.S. version of Brexit when voters chose a different course of action from polling projections. After the initial shock subsided, the markets reacted favorably with a strong showing in November that carried the markets through the end of the year.
Junior: What is driving the recent increase in market volatility?
Charles: Market volatility tends to increase with major headline events or when investors focus on a specific economic risk. For example, earlier in the year, concerns related to the Chinese economy, central banks’ monetary policy and falling crude oil prices caused investors to sell equities to move into cash or government bonds. Similarly, in June, Britain’s unexpected vote to leave the European Union (the so called “Brexit Vote”) triggered a sharp, but brief, market selloff. Also, quarterly earnings, where companies report results and provide commentary on their business outlooks, can unsettle the markets. Recently, the focus has returned to interest rate policies of the Federal Reserve, and those of other major central banks, as investors worry about the timing of an eventual end of the prolonged period of historically low interest rates. Other factors, such as the upcoming U.S. presidential elections and rising political tensions around the world, are weighing on sentiment as well. And, moderate to weak economic growth in the major world economies feeds the perception of a possible recession. In other words, there is no shortage of investor concerns; but, then again, that is not unusual. Indeed, despite the myriad pressures this year, the major indices are up nearly 5% while mid-cap and small cap stocks have done even better, supporting the adage that markets climb a wall of worry.
During the first half of 2016, headline events including the health of China’s economy, the monetary policies of central banks around the globe and the price of crude oil dominated investor sentiment. In early January, stock prices declined on the news of a sharp correction in the Chinese stock market and further devaluation of the yuan. Recent decisions by the European Central Bank and the Bank of Japan to adopt negative interest rates raised concerns that the world economy was on the verge of recession. Disappointing corporate profits and slowing growth in China seemed to validate these fears; also, falling oil prices and a decline in manufacturing further exacerbated investor pessimism. Indeed, the major stock indices recorded their worst ever results in January. Against this backdrop, the Federal Reserve modified its expectations for upcoming rate hikes. The Fed’s policy shift, along with more positive economic data, sparked a stunning relief rally: the S&P 500® Index, which had fallen more than 10% by mid-February, rebounded with the largest recovery for any quarter since the Great Depression; by the end of March, the Index was in positive territory.