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Investment Update: An Uncertain Fall

October 2013

Jeffrey Mortimer, CFA

Director of Investment Strategy, BNY Mellon Wealth Management

With October comes Halloween. I can remember trick-or-treating as a boy on a crisp Maine night thinking about ghosts and goblins as I went from house to house. The roads were pitch black in my rural hometown as I would head down long wooded driveways with my buddies, wondering if something would jump out and scare the living daylights out of us. Inevitably, I would make it back to my house with a bag full of candy and no bogeymen in sight.

As we move into fall and the final quarter of the year, markets are digesting a number of perceived bogeymen that could sidetrack what has thus far been a strong year for stocks. Many investors remain spooked by the government shutdown and budget debate, Federal Reserve policy changes and an unemployment rate that remains stubbornly above 7%.

Certainly markets always have catalysts on the horizon that could send investor sentiment spiraling up (if they resolve) or down (if they unravel). Today's potential bogeymen — Washington, the Fed, unemployment — are no different. Investors would be wise to recognize these potential influencers and that markets are resilient at this stage of the economic cycle. In the current environment, markets have had a remarkable ability to grind higher in the face of challenging news.

Government Gridlock

As of this writing, the September 30 government shutdown was entering its second week, with an October 17 deadline to raise the debt ceiling. While longer-term problems include the U.S. deficit, health care spending and Social Security reform, markets have a tendency to focus only on what they can see. Their point of view is only a few years, if even that. By focusing only on what is front and center, markets are likely to bump up and down as a situation plays out day by day, with the potential for spiking volatility as political brinksmanship simmers.

Despite partisan showmanship, Washington has shown that it can resolve a problem on its plate, albeit slowly. The government is a slow-moving behemoth that reacts to public opinion, global headlines and market performance as it navigates through a crisis.

We believe the shutdown will have limited long-term investor impact. In fact, markets historically have delivered strong gains in the face of tough news out of Washington. In all 17 previous government shutdowns between 1976 and 1996, the S&P 500 was up 1% in the 10 days afterwards. In 2012, the S&P 500 gained 16% despite the looming "fiscal cliff" that was averted by an 11th-hour legislative deal. As of September month-end, the S&P 500 was up 19.8%, although markets for months have seen a potential shutdown and tough budget negotiations on the horizon. Markets can be resilient in these situations, and any short-term weakness in equities caused by the wrangling in Washington can be an opportunity to buy.

Unemployment

Visit any coffee shop, golf course range or sports bar on a Sunday afternoon and you are likely to hear somebody talking about the jobless rate. Everybody knows somebody who is out of work, can't find a new job or has given up looking. Almost five years after the Great Recession, it's understandably on everyone's minds. As Exhibit 1 shows, unemployment stands at 7.3% as of the end of August. If we include the people who have stopped looking, or who are "under employed" and settling for part-time work, unemployment is actually at 13.7%.

While unemployment hasn't fallen as far or as fast as any of us would like, it is important for investors to understand how far we have come. In October 2009, unemployment stood at 10.1%, a far darker picture. The trend is moving in the right direction. Investors who were worried about unemployment over the past few years would have missed out on market gains of more than 170%.

Also note that the unemployment rate is a lagging indicator that falls only after markets have been heading north for some time. We are likely to see the rate continue to drop as economic growth gains steam in 2014.

Exhibit 1 // Slow Improvement in Employment

Exhibit 1 // Slow Improvement in Employment

* Includes officially unemployed, those who want a job but stopped looking, and those who need full-time jobs but can only find part-time work, measured as a percentage of the civilian labor force plus all the marginally attached workers. Shaded bars represent U.S. recessions.

Sources: Bureau of Labor Statistics and FactSet. As of 8/31/13.

Fed Taper

The Federal Reserve surprised the markets last month by announcing it would not begin to taper its purchases of mortgage-backed securities (MBS) and long Treasuries. The Fed said it needed more proof that the economy is strengthening, with Chairman Ben Bernanke noting that "conditions in the job market today are still far from what all of us would like to see." Markets, which always price in expected Fed action, initially responded positively to this unexpected news but have trended lower since then. We believe the taper will begin as early as December, but more likely in January or March. There will be a beneficial impact on markets as interest rates move toward normalization, though a brief initial period of volatility would not be surprising. As long as rates begin to normalize because of a generally strengthening economy, versus a reappearance of inflation, this should prove an excellent backdrop for risk assets.

Exhibit 2 // Consumer Confidence Has Risen But Remains Weak

Exhibit 2 // Consumer Confidence Has Risen But Remains Weak

Source: The Conference Board. As of 9/30/13. Shaded bars represent U.S. recessions.

If the Fed is successful in fostering an environment of stronger growth, consumers will benefit. Consumer confidence has been weak, but improving, over the past few years as the economy has recovered (Exhibit 2). Confidence is at its strongest rate since January 2008, but well below its 2007 high. It is understandable that consumers are holding back, given the uncertainty they are seeing around them. As the economy gains strength, confidence will rise, consumer spending will increase and the recovery should become self-sustaining.

Conclusion

Investors should keep in mind that the economic and market backdrop is relatively benign, and the potential for a "black swan" event has been reduced over the past year. Corporate fundamentals remain strong as the U.S. economy is transitioning into a multi-year period of faster growth, with no sign of inflation on the horizon. Interest rates, even with the recent increases, are historically low and entering a period of normalization.

A key factor in making sound investment decisions is one's time horizon. Allowing short-term issues to influence long-term investment decisions will impact or even prevent investment success. Remaining market factors could create a bumpy ride for investors over the next three to four months. But remember that things that go bump in the night often are not so spooky in the light of the day.

Each month, for clients and associates of BNY Mellon Wealth Management, we provide commentary on the stock markets and the economy through the Investment Update.

BNY Mellon Wealth Management is a nationally recognized leader in investment management, wealth and estate planning, and private banking and finance capabilities to financially successful individuals and families, their family offices and business enterprises, charitable giving programs, and endowments and foundations. Our clients benefit from our wealth management excellence and our commitment to adapting our organization's strengths to their unique circumstances.

For more information, please visit www.bnymellonwealthmanagement.com.

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10/2013