MARKETS AT A GLANCE

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Market Update for the Month Ending October 31, 2018

Posted November 6, 2018

More tricks than treats for markets in October
Unfortunately, October lived up to its scary reputation for the markets. Here in the U.S., all three major indices were down for the month. The Nasdaq Composite fared worst with a 9.16-percent loss. Meanwhile, the S&P 500 and Dow Jones Industrial Average lost 6.84 percent and 4.98 percent, respectively.

Slowing growth and a change in sentiment with regard to large technology companies drove the stock sell-off. The big tech names have been a major driver of returns throughout the year. As such, a pullback here had a disproportionate impact on the broader markets. From a technical perspective, all three indices finished the month below their 200-day moving averages. But a rally at month-end cut losses and moved them back toward the trend line.

Given this partial recovery, there is reason to believe that the sell-off may have been a bit overdone. For example, fundamentals for U.S. companies remain strong. According to FactSet (as of October 26, 2018), with 48 percent of S&P 500 companies reporting, the blended average earnings growth rate was 22.5 percent. This result is an improvement from the beginning of the month, when analysts projected earnings growth of 19.3 percent. In the long run, fundamentals drive performance, so these better-than-expected results are encouraging.

International markets also experienced volatility. The MCSI EAFE Index fell 7.96 percent, and the MSCI Emerging Markets Index declined by 8.70 percent. From a technical perspective, both indices remained well below their 200-day moving averages, as they have for the past few months. Political concerns in Europe and a strengthening dollar contributed to the losses seen in foreign markets.

Even fixed income markets fell in October, albeit for different reasons. The Bloomberg Barclays U.S. Aggregate Bond Index dropped by 0.79 percent, driven by rising interest rates. The 10-year Treasury yield ended September at 3.05 percent. It reached a high of 3.23 percent midmonth, before finishing October at 3.15 percent. This increase was caused in large part by rising inflation concerns.

High-yield fixed income also had a rough start to the quarter. The Bloomberg Barclays U.S. Corporate High Yield Index fell 1.60 percent in October. The high cost of capital and a risk-off stance by investors caused turbulence in this historically volatile asset class.

Slowing economic growth
October's data painted a picture of slower growth throughout the economy. Third-quarter gross domestic product growth came in at 3.5 percent (annualized). This result was down from 4.2 percent in the second quarter. The pullback from the torrid pace of the second quarter is a bit disappointing. But it was also expected and still represents a healthy level of growth.

One of the major drivers of slower economic growth was a decrease in consumer spending. Retail sales disappointed for the second straight month in September, with a modest gain of 0.1 percent. This might indicate that the high levels of spending we saw in the second quarter were unsustainable. Despite the slowdown, spending growth remains at levels that will support continued economic growth for the time being.

Slowing wage income growth likely drove this slower spending growth. In September, only 134,000 new jobs were added, the worst monthly result since September 2017. Wage growth also declined to 2.8 percent on an annualized basis. The news turned around for October, however, as employers added 250,000 jobs, and annual wage income growth rebounded to 3.1 percent. The hurricanes in September and October may have distorted the results for both months, but there is a real prospect for job growth to continue at a strong pace through the rest of the year. Still, there may be constraints given the record number of job openings in the country and an unemployment rate of 3.7 percent.

Housing sales disappoint 
With the economy growing but slowing, the housing market also extended its slowdown. Both new and existing home sales fell in September, as higher mortgage rates discouraged would-be buyers. Slower demand growth also resulted in relatively large growth in available housing supply in the third quarter. As you can see in Figure 1, supply grew at a modest rate in the first half of the year. But in the third quarter, housing supply grew more than 15 percent, the second-fastest rate since the last recession.

Figure 1. Monthly Supply of Housing in the U.S. (Quarterly Change), 2008–2018

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Economists have cited a lack of supply as one of the reasons for the slowdown in housing this year. This time, however, lack of supply was not the cause. The decline in housing sales in September was disappointing, but there may be a lag between increased supply and sales growth. The recent hurricanes have also likely had an effect, as they did on jobs. So, October's data will be worth watching. Home builders remain confident in the market, so things may pick up again.

Political risks take center stage
Once again, we've seen the major effect that politics can have on the markets. Here in the U.S., the upcoming midterm elections have generated a lot of media coverage and increased public uncertainty. But from an investment perspective, it does not matter who ends up controlling the House and the Senate. Any result is likely to be positive for the markets as the uncertainty subsides and the policy path forward becomes clearer. Historically, markets have performed well following midterms. As such, and given the usual positive year-end trends, tailwinds may resume after the midterms are over.

From an international perspective, concerns surrounding a global slowdown spooked the markets. Brexit, as well as the struggle between the Italian government and the European Union, has increased political uncertainty and economic fears in Europe. Further, German Chancellor Angela Merkel announced she will be stepping down as head of her party at the end of 2018. This move leaves the door open for new leadership in Germany for the first time in almost two decades. German leadership has been a major source of stability during Merkel's time in office, so this will be a closely followed transition.

Last but not least, the ongoing trade disputes between the U.S. and China continue to rattle markets. With a new round of tariffs pending, and companies trying to deal with the effect, this remains a source of risk.

Short-term risks remain, but fundamentals are strong
Concerns over a slowing global economy, elections, trade, and rising interest rates could affect the markets. As such, the volatility seen in October could continue. That said, we have also seen strong corporate earnings growth and solid economic data. Plus, economic growth has remained steady, even through the slowdown. Given these healthy fundamentals, we are well positioned to weather any further volatility.

It's also important to keep in mind that the uncertainty will subside. The midterms will pass, and Europe will likely find a deal again. Even a trade agreement remains possible, which would substantially calm markets.

Of course, short-term volatility is concerning and the risks are real. But when you look at the big picture, things look good right now. Given the otherwise healthy state of the economy, prospects remain positive. Even if there is more volatility ahead, over the long term, a well-diversified portfolio matched with an investor's time horizon offers the best path to reaching financial goals.

Co-authored by Brad McMillan, managing principal, chief investment officer, and Sam Millette, fixed income analyst, at Commonwealth Financial Network®.

All information according to Bloomberg, unless stated otherwise. 

Disclosure: Certain sections of this commentary contain forward-looking statements based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets. All indices are unmanaged and investors cannot invest directly into an index. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. The Nasdaq Composite Index measures the performance of all issues listed in the Nasdaq Stock Market, except for rights, warrants, units, and convertible debentures. The MSCI EAFE Index is a float-adjusted market capitalization index designed to measure developed market equity performance, excluding the U.S. and Canada. The MSCI Emerging Markets Index is a market capitalization-weighted index composed of companies representative of the market structure of 26 emerging market countries in Europe, Latin America, and the Pacific Basin. It excludes closed markets and those shares in otherwise free markets that are not purchasable by foreigners. The Bloomberg Barclays Aggregate Bond Index is an unmanaged market value-weighted index representing securities that are SEC-registered, taxable, and dollar-denominated. It covers the U.S. investment-grade fixed-rate bond market, with index components for a combination of the Bloomberg Barclays government and corporate securities, mortgage-backed pass-through securities, and asset-backed securities. The Bloomberg Barclays U.S. Corporate High Yield Index covers the USD-denominated, non-investment-grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below.

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TOPIC OF THE MONTH

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How Do Restricted Stock Units Work?

Restricted stock units (RSUs)—a contractual right to receive company shares or an equivalent cash payment at some point in the future—are an increasingly popular form of equity award offered by companies of all shapes and sizes. Companies are shifting to RSUs because they are administratively convenient, are easy for employees to understand, and can be structured in a way that helps attract and retain key employees and drive performance.

Given this growing trend, let’s take a closer look at what RSUs are and how they can work for employees.
 

You’ve been granted RSUs: Now what?

If you’ve been granted RSUs, congratulations! You have likely been given this equity award because you are valued, and your employer wants you to stay with the company and meet certain performance benchmarks. But it’s important to understand that your employer has merely promised to deliver shares (or an equivalent cash payment) to you at a future date. As such, RSUs can be thought of as a form of deferred compensation.

You do not owe any tax at the time of the RSU grant. In fact, you will not owe tax until you actually receive the shares. RSUs typically come with a vesting schedule, and there may be performance conditions that must be satisfied before the stock can be delivered. Unlike a stock option, your RSU has intrinsic value; whether the value of the company increases or decreases after the grant, the stock will have value and can never be “out of the money.”
 

What happens when RSUs vest?

Once RSUs vest, they will be delivered to you and you will recognize ordinary income based on the fair market value of the stock at the time of delivery. Unlike with stock options, no analysis regarding when to exercise is needed. In most cases, the employer will withhold shares in order to cover the tax, delivering the net shares to you. You may have additional options for withholding, you may be able to elect to receive cash instead of stock, or you may be able to defer the delivery of the shares beyond the vesting date. Be sure to check your plan document to ensure that you understand all of your options.

Once you own the employer stock, you are free to hold it or sell it immediately. Your cost basis in the shares is the fair market value on the date they were delivered. So, if you sell the shares immediately, there will be no additional taxable gain. But if you choose to hold the shares and sell them down the road? You would pay capital gains tax on any gains earned since you acquired the shares; if the shares decrease in value, you would have a capital loss that you can use to offset other capital gains.
 

Planning questions you should be asking
Should I hold or sell? It may help to think of RSUs as a cash bonus paid to you in the form of company stock. Because you pay the tax upon delivery, there’s no holding period to worry about. You’re free to sell the shares immediately and do whatever you’d like with the cash, similar to a cash bonus. If you wouldn’t take a cash bonus and purchase shares of your company with it, you probably should sell the stock and save or invest the proceeds. If you believe the company is a great long-term investment, however, you may prefer to hold the stock.
 

What happens if I leave the company? Generally, any unvested RSUs would be lost if you were to leave the company. If you’re considering taking a new job but have a number of RSUs about to vest, for example, you may want to consider sticking it out a little longer. After all, RSUs are designed to help retain employees!
 

What if I’m planning to retire? Employers tend to treat retirement more favorably than leaving to work for another company. Still, how your RSUs will be treated depends on the employer and whether you’re retiring “early” or at an age that would be considered “normal.” Your employer may allow vesting to continue after retirement, or the employer may accelerate your vesting. Be sure to check your plan document to understand how your unvested RSUs will be treated upon your retirement.
 

What’s the risk? Many employers grant RSUs to employees annually. This means that after a few years, RSUs will start vesting and you’ll start receiving (potentially large) quantities of shares annually. Depending on your other investments and employee benefits, employer stock could represent a sizable portion of your net worth—exposing you to significant risk if the company were to face a sudden downturn. In this case, you may want to consider selling shares and reinvesting the proceeds in a diversified portfolio.
 

Will I be pushed into a higher tax bracket? It’s possible that the taxable income from your RSUs’ vesting will push you into another tax bracket. If so, there may be other sources of income whose timing you can shift to work around your RSU vesting schedule. Or, if your employer allows your RSUs to be deferred beyond the vesting date, it may be possible to defer the tax recognition of the RSU to a more opportune time.
 

A valuable benefit
RSUs can be a valuable piece of an employee benefits package, especially when they are incorporated into a large financial plan. Be sure your advisor and tax professional know about any RSUs you’ve been granted—and when they will vest—so that they can help you plan accordingly.

© 2018 Commonwealth Financial Network®