Headwinds and Tailwinds Collide, Roiling Markets

Though the U.S. economy remained on firm ground in the first quarter of the year, growing by an estimated 2.8%, the new year has started with markets behaving very differently than in the recent past. In the last couple of years, markets have been characterized by steady, positive returns accompanied by below-average volatility. The first quarter of 2018 broke both of these trends. U.S. stocks, as measured by the S&P 500 Index, declined by 1.2% in the period, the first quarterly loss in two years. Bonds also suffered as the yield on the U.S. 10-year Treasury note climbed from 2.46% on January 1 to 2.74% by the end of the quarter as investors reacted to a 0.25% rate hike by the Federal Reserve in March. (Bond prices decline as yields increase.) Today, as I write this note on April 24th, the 10-year Treasury closed above a 3.0% yield for the first time since January 2014.

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Headwinds: Inflation, Trade Fears

The significant volatility seen in both equity and bond markets in the quarter emanated from two sources: an inflation scare and growing concern over a potential trade war with China.

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The Federal Reserve and investors alike are on a keen lookout for signs of inflation. If economic data shows that inflation is heating up at an unexpectedly rapid rate, the Fed would likely be compelled to move up its time table for increasing interest rates. Rapid rate increases would cause a decline in bond prices (especially long-term bonds) as well as pressure so-called “bond-substitutes” that are, in fact, equities but are often seen as stand-ins for bonds because they offer high dividend yields. Utility, telecom and real estate stocks fall into this category.

On January 26th, the Department of Labor reported that wages had increased by 2.9% over the previous year. This higher-than-expected number rattled investors and made January 26 the high-water mark for stocks in the quarter. (Wage growth is often a sign of impending inflation, as it reflects a tight labor market.) Investors’ swift reaction to this number took the equity market down by about 10% over the next couple of weeks. Stocks found their footing in early February and began to retrace their recent losses until talk of tariffs and trade wars undermined their returning confidence in the waning weeks of the quarter.

Tailwinds: Strong Earnings, Tax Cuts

While investors are wringing their hands over inflation and trade war fears, they are also in for a deluge of robust corporate earnings, by far the most important tailwind for equities in 2018. Analysts are expecting earnings to come in 17%-18% higher in the first quarter of 2018 than in the year ago period, a rate of growth much higher than normal. Investors are now penciling in earnings growth of approximately 15%-17% for all of 2018 and a further 9%-10% in 2019. With S&P profit margins currently sitting near at 10-year high of 11%, expected sales growth of 7% and a big tax cut to boot, U.S. companies have not often operated under more favorable conditions.

What could upset this bright outlook?

While the two-year outlook for corporate profit growth has rarely been better, investors seem to be wondering if the peak of economic and profit growth is coming into view. After a long but slow period of growth from the depths of the 2008-09 recession, investors are questioning if the Fed’s concerted action to tighten monetary policy will put an end to our much longer-than-normal expansion. They are also wondering if, as the economy continues to grow, the twin pressures of higher commodity prices and increasing labor costs will put a dent in corporate margins.

Investors should be careful not to overact during occasional bouts of volatility, which are normal and relatively frequent occurrences in all functioning markets. In fact, investors with longer time horizons will be particularly well served over their investing lifetimes if they learn to put money to work when traders are nervous and prices are down. Dimensional Fund Advisors recently did a study that showed that for the U.S. stock market since 1979, the average intra-year decline was about 14%, but that overall returns were positive in 33 out of 39 calendar years.

Please don’t hesitate to get in touch with me if you would like to discuss your portfolio or the markets.

 

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