For the first few weeks of 2018, equity markets echoed the same trend we saw in 2017: steadily marching higher in the face of both good and bad economic/political news. Beginning in early February, markets began to behave differently with dramatically higher volatility. There have been many reasons discussed by financial pundits for why this change occurred, with the most likely culprits being the Fed’s tightening monetary policy (to contain inflation), Washington trade policy negotiations via tariffs and the leadership of large cap Technology companies potentially coming to an end. While this volatility may somehow feel “different” and certainly uncomfortable, our view is this reflects a more “normal” risk market and is most likely a trend that will persist. The good news is that the economy is still showing signs of strength, earnings are expected to continue double-digit growth for 2018, and market valuation multiples have dropped to reasonable levels given relatively low interest rates and above trend growth in GDP.
Despite the resurgence of volatility, the overall U.S. economy is powering ahead. For the first three months of 2018 the economy generated over 600,000 new jobs, as measured by the nonfarm payroll. This lowered the unemployment rate to 4.1%, the lowest since early 2000. With no indication that this trend is abating, we believe economic growth will surprise to the upside; notwithstanding a shock such as a prolonged trade war (more on that later) or tightening monetary policy.
The chart above shows the steady decline of the unemployment rate since the last recession, obviously a sign of a strong economy. The troubling trend has been slow wage growth during this period; the last reading in February came in at 2.5% annual growth, versus the long run average of 4.2%. This is the sticking point for the Federal Reserve in their pursuit of managing a steady inflation rate while maintaining full employment. Inflation has had a hard time achieving the 2% target rate with wage growth weaker than in previous economic recoveries. If the Fed raises rates too aggressively, further wage growth will be in jeopardy absent a sudden unexpected jump in productivity. The preferred measure of inflation at the Fed is the Core PCE deflator; the chart below shows the last reading at 1.6%. We are hopeful the labor market tightens enough to justify higher wages allowing the inflation rate to reach an acceptable level, giving the Federal Reserve a reason to take a slower approach to raising rates.
One topic we have not had the pleasure of discussing in recent memory is the concept of trade deficits and tariffs. While we will not spill a lot of ink in this area, a few comments are warranted since this seems to be the fuel for recent market volatility. The current Administration believes in a fair-trade system and against large trade deficits with any given country, primarily China. Everyone must acknowledge many of our trade partners charge tariffs on U.S. goods which are not reciprocated on our end. History has shown that a prolonged trade war (what transpired with protectionist policies during the Great Depression being a good example) can result in all parties losing. Our impression of recent Administration moves to even out the playing field is more posturing (i.e. a negotiating tactic) than a start of a multi-faceted, drawn-out trade war. The stock market has moved several percentage points in both directions as it attempts to price in the current headline. We believe calmer heads will prevail, avoiding a mutually destructive scenario, and the market will likely come to accept the new negotiating tactics over time. Some evidence of this belief can already be seen by the tariff exemptions for many trading partners. We do acknowledge the markets’ adjustment to sensitive economic policies may take time, and will likely create buying opportunities along the way.
The Federal Reserve did raise short term rates by 0.25% in the March policy meeting. They also signaled between 2 and 3 additional hikes during 2018, depending on economic data. Since that meeting, several Fed Governors have indicated the tariff discussion may introduce enough uncertainty to slow the current tightening cycle in a “wait and see” approach. Nevertheless, the chart below shows that Financial conditions are beginning to react to the rate hikes occurring thus far. A positive value indicates financial conditions are tighter than average, while negative values indicate conditions are looser than average. The March reading came in a -0.74, however the trend appears to be adhering to the Fed’s goal of withdrawing monetary stimulus. Our view is if this level of market volatility continues, inflation stays marginally below target, and conditions stay on this trend, we may well see only 1-2 hikes throughout 2018 versus the 3 hikes some governors signaled.
On a positive note, consumer confidence is still well above average, as one would expect with a historically low unemployment rate coupled with a tax cut bill. With consumption comprising up to 70% of our GDP, this bodes well for future economic growth assuming an over-aggressive Fed or hawkish trade policy does not interfere. Not coincidentally, the March consumer sentiment reading of 101.4 is the highest since 2000, the same year as we last saw a comparable unemployment rate:
For the first quarter of 2018, the S&P 500 posted a negative 0.8% total return. U.S. Equity markets experienced their first quarterly loss since Q3 2015. After a lengthy period of low market volatility, Q1 saw a return of volatility, with the S&P 500 suffering 11 days of declines of 1.0% or more during the quarter. Equity markets started off strong in January, but finished the quarter about 8.0% below January peak levels.
For the first quarter, only two of the eleven economic sectors in the S&P 500 posted positive results. The Technology sector was the best performing sector during Q1 (up 3.5%), with the Consumer Discretionary sector finishing in a close second (up 3.1%). Growth continued its outperformance over Value with the Russell 1000 Growth index (up 1.4%) outperforming the Russell 1000 Value index (down 2.8%) during the quarter.
The two sectors that were hit the hardest in Q1 were the Telecommunications sector (down 7.5%) and the Consumer Staples sector (down 7.1%). These sectors, along with other “bond proxy” sectors, were hit by rising interest rates. Sectors that carry higher dividend yields often look less attractive to investors when bond yields are rising.
The chart below shows the price-only returns of the three major U.S. equity indices, along with the price volatility experienced during the quarter. Early on in Q1, investors were concerned about inflation and the impact of rising interest rates on equity valuations. Those concerns were replaced later in in the quarter by both trade war concerns from new tariff announcements, and data privacy concerns from social media and potential regulatory actions across the tech/media space.
Although volatility has returned from its hibernation, some level of volatility is normal, and equity markets are now looking more attractive from a valuation standpoint. With the assistance from the TCJA (Tax Cuts & Jobs Act) and the lowering of the U.S. corporate tax rate, S&P 500 earnings are expected to grow 18% this year, and another 10% in 2019. According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is 16.1x, which is now in-line with the 5-year average and well off the recent peak (of 18.4x). Any constructive news from the upcoming Q1 earnings season could help to alleviate some of the market concerns that have added to the recent volatility.
U.S. Bond markets were off in the first quarter, falling a little over 1% as measured by the Barclays Intermediate Government/Credit Index (GVI). Rates rose across the board, with longer dated bonds suffering more than the short end, and lower rated bonds underperforming the higher rated sector. The 1-3 year sector was off a modest 0.20% versus the 10+ year sector falling 3.57%. The AAA sector of the market was down 1.17% versus the BBB sector down 2.15%.
These negative returns are consistent with pricing in a continued tightening monetary policy from the Federal Reserve, along with rising inflation expectations. While the 5-year Forward Inflation expectations (as seen below) appear to be moderating, the trend is still moving higher which gives the Fed an argument that long term expectations warrant additional hikes.
One notable trend change that has occurred is that the “risk-off” trade we have seen over many years does not appear to be helping bonds so far this year. In many cases when there has been an economic/market shock, stocks would fall and bond prices would benefit as the “flight to safety” trade would invariably take place. We believe that this lack of correlation may be due to the nature of the shock, primarily tariff discussions. Many of our trading partners, including China, are major holders of the U.S. Treasury market. Any destabilization in these relationships could manifest itself in a buyers’ strike in our bond market, at a time when we are projected to run somewhere around a $1 Trillion deficit. Another argument can be made that tariffs necessarily raise prices, which would directly impact bond prices through inflation. Our view is that the bond market will ebb and flow until the market has clarity on the Fed’s future actions and the tariff discussion fades. The good news is that we are now able to invest at the highest level of yield in nearly 10 years, as we are seeing value in the 4-5 year sector in the 2.75 to 3.25% level.
The Municipal market faired a little better than the taxable sector, falling 0.9% during the period. The passage of the tax bill in late 2017, and the fear it would curtail tax-free issuance, pulled a lot of new issue offerings into the end of last year, materially lowering available supply to start 2018. Demand remains high, and investors need to be in a fairly high marginal bracket for this sector to make sense. In some cases bonds are trading at sub-70% of the taxable Treasury equivalent. We are finding value in the 4-5 sector of the market at the 2%+ level, and maintaining an intermediate duration.
As we said last quarter, sentiment can change suddenly – and it has. Fundamentals continue to be strong though and we are not overly concerned about a prolonged trade war and the Fed continues to unfold a well telegraphed plan for higher rates. We are monitoring the issues enumerated above closely and while we acknowledge the spike in volatility, we are still convinced the big picture looks good.