First Quarter 2018 Market and Economic Review
After an historic advance, U.S. equity investors recently witnessed their first stock market correction since 2015.
Since November 2016, U.S. equity markets have marched steadily higher. And in January, stocks rose sharply. At the equity market’s January 26th peak, the three main U.S. stock indices had risen between 7.5 percent and 8.7 percent in less than a month.
One likely driver of the rise was enthusiasm around the government’s fiscal policy becoming more supportive of capital expenditures and business investment. The idea is that strong business spending would support key economic drivers like wage growth and consumer spending. Another driver was increasingly strong business fundamentals, such as earnings growth, which surged throughout 2017. Looking at the price-to-earnings ratio (which measures how expensive stocks are relative to company earnings), stock prices reached above average levels but never reached valuations that would historically be considered over-valued.
On January 26th, however, investors re-discovered that equities could go down as U.S. markets peaked and started to decrease into market correction territory in February.
Market corrections are defined as a decrease in value of more than 10 percent from a 52-week high, but less than 20 percent down – the point at which a bear market begins. Over the last 30 years, the S&P 500 index has seen a market correction occur about once per year. With such strong equity growth over a 15-month period, it is not surprising that we’re seeing one in 2018. Corrections are a normal part of a healthy market cycle and, while unsettling, are necessary for future growth. They also provide value opportunities for those looking to invest at a discount.
There are multiple explanations for this year’s correction. Higher than expected U.S. wage growth in January increased concerns about inflation. And some investors fear that multiple interest rate hikes by the Federal Reserve could stunt economic growth. The threat of trade wars as a response to U.S. tariffs has also played a role in the recent downturn.
Global equity markets had a similarly strong start to 2018, but also experienced a correction in the first quarter. Threats of a trade war between China and the U.S. and geopolitical risk with respect to Iran and North Korea are likely drivers. Overall, earnings are trending upwards internationally. Also, international stocks have cheaper valuations than U.S. stocks when looking at the price-to-earnings ratio. With good growth and lower price valuations than the U.S., investment exposure to international stocks is a good strategy over the next year.
On the fixed income side, bond markets continue to be under pressure as interest rates rise. Moderate GDP growth and rising inflation usually lead to higher interest rates, which puts pressure on returns. Ten-year Treasury yields increased to a four-year high of 2.94 percent in February, a 20 percent increase year-to-date. However, yields remain well below historical levels.
The best way to limit risk from rising rates is to move to shorter-term bonds, which keeps investors from locking in lower yields. This is a strategy we have utilized as rates have risen. Bonds remain an important element of a well-balanced portfolio, providing valuable protection and a counter to stock market volatility.
The benchmarks, listed in the table below, are the same benchmarks as those in the Risk/Return and Account Analytics sections of client quarterly performance reports. By comparing your portfolio’s return to the benchmark with the closest risk/return characteristics, you get a more accurate reading of portfolio performance than using a less diversified benchmark, such as the S&P 500 index.
* Each benchmark is allocated based on assumed Risk Profile of underlying indices.
**Benchmarks include a mixture of ICE BofAML US 3-month Treasury Bill Index, Barclays Global Aggregate Bond Index, Barclays US Aggregate Bond Index, MSCI EAFE Index, and the Value Line Composite Stock Index (Geometric).
At the March meeting of the Federal Reserve Board of Governors, the decision was made to raise interest rates by 0.25 percent, up to a range between 1.5 percent and 1.75 percent. The Board still predicts they will raise interest rates by 0.25 percent three times this year, though the projection could change if the U.S. economy experiences much higher inflation.
Earlier in the year, a surprising 2.9 percent jump in U.S. wages increased concerns about inflation and the likelihood of more aggressive tightening by the Federal Reserve. While the Fed noted that inflation drivers have increased in recent months, their short- and longer-term inflation expectations remain low as they target inflation to increase and then stabilize near their 2 percent inflation target. This means higher prices for goods and services for American consumers. That being said, 2 percent inflation is fairly modest compared to previous inflationary periods and is within the 2-3 percent range that we would consider healthy.
The Fed also raised their forecast for GDP growth for 2018-2019, stating, “the economic outlook has strengthened in recent months.” For 2019, their forecast for GDP growth increased from 2.1 percent to 2.5 percent, almost a 20 percent increase. This is encouraging, as it’s hard to envision a solution to our government’s budget deficit and total overall debt without higher GDP growth than we have been seeing.
As of now, the markets are in a wait-and-see period that looks much different than last year’s gradually increasing, low volatility market environment. Investors are waiting to determine whether the nine-year bull market is in the midst of a correction or whether we are entering into a bear market cycle, defined as a decrease in stock prices from 52-week highs of 20 percent or more.
As the market goes through its cycles, it’s important to understand what the sequel for each stage will be and how to look for opportunities in each cycle. Lowering the duration of bond holdings, increasing exposure to international equities, and taking advantage of buying opportunities that present themselves in a correction or bear market are a few strategies that we are considering early in 2018.