Following 2017’s remarkably smooth ride up, 2018’s tumultuous market action has investors once again on edge and reaching for a bottle of Dramamine. The market’s impressive start to the year suggested an encore performance might be in store as major equity averages sprinted to fresh all-time highs. However, by the end of January, investor sentiment soured, and Mr. Market served up a reminder that there is no free lunch in the world of investing.
The turbulence started with reports of elevated wage growth. Investors extrapolated this data to mean that the tight labor market was stoking an inflationary flare up. Higher inflation could force the Fed to raise rates on a faster pace which would pose a threat to stock prices. This development led to first official 10% correction since the summer of 2016; thereby ending the longest stretch on record without as much as a 5% market pullback.
Markets bounced back quickly, but then ran into more trouble as Trump ignited fears of a global trade war by imposing tariffs on washing machines, steel, and aluminum. To add fuel to the market turmoil, Facebook and other new media companies took a direct hit following news that Facebook allowed unauthorized use of users’ personal information. The soaring technology sector has provided market leadership for the bull market over the last few years. After all the ups and downs, the S&P 500 only finished down approximately 1% (including dividends) for the quarter, marking the first quarterly loss since the 3rd quarter of 2015. Bonds fared slightly worse with a 1.5% loss in the quarter as interest rates rose, putting pressure on prices.
Whereas last year the stock market shrugged off negative headlines, this year’s market has proven more vulnerable. The market’s newfound sensitivity is likely the result of elevated stock valuations against the backdrop of a less accommodative Federal Reserve. It would not be surprising if volatility remained high for a while as corporate earnings catch up to extended stock valuations.
Despite the renewed volatility, strong underlying profit growth, and the continuation of the global expansion will likely keep this bull market from turning into a near term bear. However, investors will need to readjust to the more volatile environment for both stocks and bonds. Maintaining diversification across investing styles, geography, and asset classes is warranted in this environment. In addition, incorporating some lower volatility strategies into the equity allocation and holding some cash can help provide a smoother ride until the market works through the current rough patch.
Inflation Still in Check
The first quarter’s volatility was triggered by the perception that higher labor inflation would lead to a broad-based uptick in core inflation. The economic data, however, is still showing otherwise. As you can see from the Personal Consumption Expenditures (PCE) chart below, core inflation (excluding more volatile food and energy prices) remains below the Fed’s 2% target. While headline inflation did tick up over 2% on an annualized basis toward the end of 2017 as a result of higher energy prices, it has since trailed back down.
Higher inflation that typically accompanies a low unemployment rate and late-stage economic cycle remains elusive. Even so, the Fed has been moving ahead with its slow and steady interest rate hiking campaign to make sure they do not fall too far behind should inflation expectations materialize. The Fed is also mindful that aggressively raising rates could snuff out the expansion. Over the last year, the Fed has raised rates from 0% to its current level of 1.5% through a gradual series of 0.25% increases. The Fed is widely expected to hike rates 0.25% at least two more times in 2018.
The chart below compares the current U.S. Treasury bond yield curve to what it looked like a year ago. What’s notable is that while the Fed has been increasing short term rates, longer term interest rates (which are determined market forces) have largely remained anchored around 3% given the subdued inflation readings. This has resulted in a flatter, yet still upward sloping yield curve.
The slope of the yield curve is closely watched by the markets and the Fed since a flattening or inversion of the curve (where short term rates exceed long term rates) tends to signal weak future economic activity and the onset of a recession. Unless, inflation starts perking up and pushing longer term interest rates higher, the Fed will be hesitant to raise short term rates much further for fear of inducing the next recession.
Corrections Come, Corrections Go
It is evident that the market is currently undergoing a corrective phase that began the end of January. The chart below shows that the market has experienced several such corrections of varying degrees since the financial crisis ended and the current expansion began in 2009. While frustrating to watch accounts lose value, corrections are a normal part of a functioning market. Corrective phases vary in duration but can last anywhere from a couple of months to over a year. Once a correction runs its course, the market typically resumes its upward trajectory unless the economy goes into a recession and a bear market ensues.
Earnings to the Rescue?
While there are no guarantees the current correction will not morph into a deeper bear market, it is likely the current bull market is not quite done just yet given the strong earnings outlook, fiscal stimulus in the form of tax cuts, and the global economy showing solid signs of growth.
Operating earnings for S&P 500 companies are currently forecast to grow by a whopping 24% on a year-over-year basis with corporations benefitting from both a lower corporate tax rate as well as top line revenue growth associated with a healthy job market and expanding global economy.
At the start of the year, the S&P 500 traded at a historically lofty p/e multiple of 22x trailing earnings as investors drove up equity values on the heels of corporate tax reform. As earnings grow and the market stays range bound, the valuation levels are getting more reasonable. Should earnings play out as expected and the market hovers around current levels, the S&P 500 will be trading at a more attractive 17x trailing earnings by the end of the year.
The tug of war between growing earnings and a less accommodative Fed Reserve will continue to play out until the next recession takes hold, which will likely result from the Fed pushing too hard on the brakes as in prior economic downturns. Investors should continue to stick with their targeted exposure to stocks but incorporate exposure to non U.S. developed and emerging markets that are earlier in their respective economic business cycles.
Furthermore, while growth continued to beat value stocks in the first quarter, there are signs that a swing in value’s direction is underway. Value stocks, which tend to do well when the Fed is raising rates, should regain relative ground at some point particularly given the emphasis on the financial and energy sectors which tend to do well late in economic cycles.
REITs, which got hit hard in the first quarter on fears of rising rates, is an area that investors might wade into for income and appreciation potential given more attractive valuations and an excellent long term return profile. Furthermore, the new tax law provides non-corporate REIT holders with a 20% deduction on pass-through income, making REIT income even more attractive and competitive with dividends on common stocks or interest income on bonds on an after-tax basis. Finally, given the modestly higher interest rates, cash can help cushion the portfolio against volatility while providing modest returns in this environment.