Despite an unusually strong start to 2018, the market gave back most of the gains by quarter-end. We experienced more volatility in the past few months than we have seen in the last eleven years although volatility of this magnitude is not unusual if we look back at the past market history. We have had many 1 to 2% daily declines over the last 100 years. As we have said before, a 1% decline today moves the market 270 points, whereas a 1% decline forty years ago represented a 10 point move of the market. So we should not be overly concerned with the latest volatility.
Some of the recent concerns clients have asked about are rising interest rates, government debt, trade wars, inflation, and North Korea.
Rising interest rates – We believe rising interest rates from these low levels should not present a major problem for corporations. Remember, the interest paid to bondholders will go back into the economy as buying power. Additionally, corporations have been able to function with rates more than double the present rates. The market can still advance even if ten-year Treasury rates get up to 3.5% or 4%.
Government debt – While the government debt is increasing as a percentage of GDP it is not way out of line. In the past when the debt hit $2 trillion, $4 trillion, $6 trillion and $10 trillion, we heard the same outcries as we are hearing today. It is true that interest on the debt keeps increasing but most of those interest payments are recycled into the economy. We do not believe government debt at present levels is a major problem.
Trade wars – Although trade wars could be a real threat, they are a negotiating tool of the administration to avoid using sanctions. Because tariffs negatively impact all parties involved they are generally a tool of last resort.
Inflation – Wage inflation is the major component of overall inflation. While wages in the lower income level are increasing, they do not present an immediate threat.
North Korea – Hostilities between the U.S. and North Korea are subsiding slightly and the possibility of a favorable outcome is positive for the market.
Overall, we foresee sideways movements for the stock market within a 10% to 15% band, with expectations of middle to high single digit returns for 2018. The economy is remaining strong and picking up steam. An economic and market downturn, other than a correction, seems to be a low probability in the near term.
The trading year of 2018 started out in spectacular fashion. The market soared 7% within the first month, adding to 2017’s return in the most remarkable way. Advances for the major market indexes in January were the largest since 1997, but after the 15 month long stretch of uninterrupted market gains investors were forced to rediscover the pain of volatility. The advances of the first month of the quarter were followed by the first 10% market correction since early 2016 and, despite a subsequent 8% rebound, the equity markets ended the first three months of the year with small losses. Growth stocks, generally known to be technology heavy, outperformed their value counterparts by 4 to 5%, while small and mid-cap positions ended the quarter virtually flat. Cyclical stocks outpaced the defensive ones by almost 10%, with Technology and Consumer Discretionary posting low single-digit returns. The remaining sectors of our domestic economy ended the quarter with declines.
International equities also posted losses, shedding a little more than 5%, despite the falling U.S. dollar, which in the past has been a significant tailwind for domestic holders of international investments.
The fixed income markets excited investors over the past few months. Interest rates were a constant topic of conversation as they continued to increase at a steady, albeit slow, pace in accordance with the Federal Reserve’s intention to support the economic growth. Slightly higher rates put pressure on the price of bonds, with the Barclays Aggregate Bond Index falling 1.5% for the first quarter. High-yield bonds fared better in light of their connection to a steadily improving economy.
Our domestic economy did not show signs of slowing down, and hiring actually strengthened during the first quarter. Both consumer confidence and business confidence remained at levels not seen since the dot-com boom. Corporate spending continued to grow, and U.S. manufacturing did extremely well due to strong growth abroad accompanied by a relatively cheap dollar. In fact, the growth of GDP at the end of last year was reported higher than expected. The Federal Reserve raised interest rates with the clear expectation that the economy was healthy, and likely to show sustained improvement. The recovery cycle in the U.S. is continuing, but against a backdrop of substantial policy shifts. The Tax Cuts and Jobs Act of 2017 is in full effect this year. Employment remains strong, with the employment-to-population ratio improving gradually and more people rejoining the workforce. Real wages are growing nicely, thanks to modest inflation. All these factors should position the American consumer sector to remain vibrant. We have not yet observed the strong effects of tax reform on capital spending, but expanded government spending limits should provide momentum through the remainder of this year and into 2019. Real gross domestic product (GDP) growth is shaping up to be soft in the first quarter, but some of this weakness represents expected seasonality; we expect three strong quarters of growth to follow.
As we move deeper into the year, we are most likely to see a contest between the positive and negative forces across global markets and economies. U.S. tax cuts, global growth and strong earnings are likely to push stocks higher. Rate hikes, rising inflation and current geopolitical events may negatively affect the market. For now, we believe, the cycle positives are stronger, and may gain even more strength if the first quarter’s earnings prove to be solid. The previous year provided investors with high quality returns across all asset classes and low volatility. With this environment changing over the last couple of months, it will be no surprise if markets will once again engage in a tug of war while debating their future direction. But just as the absence of volatility during the past year should not have given rise to expectation that risk is not a reality, the current swings in equity prices should not sway investors from their overall goals and objectives, and, above all, should not alter long term decisions.
Dumont & Blake Investment Advisors, LLC
March 31, 2018